investment properties, 101 determining value – how much return do you want from your investment?
This is the ‘cap rate’ — the capitalization that you make from the net income of an investment property… Put simply, the cap rate is the net operating income divided by the sales price or value of a property expressed as a percentage. Investors, lenders and appraisers use the cap rate to estimate the purchase price for different types of income producing properties. A market cap rate is determined by evaluating the financial data of similar properties which have recently sold in a specific market. It provides a more reliable estimate of value than a market Gross Rent Multiplier since the cap rate calculation utilizes more of a property’s financial detail.
The GRM calculation only considers a property’s selling price and gross rents. The Cap Rate calculation incorporates a property’s selling price, gross rents, non rental income, vacancy amount and operating expenses thus providing a more reliable estimate of value.
When evaluating a potential investment property you want to consider of course the location (is it a desirable place for renters?), its condition andwhether it’s up to the local city code guidelines (hardwired smoke & fire alarms can be quite expensive!), and the return on investment… the return also depends on how $$$ much you are putting down vs. mortgaging. Carefully consider the expenses (does owner pay for the heat, from one common furnace?) and estimates for maintenace and vacancies…
If you are able to obtain a market cap rate, you can then use this information to estimate what similar income properties should sell for. This will help you to gauge whether or not the asking price for a particular piece of property is priced well.
NOI NOI
Cap Rate = ——– Est. Value = ———–
Value Cap Rate
Example: A property has a NOI of $17,000 and the asking price is $145,000.
17,000
Cap Rate = ———- * 100 = 12
145,000
if cap rates in the area average about 12%, estimated market value is:
17,000
———- = 142,000
.12
Net operating income is determined by subtracting vacancy amount and operating expenses from a property’s gross income. Operating expenses include the following items: advertising, insurance, maintenance, property taxes, property management, repairs, supplies, utilities, etc. Operating expenses do not include the following items; Improvements such as a new roof, personal property such as a lawn mower, mortgage payments, income and capital gains taxes, loan origination fees, etc.
Vacancy Rate: Locally, Merchants Bank Commercial Lending division typically uses 7% for their vacancy rate in evaluating a property value.
If you have questions about commercial loans, try Kathy Yost with Merchants (610.253.5117) or Karen Miller with Karen Miller Mortgage Group (610.250.5920)
commercial loans: from a lender’s perspective, what is considered ‘commercial’ and what does it matter?
…this is an important question, since your mortgage loan terms are directly affected… for an investment property OVER 4 residential units, this is considered a commercial property. for a property that has a mix of residences and shop or commercial office space, this is a mixed use property and therefore you are again looking at a commercial loan.
Commercial loans have much stricter terms than conventional loans. in general you will need about 15-20% down $$$ on the commercial property (this can vary among banks – some require 25% and some may go as low as 10% down) and your interest rate will be % higher — prob. a couple points higher than the current conventional loan rates.
excellent investment property evaluation tools here, fyi: www.mortgage-investments.com
What is a ‘tax deferred real estate exchange’ and why should I care?
A 1031 tax exchange, or like-kind exchange where a taxpayer can sell his/her property and defer the federal capital gains tax, state tax and depreciation recapture taxes.
‘Like Kind’ is a little misleading; the next property ‘B’ you purchase with the proceeds from property ‘A’ could be any income property (not personal residence) in the USA – “for use in a trade or business or for investment.”
What’s so great about these? It’s an excellent way to defer paying capital gains on property sale gains, and you can snowball this into a nice big deferred-tax real estate fortune that goes to your heirs (which don’t need to pay capital gains on the value), or results in your goal-property of a multi-unit on the Jersey shore, or just a deferred tax paid on your capital gains at the end, when you do finally ‘cash-out’ (in this case you do need to pay what is called a ‘recapture’ for the deferred gains – however with inflation over the years the blow may not be as horrible as ‘real time’.
So, if A is a 3-unit in allentown – you can purchase B, a 7-unit motel in venice beach, FL or even a commercial fishing-boat, that will run deep-sea fishing trips. If the target property is less than the one sold, that money is called ‘BOOT’ and uncle sam will naturally come trotting in to collect his capital gain (15%) on that amount.
You need to identify up to 3 ‘target’ properties within 45 days of your property A sale (but you can still switch those down the road), and 180 days to settle on target-property ‘B’. A Qualified Intermediary “QI” facilitates the 1031 Exchange by preparing the necessary documents, and holding the sales proceeds in escrow, for a deferred exchange.
The Reverse Exchange is a variation on the typical deferred exchange. This is when a taxpayer acquires the new investment property prior to selling the old. This frequently occurs when a taxpayer constructs a new office building, for example, and is obligated to purchase the land and pay for construction costs to make it ready for occupancy prior to selling the old office building. A reverse exchange is somewhat more complicated than a deferred exchange, and involves different documentation, accounting, and especially lender concerns.
The law is very explicit in limiting the taxpayer’s rights to “receive, pledge, borrow, or otherwise obtain the benefits of” the sales proceeds from a 1031 Exchange. For this reason, the IRS prohibits a taxpayer from using his or her attorney, accountant, broker, or real estate agent as the qualified intermediary – you must use a qualified third party.
It sounds complicated but a good Realtor + QI team can help guide you through, and get you on your way to saving $$$ up lots of money in investment properties. A good book to learn more about 1031s is “Essentials of Real Estate Investments” by David Sirota.
