Okay… you have the “cap rate” and the asking price and you know what kind of annual return you want on your money but what offer do you need to make?

The problem with “cap rate” is it’s the rate that you would earn on your money if you bought the investment for cash. But, most of us are going to finance around 70% of the purchase price. So… if we wanted to earn 12% on our cash investment, how do we work out what our offer should be?

The way to work it out is to take into account the financing rate, the amortization term & ratio to value as well as the required “cash-on-cash” return required on the cash investment you’re making and it’s ratio to the purchase price.

Let’s look at an example:

A commercial investment is advertised for $1,250,000 with a NOI of $112,500. That equates to a “cap rate” of 9% – $112,500 / $1,250,000 => 9%.

But, you want a return of 12% so what should you pay? Easy enough, take the NOI / required return i.e. $112,500 / 12% => $937,500.00

So, if you had enough cash to pay for this deal in full we’d be done now.

BUT…. most investors don’t want to put down all cash. Most want to put down around 30% and finance the rest. And depending on your financial situation and the property in question, the financing you’ll be offered will have differing terms – some people or some properties (or a combination!) will qualify for 8%, some for 5% and some for 10%. Many factors are in play. So…. with the same 12% return required on your funds, what offer price should you make?!!

Don’t worry, there’s a very easy 4-step solution.

Firstly, let’s get some details on the financing:

- let’s assume we can get a 6.5% interest rate
- amortized over 20 years

1. Find the “Mortgage Constant”
To calculate a “mortgage constant” we divide the annual payment by the amount financed.
So, let’s say we are looking at $10,000 and, using the 6.5% interest rate & the 20-year amortization we calculate a monthly payment of $74.156. So, the annual payment would be $889.87.
So, the mortgage constant is:
=> annual payment / amount financed
=> $889.87 / $10,000
=> 0.08899

2. Identify the “Equity Constant”
This is the return you require on your investment funds.
So, in this case we want to earn at least 12% on our investment.
So, the “Equity Constant” is 0.12

3. Calculate a “Derived Cap Rate”
Now we need to work out a derived “cap rate” using our two constants and the ratio of each component in the whole investment:
=> (LTV x mortgage constant) + (ETV x equity constant) [LTV = Loan to Value; ETV = Equity to Value]
=> (70% x 0.08899) + (30% x 0.12) [The loan is for 70% and the cash deposit is 30%]
=> 0.06229 + 0.03600
=> 0.09829
=> 9.83%

This percentage, 9.83%, is now the “derived cap rate” that you can use to quickly calculate what your offer price needs to be to obtain the required return on the amount of money you’re investing! So, just one thing left to do….

4. Calculate Purchase Price!

To work out exactly what we should be paying, do the following:
=> NOI / derived cap rate
=> $112,500 / 9.83%
=> $1,144,456

At that purchase price, based on what we’ve been given as to the NOI of the investment and your cost and amount of financing, your “cash-on-cash” return will be 12%.

This calculation:
- is fairly quick and easy to calculate if you’re in a rush
- is a good starting point for further investigation
- does NOT take into account a final sale price (see “IRR“)
- does NOT take into account subsequent changes in NOI (see “IRR“)

Thanks for your time!

Lance Langenhoven
Commercial Real Estate Investment Specialist
Cell: 832-483 8655

This is definitely something worth knowing!

Firstly, what is “Cap Rate” – it stands for “Capitalization Rate”.

To arrive at the Cap Rate one does the following:
- tally up all the income a property produces for the owner
- tally up all the costs that would be the responsibility of the owner
- subtract the costs from the income and you are left with the NOI

What is “NOI”? – it stands for “Net Operating Income”.

If you divide the “NOI” by the Purchase Price, the ratio expressed as a percentage that you are left with is the “Cap Rate”.

A Cap Rate is similar to, for instance, the interest rate quote you receive from a bank on your savings account.

It is an extremely useful ratio. It is a very quick and easy way to compare different investments as it ignores financing i.e. the “cap rate” stays the same whether you pay all cash for a deal or whether you finance 90% of the deal.

But, it has it’s limitations as well. It is a “snapshot” on a particular day and does not take into account subsequent changes in income or costs.

So, a cap rate is a reasonable tool to use when looking at a NNN deal where the income is the same for maybe the next 10 years and all the expenses are the responsibility of the tenant.

However, when you are purchasing a multi-tenant strip center or shopping center or office building, the “cap rate” could be changing from month to month as tenants move in and out and as expenses fluctuate. A better financial tool in such an instance is the IRR.

What is “IRR”? – it stands for “Internal Rate of Return”.

The IRR takes into account estimated annual cash flows as well as expenses. So, if rents are increasing every year, the IRR captures that information. If expenses are projected to be increasing, the IRR captures that information. If the property kicks off cash and that cash is invested at a particular rate, the IRR can capture that information. If the property is sold at the end of the review period at a particular projected sales price, the IRR includes that final reversion of cash as well!

So… the IRR tells you what each dollar invested into a commercial investment is projected to earn over the investment period you are considering.

So, let’s compare the cap rate on a deal with the IRR to show the difference.

Deal Assumptions:
- $1,000,000 = Purchase Price
- 2% Acquisition costs as a % of the Purchase Price
- 7% Selling costs as a % of the Selling Price
- $100,000 = total annual income
- $10,000 = total annual costs
- $300,000 = cash deposit
- $700,000 = amount financed
- Loan: 20-year amortization, 10-year term, 5.5% interest rate
- 10 years: Expected holding period
- Selling Price is assumed at a 9% cap rate
- Contracted rents are increasing by 3% per year
- Expenses are assumed to be increasing by 2% per year

Okay. So, what can we figure out right away? Well… we have the total annual income and the total annual costs so we can work out the NOI. Right?
Yup… so, $100,000 less $10,000 is $90,000. So, the NOI is $90,000.

Also, we know that the NOI divided by the Purchase Price is the “cap rate”. Right?
Correct, so, $90,000 divided by $1,000,000 is 9%. So, the cap rate is 9%. Easy!

But… our rents are increasing by 3% each year… and we financed 70% of the deal. So, what is our return on our investment over the 10-year holding period?

This is not so easy to work out so, I’m going to give you the numbers!

In the image you can see the initial investment going out. It includes acquisition costs.
Then you can see the annual cash-flows coming in to you.
In the 10th year the property is sold and your initial investment and any additional equity that’s built up over time is returned to you.

The result? Well, in this case, with the assumptions we used, your before tax IRR is a healthy 18.71%!!!

This is just over double the 9% cap rate.

So, if you had made a decision based on the cap rate alone, you would have missed out on a great investment. Anybody that can earn around 18% on their money pre-tax is not doing too badly!!!

So, unless you’re buying single-tenant NNN deals with 10 to 15 years left on the lease terms, get somebody to help you analyze the investment in more detail to take into account the annual cash flows and work out the IRR. It could be worth a lot of money to you!

Contact: Lance Langenhoven
Commercial Real Estate Investment Specialist
Cell: 832-483 8655

I closed another great commercial investment deal for a client last week. Here’s the case study:

1. THE CLIENT

The client was a Mexican National that is now living in The Woodlands. A successful executive with commercial investments in Mexico but that wanted to find a good investment here in the US.

2. THE REQUIREMENT

The purchase price requirement was:
- anywhere from $700k to $1.5M USD.
- a cap rate of at least 10%
- willing to purchase locally or out-of-state for the right deal
- preferred single-tenant NNN deals but was willing to look at other options

3. THE HUNT

We analyzed numerous single-tenant NNN deals (many out-of-state) but each was disqualified for various reasons:
- town population too small
- population growth rate flat or negative!
- traffic count low
- crime rate high

Eventually we started looking at multi-tenant deals. Their leases are not quite as long as a single-tenant NNN deal but they provide other benefits i.e. it’s extremely unlikely that all tenants will vacate the property at the same time. If we had selected an out-of-state deal, we would both have flown to the property to complete our due diligence.

4. THE PROPERTY

Eventually we found a deal that looked promising. The asking price was just over $1.5M USD. The cap rate was 9.75%. It was a strip center with six tenants.
Upon further analysis I found:
- the town population was reasonable & expected to grow 7.5% in the next 5 years
- median age was 36, good sign, young people coming in.
- The average rent for the center was in line with the market & not way over market – a risky situation
- The leases were NNN which meant tenants paid for tax, insurance & maintenance
- The building was built in 2009 so it was still in very good condition
- The traffic count was very good
- The property was within a few 100 yards of a Walmart & right next to a CVS
- The crime rate was low, schools were good & locals confirmed
- The property was just over 2 hours drive away from The Woodlands

4. THE DEAL

We negotiated a purchase price that gave my client an 11% cap rate. This is an extremely good result as cap rates have been falling due to heavy demand from investors. An 11% cap rate basically means that that is the return an investment will generate if you paid cash for it. However, due to the fact that in this deal the investor was using some cheap financing (around 4.2% – I can show your investors how he managed to get this sort of rate) his “cash-on-cash” return was even higher.

We worked with a well-known local Law Firm to review the title commitments & the purchase contract. Our phase 1 inspection came back clean, our building inspection had no big red flags, just some minor maintenance items.

However, the seller had not completed concrete pathways at the rear of the building for 3 tenants so we negotiated an additional credit from the seller to allow us to complete that post-closing.

The day after the closing the new owner left for Mexico for a two-week vacation and I’m helping the new owner:
- transfer all utilities to the new holding entity
- transfer all service contracts to the new holding entity
- arranging for some immediate concrete repairs & some painting & possibly some striping of the parking lot

4. IN SUMMARY

The complete process from first meeting the client to closing the deal has taken about four months. But, the end result is that when the new owner returns from Mexico in a few weeks he will have a nice investment, completely stabilized, 100% leased out in a location where no red flags popped up during the due diligence process.

Contact: Lance Langenhoven
Commercial Real Estate Investment Specialist
Cell: 832-483 8655