To Become Wealthy: Cap Rate

I have discovered that the cap rate is useful when determining the value of a property. Cap rates differ with each area and type of property, but on average you want the cap rate to be between 10-12% for a good investment.

The cap rate is basically the ratio of the net operating income to the price of the property, expressed as a percentage.

CAP RATE= NOI/PRICE

Sounds simple enough, right? I believe it is. So basically the price that I would want to pay for a property should be no more than 10 times what I calculate for the net operating income.

In case you do not know, the Net Operating Income is calculated before any debt services or taxes are considered. It only takes into considerations the cost of operating the property.

Here is how it is calculated:
Goss Income from rents
- any vacancies (assumed at 3-5%)
- taxes
- insurance
- utilities
- property management
- repairs and maintenance
- supplies
= Net Operating Income

So, I am going to start considering this for every property that I investigate.

To Become Wealthy: A Better Property in Dallas

I have spent the last two weeks looking over one very good property. We are about to bid on it. I have gone over all sort of numbers and asked all sorts of questions and learned all sorts of info about it.

It is a 15 unit building that has had some work done to it over the past year to each unit. I am not-so-secretly proud of myself for finding it. Now I just hope that all of the details of the bidding process and purchase go thru.

Here are some numbers:
Gross Scheduled Income: $82,200
10% estimated vacancy : $8,220
(only one unit is currently vacant)
Insurance: $4,500
(based on current coverage)
Taxes : $6,630
(based on current year)
Utilities : $4,620
(elec for common areas, water/sewer, garbage)
10% for property manager: $8220
NET OPERATING INCOME: $50,010

The current asking price is $425,000. At that price, with 15% down and a 30yr fixed mortgage at 7.5%, we would pay $30,310.92 for the year, leaving us with approx $19,700 pre-tax profit for the year. We have no plan on bidding that much, but it is the amount that I use for my calculations.

Our wonderful realtor has sent me some background info on the property. The current owner bought the property in Sept. of 2005. He purchased it for $204,000. Since that time he has put in $66,000 to redo each unit. From what I can estimate, he did make some money off of rents collected thru the year. From the rent roll I can see that most of the units were vacant until they were redone. So vacancy has increased steadily throughout the course of the year.

I think $425,000 is a bit much to be expecting from this property, even though it is still a money maker at that price.

Here is what I am estimating his thought process to be for the money he might want to make off of this sale.
$204,000 initial purchase price
$10,000 in possible closing costs for initial purchase
$66,000 in improvements
$5-10,000 loss from vacancies
$5,000 loss due to bad property manager who can off with some money. (We heard this from the previous property management company.)

So that is a minimum of $295,000. Add in a generous $50,000 profit and we get almost $350,000. That is probably going to be what we will bid. I may even go as high as $375,000. There is also an offer from the seller for a credit to redo the outside stucco and siding.

So at the price of $375,000 and NOI $50,000, that cap rate is 13% which is pretty good. I do not yet know how to calculate the prevailing cap rate in the area, but it seems that most places use 10-12% as the average.

How does this deal sound? Much better than the last one, right?

To Become Wealthy: To Bid or Not To Bid

I have learned to break down the numbers to evaluate any given property from two books by the same author, Frank Gallinelli. The first one is called “What Every Real Estate Investor Needs to Know about Cash Flow.” This is the main one that I am using this week to decided to bid or not to bid on a quad-plex in Dallas, TX.

These are the numbers that are given on the MLS listing:
Asking price $174,900
Gross Rent $1975/mo or $23,700/yr
Taxes $2717
Insurance:$2200
Owner pays Water/Sewer/Trash:$175/mo or $2100/yr

These are estimates of other expenses that we will have:
Property Management: $1896/yr
Repairs and Maintenance: $1200/yr

This gives me a Net Operating Income of $13587.

I have not added in a vacancy rate because I have been told that all tenants are long term tenants. Of course I will verify this once I get the opportunity to see the leases.

So far the numbers look pretty good to me, until I calculate the mortgage costs. My knowledge of mortgages comes solely from the purchase of my primary residence last year.

First I looked at a 30yr fixed at 7.5% with 10% down payment and no PMI. (I am assuming that we can do an 80:10:10 piggy back loan.) In this case, my mortgage payment for the year would be $13.207.56.

This will only leave me with $380 pretax cash flow for the entire year. This is a whopping 2% return on our initial investment of the down payment.

Then I thought about an interest only loan at the same rate for the same amount. Then the payments for the year would be $11805.72.
This leaves me with $1781 pretax cash flow.

Now, I have done a lot more numbers with the mortgages, since that is the biggest expense by far for the whole property. If we put down 20% instead of 10% then we increase our yearly cash flow to $1847 and that increases our cash on cash return to 5%. This is the bare minimum cash-on-cash return that we want for our money. However, we do not want to put that much money into any one property unless it has a lot more units in it.

Our best bet will be to take shorter terms for a much lower rate. If we could get an ARM with a 6% rate. With only 10% down, the yearly payments would be $11,325, leaving us with a positive cash flow of $2262. A 13% cash on cash return would result. If you add in an estimated $10,000 other up front costs (lawyer, etc), the return on investment is 8%.

So, is this property worth my while? I still need to evaluate the taxes and depreciation, and then do another analysis to figure out how low I should bid.