By Tom Raub, CCIM
I am a believer that real estate can provide good investment opportunities; otherwise I would not be in this business. In any investment, including stock, real estate, and business, the potential gain has a direct correlation to the risk. The more risk, the more "potential" for gain and obviously also the more potential for loss and the amount of the loss.
Analysis of a real estate investment opportunity can be complex as each property has a unique set of intra-dependent variables that include: location, physical condition of the building(s), zoning, quality of the tenants, quality of leases, etc.. Prior to this
in-depth analysis a quick Cap Rate calculation is often done to gauge whether or not to proceed to the more detailed analysis.
Cap Rate is defined as the NOI (Net Operating Income) /Offering Price. NOI is the net income on the investment, after all expenses have been paid (with the exception of income taxes and debt service). Therefore if an investment property had an NOI of $10,000 and an offering price of $100,000 the Cap Rate would be 10,000/100,000 or 10%.
Typically investment properties sell in the range of 8% to 15%. A property selling in the 8% Cap Rate range would be a lower risk investment property (strong national tenant with a bonded long term lease). A property selling for a 15% cap rate would be a more risky investment (weak local tenant, poor location, vacancies in property, building needing repair or updating, etc.).
If the Cap Rate on a specific property (based on the provided NOI) appears to be within the investor’s criteria for risk vs. gain, financing considerations are usually looked at next.
Commercial lending terms and conditions are different than for a personal residence. There is much variation in terms, depending on the specific investment. As a general rule, for a first look at an investment property, the following are reasonable assumptions.
· Interest rate 1.5% to 2.5% over prime
· Downpayment 20% -30%
· Term 5 –7 yrs. (amortized over 20 years, so there would be a principal payment due at end of the 5-7 yr. term)
· Debt Coverage Ratio (DCR) of 1.2 –1.3 (NOI/mortgage payment). This is a bank requirement to provide some safeguard on the investment income being able to cover the mortgage payment. In some instances, it is necessary for a buyer to increase the downpayment to more than 30% (thereby reducing the mortgage payment) to satisfy the DCR.
Using the above parameters, a mortgage payment amount can be calculated. Deducting the calculated mortgage payment from the NOI yields the cash flow provided by the investment. This can be looked at as the return on the down payment provided by the investor to secure the loan. This is a before income taxes number and is called Cash on Cash. In addition there will be an income tax deduction for property depreciation and mortgage interest paid. Hopefully over the years, there will also be an appreciation in the value of the real estate.
The above suggested analysis is very preliminary as it is based on information provided and is not sufficient to make a sound investment decision. The next part of the process is to begin the “due diligence” part of the process where the income and expense information is examined in more detail and modifications made to the numbers based on what is found. This might also include deductions for repairs needed to the property, adding a reserve fund, adjustment of vacancy factor, management fees, anticipated tax increases, etc. This may result in significantly different Cap Rate and Cash on Cash numbers. The investor then has to weigh the resultant numbers against their own criteria for “gain vs. risk”.
What is available in the Burlington area for investment properties? While the area is not flush with available investment properties, they do become available. Most common are apartment buildings of 2-6 units. Dependent on location and condition, they are usually in the 9% -12% Cap Rate. Typical offering price would be in the $125,000 to $450,000 price range.
Harder to find are office or office/retail properties. These usually move more by word of mouth rather than a heavily marketed sale. As an example, a recent sale that I represented the Buyer on was for a downtown office building, completely leased by a strong local tenant that sold for a little under $2,000,000. The cap rate on this property was a little over 9.6%. Property availability in this price range is not frequent. A more typical price range would be $300,000 to $600,000.
Hopefully the above has given you some idea about what reasonable expectations might be for your commercial real estate investments. Hickok and Boardman Commercial Realty would be happy to address any questions you might have in regards to the above and to assist you in your search for investment properties.
Thomas J. Raub CCIM
Vice President/Commercial Broker
Hickok & Boardman Commercial Realty
802-846-9526 (direct line)
tjraub@ccim.net
