Between the years 2010 and 2015 many banks will be forced to foreclose and liquidate a portion of their commercial holdings. The reason for this is several banks have too many commercial loans on their books and are required by federal regulation to reduce the number of loans they have. With that being said, during the next five years we are going to see a large percentage of commercial loans come due which will give the banks the opportunity to require the loans payoff OR they will be forced to foreclose. It took me a while to get my arms around this. Why would a bank ever foreclose on someone that is making their payments? Although the answer is simple, it may not make since. They will be forced to foreclose by the FDIC to reduce the number of commercial loans on their books.
Most commercial loans are short term, meaning they have to be repaid in full within a few years. It is not uncommon to see terms as short as three to five years. In the past when real estate appreciated, banks would just charge a small fee and renew the loans. Now that commercial properties have depreciated and many owners are underwater banks can’t renew the loans unless the owner contributes a large amount of cash to keep the total loan to value within bank guidelines. It can be very difficult to come up with a large amount of cash so many owners will be unable to keep their properties. Keep your eyes open because we are going to see some tremendous opportunities in commercial real estate over the next several years.
Just like residential, I believe it is important to be able to run the numbers on a property quickly to know if you want to spend any time on a deal. You should be able to rule out about 90% of the deals you look at within the first three minutes so you only spend quality time on deals that you would actually buy.
What is the CAP rate?
The first thing you need to understand is the capitalization rate (CAP). This is the ratio between the income and the price. This number will either tell you what the property is worth or it can be used to determine if a deal is strong enough for you to spend additional time. The higher the CAP rate the lower the price of the property compared to the income it produces. It works this way because when investors demand a higher return they need to pay less. Some quick points on CAP rates:
- The nicer the area and/or the building the lower the CAP rate
- The easier a property is to manage the lower the CAP rate
- Bad buildings and bad areas mean a higher CAP rate
- The CAP rate is always calculated on an annual basis
The formula is CAP = Net Operating Income (NOI) / Price
What CAP should you expect?
This is the key to analyzing your deal. Each neighborhood and area will require different CAPs. It is best to start by picking one or two areas you want to buy in and work with an experienced Realtor. Ask the Realtor what CAP you should expect in an area. Over time you will began to see trends on the CAPs in different areas. You can also pick a CAP that you are comfortable with and look for areas that can produce it. There is a good chance you won’t want to manage your own property so you may not want to limit your search to your own back yard; especially if you are trying to hit a certain CAP rate. Some of the best deals will be in another part of the country.
Analyzing the deal
Once you either know a CAP that you want to accomplish or a few areas you want buy in, it is time to start looking at deals. If the CAP that you come up with is close to what you would expect for the area or is high enough to meet your goals you will take the next step in your analytics. The next step could be a letter of intent or simply spending more time on diligence.
To analyze the deal in three minutes you will divide the NOI by the listed price. I see a lot of mistakes in obtaining the NOI. Here is how it should be done; gross income minus expenses. Sounds easy, right. Let’s go through it.
+ Other income (vending machines, laundry, retained deposits, etc.)
= Effective Gross Income
+ Utilities (gas, electric, trash. Who pays what?)
+ Reserve to replace
= Total expenses
Effective Gross Income – Total Expenses = NOI
Most of the numbers are self explanatory and you should be able to obtain them unless you already know what they should be. Most of the time the seller will give you this information and it will be accurate. There are a few variables I want to address and I recommend using your own numbers and not what the seller tells you. All percentages are based on the gross income before vacancy.
Always use a least 5% even if vacancy rates are a little lower. Be conservative here. Some areas could be even higher and reach closer to 10%. As a general rule bad areas could be closer to 10% and good areas will be closer to 5%.
This is going to be highly dependent on the area and age of construction. As a general rule you will use:
– 10-15% for higher income areas with newer constructions (could be as little as 5-7% but be careful)
– 15-20% for lower income areas with older constructions (I have seen this as high as 25%)
When you are dealing with apartment buildings there is less pride from the tenant then when you are renting single family housing so you should expect maintenance expenses to by higher with multi family.
***it is not uncommon for sellers to remove repair expenses from the books they provide you to make the income look stronger***
Reserve to replace
This is the number most often missed because it will not show up on the seller’s income statement. You don’t need to actually set up an escrow account for this but it is a good idea to understand that occasionally larger repair items will come up that will affect your income. For this reason you need to account for it when looking at a deal. You should use 1.5% for newer construction and 3% for older construction.
Other general rules for quick analysis:
– Management fee – use 10% (even if you manage it yourself)
– Utilities – use your best judgment
– Taxes – you can look this up with the county or for a quicker guess use 1.25%
– Insurance – use .5% to .7%
– Accounting – use $300-$500 per property
– Other – this could be legal fees for evictions, HOA fees or anything else you have forgotten
Just a quick note on evictions. You should expect 10-12% eviction rate each year. So if you have 100 units you will probably initiate 10-12 evictions each year.
My suggestion to you would be to create a spreadsheet using the information provided above to quickly calculate your CAP. Once you have the CAP you can decide if the deal is worth any of your time.
For an even faster way to run your numbers it is pretty safe to calculate an estimated NOI using these numbers:
Nice building in a nice area – multiply Gross income by 70%
Bad building in a bad area – multiply Gross income by 50-55%
Once you get a deal worth your time you will want to verify all your numbers and view the property. You will also want to add debt service for the loan you will be getting to determine your cash flow and your cash on cash returns.
One final thought. If you see potential to negotiate a steep discount or a way to increase the current income, you may consider spending more time on the deal.
I hope this article was helpful for you and I hope you are as excited as I am to look at commercial deals in the next several years.