Here are the words you need to know to navigate this chapter and talk the talk:
Capitalization rate: Your capitalization rate is your net operating income divided by the sales price. Also known as the cap rate, it’s the measure of profitability of an investment. Cap rates tell you how much you’d make on an investment if you paid all cash for it; financing and taxation aren’t included:Cap rate = net operating income ÷ sales price
Cash flow: Your annual cash flow is net operating income minus debt service. You also can figure monthly cash flow by dividing your annual cash flow by 12:Annual cash flow = net operating income – debt serviceMonthly cash flow = annual cash flow ÷ 12
Cash-on-cash return: To find your cash-on-cash return, divide your annual cash flow by the down payment amount:Cash-on-cash return = annual cash flow ÷ down payment
Debt service: Debt service is calculated by multiplying your monthly mortgage amount by 12 months:Debt service = monthly mortgage amount × 12
Effective gross income: You can find your effective gross income by subtracting vacancy from gross income:Effective gross income = income – (vacancy rate % × income)
Gross income: Gross income is all of your income, including rents, laundry, or vending machine income, and late fees. It can be monthly or annual.
Net operating income (NOI): Your net operating income is your effective gross income minus operating expenses:Net operating income = effective gross income – operating expenses
Mix: When a commercial investor says “What’s the mix?,” they’re asking how many studios, one-bedroom, or two-bedroom units the property has.
Operating expenses: Your annual operating expenses for the property typically include taxes, insurance, utilities, management fees, payroll, landscaping, maintenance, supplies, and repairs. This category doesn’t include mortgage payments or interest expense.
Vacancy: A vacancy is any unit that’s left unoccupied and isn’t producing income. Remember: A unit that’s vacated and re-rented in the same month isn’t considered a vacancy; it’s considered a turnover.
Vacancy rate: Your vacancy rate is the number of vacancies divided by the number of units:Vacancy rate = number of vacancies ÷ number of units
THE TECHNICAL MEANING BEHIND THE NUMBERS
Cap rate, cash flow, cash-on-cash return, and net operating income are investment terms that we explore in this chapter, but what do they really mean to you as an investor? Here’s the in-depth explanation:
Capitalization rate: A cap rate is used as a measure of a property’s performance without considering the mortgage financing. If you paid all cash for the investment, how much money would it make? What’s the return on your cash outlay? Cap rate is a standard used industrywide, and it’s used many different ways. For example, a high cap rate usually typifies a higher risk investment and a low sales price. High cap rate investments typically are found in low-income regions. A low cap rate usually typifies a Iower risk investment and a high sales price. Low cap rates typically are found in middle-class to upper income regions. Therefore, neighborhoods within cities have their assigned cap rates “stamped” on them.That said, if you know what the NOI is, and you know the given cap rate, you can estimate what the sales price should be: sales price = NOI ÷ cap rate. For example, if the NOI is $57,230 and you want to make investments into 7 percent cap properties, the price you’ll offer will be $817,571 (57,230 ÷ 7 %). This is a good way to come up with your first offer price — at the very least, it’s a starting point.
Cash flow: Positive cash flow is king, and it’s one of your primary objectives in investing. Positive cash flow creates and maintains your investments’ momentum. When purchasing an apartment building containing more than five units (considered commercial), a bank’s basis for lending is the property’s cash-flow capabilities. Your credit score is a lower priority than the cash-flow potential. An apartment building with poor cash flow almost always will appraise much lower than its comparables for the area. Finally, positive cash flow keeps you sleeping at night when property values drop, because your bills and mortgage will still be paid.
Cash-on-cash return: This is the velocity of your money. In other words, how long does it take for your down payment to come back to you? If your down payment were $20,000, how soon would your monthly cash flow add up to $20,000? If your cash flow added up to $20,000 in one year, your cash-on-cash return would be 100 percent. If it takes two years, your cash-on-cash would be 50 percent. If it takes three years, it would be 33 percent.Commercial real estate investing can produce phenomenal returns. Cash-on-cash returns of more than 100 percent aren’t uncommon. Now, if you were to go to your local bank and deposit $20,000 into its most aggressive CD investment for one to three years, what type of cash-on-cash return could you expect? Maybe 1 percent or if you’re really lucky 4 percent? You need to put an emphasis on cash-on-cash return when you invest simply because you need to know how fast you and your investors can get the down payment back so everyone can invest it again — and again into future deals that you find.
Net operating income (NOI): This term is one of the most important ones when analyzing any deal. The net operating income is the dollar amount that’s left over after you collect all your income and pay out your operating expenses. This amount is what’s used to pay the mortgage. And what’s left after you pay the mortgage is what goes into your pocket — your cash flow.Always keep your eye on the NOI and look for ways to increase it by either raising rents or reducing expenses. As the NOI increases, so will the value of your property. In fact, if you’re in an 8 percent cap neighborhood, for every $100 that the NOI increases, your property value will increase by $1,250. Is that a good return for your efforts or what?You know that cap rate = NOI ÷ sales price, but you also can flip the calculation: sales price (or value) = NOI ÷ cap rate. Therefore, you can figure a new value by dividing your new NOI or increase of NOI by the going cap rate. So, $100 ÷ 8 percent = $1,250. Now, if you can increase your NOI by $20,000, your property value will have gone up by $250,000 ($20,000 ÷ 8 percent = $250,000).
The Commercial Property Evaluator
When you first hear the word analysis, you may freak out — especially if you aren’t a spreadsheet guru. We were intimidated by that word when we first started out, too. But through the years, we’ve come to look at property analysis more simply.
You got more than you bargained for when you picked up this book. You also get free access to a 5 Part Masterclass — How to Find, Analyze, and Make Offers on Commercial Properties That Get Accepted. We’ll also give you access to the Commercial Property Evaluator. You can let our tool do the math for you so you can quickly determine the value of commercial properties. The Evaluator helps to keep things simple and get new investors past “paralysis of analysis.” You can attend the Masterclass and get the Commercial Property Evaluator by going to CommercialQuickStart.com.
Why Seller’s Numbers Can’t Be Trusted
One of the biggest lessons to learn when you start looking at commercial properties to invest in is that sellers tend to under report their expenses. The reason for this is simple. If the expenses are lower, this increases the net operating income, which results in a higher property valuation.
In some situations a seller’s expenses are lower for a valid reason. For example, the owner may personally manage the property and do the maintenance and repairs themselves. In this case, although the owner might be providing “real” numbers, your costs to run the property would be higher assuming that you’re going to hire professional