Every activity has its own set of fundamental questions. Oddly perhaps, it seems almost like the more consequential the activity the fewer the questions. For example, in commerce there are four questions: (1) What am I going to get? (2) When am I going to get it? (3) What’s it going to cost me? and (4) When do I have to pay it?
In politics, there are two questions: (1) What do you believe? (2) Why is it important?
There is only one fundamental question in a marriage: Can I trust you?
Analyzing a property portfolio involves two questions, which probably makes it more important than ordering a book through Amazon but less important than marriage: (1) What is my risk? (2) Where is my opportunity?
Portfolio risk comes in at least two forms: cash flow and appreciation (increased equity). Cash flow is probably the more important risk factor because it’s vital for the daily running of the property.
1. Cash Flow: The minimal prudent cash flow threshold is shown by the Debt Coverage Ratio (DCR) your lender required when you last refinanced. Currently, the most typical DCR for well located apartment buildings is 1.20. That’s the number bankers divide into Net Operating Income (NOI) to determine both the maximum mortgage payment (principal and interest) the building will support at any given interest rate. It also reveals the minimum owner’s cash flow they require the building to generate before lending on it.
Example: At a monthly NOI of $12,000 the numbers would be $12,000 divided by 1.20 equals $10,000. That becomes the maximum allowable mortgage payment (principal and interest). The difference between the NOI ($12,000) and the debt service ($10,000) is the cash flow ($2,000).
The number to the left of the decimal (the “1”) refers to 100% of the loan payment. The numbers to the right (in this case, “.20”) indicates the percentage of the loan payment budgeted for the owner’s “spendable” income, i.e. “cash flow”. At 1.20 DCR we’ve just seen that cash flow equals 20% of the loan payment. At 1.25 DCR, “spendable” would be 25%; at 1.02 DCR (I just made that up); “spendable” would be only 2% of the loan payment. I’ve seen DCR’s as high as 1.55. Generally (but not always), high DCR’s mean the bank doesn’t want to make the loan. Remember when you told that boy in high school, “I’ll kiss you when the moon is made of green cheese and sold at Trader Joe’s”? High DCR’s are like that: “Not in your lifetime, Phillip!”
Exception: Some HUD loans on low income housing require a 1.55 (+/-) DCR. The Loan-to-value ratio is typically 55%. In this case it’s not because the building is particularly risky. It’s because those projects have politically capped rents, so their value goes up or down with changes in cap rates . . . you know, like a bond.
2. Appreciation: I understand it doesn’t seem quite possible, but not every property always goes up in value. The two items that most impact equity growth are (1) net operating income and (2) capitalization / interest rates, which act synergistically.
Example: Assuming the cap rate stays the same, an increase in NOI will push the value of the property up. For example, a $90,000 annual NOI capitalized at 6% indicates a building value of $1,500,000. If the NOI increased 25% to $112,500 the value at 6% would be $1,875,000.
Example: Alternatively, presume the NOI remains the same but the cap rate declines. If the cap dropped to 4% while the NOI remained at $90,000 the indicated value would be $2,250,000. That’s a 33% reduction in the cap resulting in a 50% increase in value.
The synergy comes when NOI increases while cap rates are declining. Let’s go back to our original $90,000 NOI capitalized at 6% and an indicated value of $1,500,000. That’s the baseline. Now presume that NOI increases (over time) to $112,500 and the cap rate declines (again, over time) to 4%. The indicated value of that stream of income is $2,800,000.
Discussion: Capitalization rates are joined at the hip to interest rates: interest rates go up and cap rates tend to follow; interest rates decline, and so do cap rates. The individual has personal control over neither the interest rate nor the cap rate cycles. But we can certainly take advantage of favorable caps when they appear. When cap rates / interest rates are low (meaning property values are high) we can refinance. It’s pretty much of a no-brainer.
You know that money we harvested when values were high and rates low? It goes into the bank until we find a building that makes sense. Then we use that money and buy another property or two.
Inflation is phantom growth in equity. Your property went up, but so did everybody else’s. And you still have to pay taxes on gains. When you get a chance you should ask your CPA if you have to pay capital gains taxes on gains generated solely by inflation. Take your pills first.
Increases in the inflation adjusted value of your investment come through raising NOI faster than CPI. Sometimes, for some properties, this is possible. Appreciation also happens when cap rates decline. That’s the rising tide phenomenon. When you experience both rising NOI and declining cap rates at the same time, that’s the rocket ship phenomenon.
Opportunity– the possibility of using your existing properties to buy future properties – depends on how much your equity has increased. If it hasn’t gone up at all, the chance of refinancing and buying another 15 units is pretty low. So let’s analyze George’s portfolio of three properties (from Part 1) and see if what opportunities may be present.
Cash Flow: Does it equal at least 20% of the loan payment?
Loan payments: $2,009 + $813 = $2,822 x 20% = $564 (cash flow hurdle)
Actual spendable is $553 monthly (3,375 minus $2,822), so George is almost exactly spot on.
Equity Growth: Equity is $124,500 on a property worth $900,000 (14%). You can’t buy a $900,000 property with 14% down. If George sold, he could not buy his own property back.
Discussion: Equity from this property has been harvested to buy Property B, as was disclosed at the beginning of this two part analysis. Equity harvesting is one of the elements of classic portfolio management. Good on George.
HELOC’s, are useful as temporary “bridge” loans, but their interest is commonly based on the volatile prime rate. Historically, prime has sometimes been high. For example, in 2007 the prime was 8.25%. If George’s HELOC rose to that level the payment would exceed $2,000 monthly. As soon as practical, it’s probably wise to pay off the HELOC by refinancing the new property at the current 30 year fixed rate (we can do 30 years: it’s a duplex, remember?)
Conclusion: Property A’s equity has just been harvested.
Cash Flow: Does not meet goal of 20% of loan payment.
Loan pmt: Payment $1,751 x 20% equals $350 (cash flow hurdle)
Actual spendable is $250 monthly, so George is short $100.
Equity Growth: Recent purchase. Insufficient time for equity growth.
Discussion: George harvested a large portion of his equity from Property A to purchase this duplex. It pays for itself, but the margin of safety is very thin.
Conclusion: This is a very recent purchase (using equity from Property A) and it’s unrealistic to expect immediate equity growth.
Cash Flow: Exceeds 20% of loan payment.
Loan pmt: $4,427 x 20% (hurdle) equals $885. Property C generates $2,073 in monthly cash flow, comfortably exceeding the guidelines.
Equity Growth: George has obviously had these units for a while. His net equity after sale ($572,000) would probably be sufficient to buy a $1,700,000 replacement if he chooses to do so.
Discussion: As his NOI increases over the next couple of years this property could develop enough equity to make a real contribution to George’s portfolio. Even a small property would help. It shouldn’t be too long before he’ll be able to refinance and harvest enough cash for the down payment on a duplex. George currently has 11 units and the new duplex would increase this to 13 (18% gain). An 18% gain is not insignificant; it is equivalent to adding 36 units to an existing 200 unit portfolio. Consistent 18% additions will double George’s units under management in four purchases: (1) to 13 units; (2) to 15 units; (3) to 18 units, and (4) to 21 units. If (hypothetically) a person could add 18% to his portfolio each year, he would pretty much double his units in four years. If he did it every three years, it would take 12 years to double his holdings. Taking a middle figure, if George increased his units by 18% every two years – that means it would take eight years to double (four doublings at two years each) – and in 24 years he would have benefited from three doublings. He would then own 88 units (11 to 22; 22 to 44; 44 to 88).
If he doesn’t invest aggressively, the 24 years will still pass and he’ll be just like that couple who inherited Aunt Mitochondria’s units: he’ll still have the same 11 units he started with. It’s a choice every investor has to make for himself.
These six units will probably be the next building George refinances. Managing his portfolio gives him the ability to regularly add small properties he would not otherwise be able to do. Just like small additions to an IRA, regular purchases of a triplex here, a fourplex there can have pleasing long-term consequences.
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 [email protected].
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.