Value means different things to different people. To a banker, loan value is determined by whether or not the building is likely to generate enough income to pay its expenses and meet debt coverage ratio (DCR) guidelines. It meets value or it doesn’t. An investor might have additional perspectives.
While any mortgaged investment must first conform to the banking value (see above), there are different value approaches that individual investor may overlay. This column considers some of the more common ones.
This is really important to the investor. The purpose of the Loan Filter is to generate confidence that the building’s income will make its loan payments. If it doesn’t do that, you’d have to find another way to pay for it.
Determine the Gross Scheduled Income. Gross Scheduled Income (GSI) minus Vacancy Allowance equals Effective Gross Income (EGI). EGI minus fixed expenses (these expenses exist even if the building is empty) and variable expenses (increase or decrease with occupancy levels) equals Net Operating Income (NOI). NOI is what you could put in your purse at the end of the year if you’d paid cash for the building. Debt service comes out of NOI. Divide the NOI by the Debt Coverage Ratio (DCR: hypothetically, 1.20) to get the maximum loan payment the bank will allow on that stream of income from that building at thattime. Whatever’s left is the borrower’s before tax cash flow.
Just because lease agreements indicate a building may support a given loan amount does not automatically mean the banker will write the mortgage. It’s conceivable that a borrower may rent his units to family members happy to sign a rental agreement showing rent far above what the market will really bear, confident they’ll never have to pay it. The lenders are aware of that, so they employ a secondary loan filter as a cross-check. The maximum loan amount normally will not exceed the lower of that permitted under either the Economic or Characteristic Filters.
Notice that the Economic Filter has nothing to do with the cap rate. The cap rate has an entirely different purpose.
The cap rate is a way to compare alternative, sometimes widely dissimilar, investments. Imagine you are interested in a 12 unit apartment building, but then your new son-in-law, the fry cook, wants you to buy him a restaurant in a leased location and a new truck to get to it – a 4×4 in case it drizzles. Generously, he offers to make you a partner so you now have the option of a 12 unit building or a hamburger stand. The capitalization formula can be applied to compare the different investments. We’ve capitalized the apartment model many times, so we won’t repeat it here. A restaurant is a business, much different from an apartment building. Cap rates can compare their net yields.
Formula: (1) Net Income divided by total Purchase Cost equals Yield; (2) Net Income divided by required Yield (always in decimals) equals maximum Purchase Cost; (3) Purchase Cost times required Yield equals necessary Net Income.
Capitalization doesn’t help with all investment possibilities. For example, how would you apply the cap formulas to an avocado grove outside Fallbrook? You’re buying an avocado grove, but that’s really just to get a little income while you’re land banking. Eventually, the developers will be calling and the real money is made when you sell to Pulte or Toll Brothers, or one of the other merchant builders. Capitalization considers only current yield or value. It doesn’t consider future values. We have the Discounted Cash Flow (DCF) model for that.
Cap rates only obliquely indicate how risky the investment is. Within the same asset class, the higher the cap rate the greater the presumed risk. For example, a retail store leased to a national credit tenant would presumably sell for a lower cap rate (indicating less risk) than an empty store (which would use a mutually agreeable estimated cap rate).
Characteristic filters are not used independently. They are always subordinate to assurances that the property will provide a cash flow beyond the operating expenses and the mortgage.
Cost per Unit: Sometimes lenders refer to this metric as “Dollars per door”. The formula is Purchase Price divided by Number of Units. Among otherwise similar properties, the one with the lowest Cost per Unit is probably the one you want to most consider. This tool is best used when apples are compared to apples. You can’t really expect to compare the per unit value of a building full of 3 bedroom units to a building of one bedroom units.
Dollars per Sq.Ft: Given similar properties, one way to determine which the better value is through Purchase Price divided by Net Rentable Area. NRA does not include common areas, so you’re only comparing the income generating bits. Generally, cheaper is better.
Dollars per Bedroom: This is a favorite of some very successful investors. The idea behind it is that a major source of value in a rental unit is the number of bedrooms – everyone knows that – but you still don’t want to overpay.
Construction Cost: I worked pretty closely one time with a man who would buy almost anything as long as he could get it for less than it cost to replace the improvements. Empty, trashed, marginal areas, he didn’t care as long as he could buy it for no more than the current cost to build (http://craftsman-book.com/products/). Naturally, he gave no value to the land. He was a tightwad and always tried to squeeze the last penny out of a deal. He certainly could have gone directly to one of the banks for his loans, but they could only offer their individual programs, while I could search among all the banks and get the best program for him. So although he was such a skinflint, he never tried to negotiate my fee.
After eight years he’d acquired fifteen “bargain” properties, but most of them were disappointments. “Bargain” is in quotes because there is a reason a given property is cheap, and it’s generally because its deficiencies are not correctable. Basically, you are buying somebody else’s mistake.
But folks have done very well buying properties that have correctable deficiencies, buildings that have been poorly managed and / or ill-maintained. Often, these two characteristics occur in the same property. If a building is occupied by close-to-market- rent paying tenants (not family members) even though it’s run down or poorly managed, you can almost hear opportunity knocking. Just build in the costs of correcting the problems.
There is an art – not difficult to acquire – in selecting Characteristic Filters. The market area is searched to find recent sales of comparable properties whose amenities bracket the subject’s. The sales have to be recent: nobody cares what the building sold for ten years ago.
Bracketing is important. If a single recent sale close to the hospital was found we couldn’t know by that sale alone if the location enhanced values or not. It’s possible that the increased traffic, sirens, etc. may be so undesirable that being close to the hospital actually detracts from value, notwithstanding the benefits of having a major employment center close by. If, however, another otherwise comparable sale was found beyond the noise / traffic of the hospital than we would have bracketed the matter and a conclusion could be drawn.
Selective Elements are neither Characteristic nor directly Economic filters. They are tertiary elements which may, under some circumstances, affect tenant selection or tenant turnover. Some Selective Elements should be given more importance than others. The brief list following is illustrative only. We’re not discussing every possible Selective Element.
Market Area:Glendale is just north ofLos Angeles. There are five major north / south streets there: Verdugo Rd. on the east, then moving west there’s Glendale Ave., Central Ave., Pacific Ave., and finally San Fernando Blvd. If you drive on secondary streets paralleling these five arterials you’ll notice that they form neighborhood boundaries. For example, property on Louise St. (one block east of Brand) is obviously more upscale than property on Columbus Ave. (three blocks west of Brand). Clearly, Brand Ave. is a market area border. This process can be used to determine the remaining three neighborhood borders. What is within these streets is the property’s market area.
Site Area: Bracketing properties also requires considering the site area of similarly zoned properties. It is not always true that a dozen fourplexes scattered across six acres is necessarily better than 50 units on a minimum sized lot. Landscape costs can add up, and unless you’re land banking your net income may be greater with the more crowded property. That needs to be considered.
Interestingly, the size of neighborhood lots is often enough just by itself to get a pretty clear idea of market area borders. There’s an equestrian area in Burbank on Riverside Drive where lots are permitted for horses. If you step outside of the “horse area”, you’re in a different market. Possibly due to being in a horsey area, the apartment buildings on Riverside Drive have low vacancy levels.
Topography is something to be considered. It is not always true that a view lot contributes value to a building. The view may be nice, but it comes at the cost of a steeply sloping lot, and there goes the children’s play area. Even in an area where young unmarrieds congregate, it’s hard to walk your dog on a sloping lot.
Design: Appeal can significantly affect value. Whatever property you’re considering should have recently sold comparables in the area. Hypothetical: If you’re interested in a geodesic log cabin there should be a couple of recently sold geodesic log cabins similar in living area and room counts relatively nearby. That indicates that the property’s design is accepted in the marketplace. You don’t want to buy somebody else’s mistake.
Condition: Not all, but most investors who accept deferred maintenance have a really good idea of fix up costs. I’m not worried about those guys; it’s the newer investor who reaches for the largest number of units that might stumble. Although not perfect, a possible alternative is to try to find another “fixer” that sold recently and use Characteristic Filters to estimate the impact of deferred maintenance on the subject property. For example, that eight unit building full of two-bedroom units is in about the same condition as the subject and it sold for $XXX,XXX per unit and about $YYY per square foot of rentable area. Those figures let us establish an upper limit of value for the fixer we’re interested in.
Parking: You know how important parking is, but sometimes folks ignore its impact on value. What we’re looking for is one off-street space per bedroom. For various reasons it is not always true that inadequate parking affects rent levels, but it almost always hurts (a) tenant selection and (b) tenant longevity. Who would be interested in renting an apartment where she has to park on the street? Usually, someone who doesn’t have a car, and who doesn’t have a car in urban California? Someone who can’t afford it. Do you wish to rent your unit to a person who doesn’t have the disposable income to put the occasional gallon of gasoline in the tank? And if you do, wouldn’t it be reasonable to expect that as soon as she begins to earn enough to buy a 12 year old Nissan she will move to an apartment with off-street parking? Parking is a good example of how a Selective Element can impact both the type of tenants the building gets and their turnover.
Daily Shopping: Being within walking distance of a major grocery, a pharmacy, dry cleaner, gas station and a couple of sit-down restaurants are important neighborhood conveniences. Also two beauty shops, the one you go to and the one that you wouldn’t step inside if your life depended on it. These little amenities make some locations more desirable than others.
Disclaimer: This article is for informational purposes only and is not intended as professional advice. For specific circumstances, please contact an appropriately licensed professional. Klarise Yahya is a Commercial Mortgage Broker. If you are thinking of refinancing or purchasing five units or more, Klarise Yahya can probably help. Find out how much you can borrow. For a complimentary mortgage analysis, please call her at (818) 414-7830 or email Klarise.Yahya@Charter.net.
If you’ve missed some of the prior articles, basic beginner guidelines on successful investing are in my book “Stairway to Wealth” available at www.LuLu.com