We’re continuing our annual review for the benefit of new readers. Last month we discussed What is an investment? What is an investor? Why Invest? We talked about the 4% Rule. We referenced stocks rather than income properties, and noted that the reason was twofold.

First, folks have to start somewhere, and it’s a lot easier for a new-investor-in-training to begin with a $2,000 portfolio (and add a little to it every month) at a discount stock brokerage than a fourplex by the beach. It’s easy to direct a budding stock investor to, among other options, Burton Malkiel’s A Random Walk Down Wall Street or perhaps Stocks for the Long Run by Jeremy Siegel. But if you try to tell a young investor about the glories of apartment buildings, they are sure to lose interest the moment you get to the down-payment part.

Second, everyone, even the biggest apartment investors, should have a portion of their assets in liquid funds because you just never know what might happen. The stock / bond market is one place where new investors might gain a little experience (at a stream-of-income level, there is very little difference between stocks and apartments) and for experienced apartment owners to store their liquid funds.

Speaking of experienced apartment owners, some folks are – as the saying goes – land rich and cash poor. They may have a significant number of units, but little cash in the bank. Functionally, they are not much better off than a salaryman with no savings, except that if the salaryman’s wages stop for any reason he only has to get a new job. If the apartment owner’s income stops and he can’t make the mortgage payments, he could potentially lose everything. In my mind it is even more important for a landlord to have savings than it is for a corporate executive. Lenders seem to feel the same way because one of the first things they look for is “reserves” (what normal people call savings). Even if never used, the presence of savings indicates a person who typically lives beneath his means, and lenders like that a lot.

Lenders look not only for savings in the form of stocks and bonds, but also savings in the form of cash-value life insurance, retirement funds, and annuities. It is astonishing how important this has become in the last couple of years.

Today we continue our review Value Drivers, Streams of Income, Capitalization Rates, and Synergism. Synergism is the investor’s sweet spot. It usually happens only a couple of times in an investor’s career, but when it does investment returns just skyrocket. 

Value Drivers

The value of an investment is determined by two things: (a) its net income and (b) the associated capitalization rate.  The apartment investor usually has some control over net income, but no individual can control cap rates. When you read “capitalization rate” (cap rate), think “interest rate”. There are subtle differences, but at a fundamental level they are indistinguishable.

There are only three kinds of investments that provide streams of income: bonds, stocks, and income properties. Each has a different capitalization rate due largely to their individual risk profiles. To complicate things further, cap rates change over time and as they change, values do as well. Generally when cap rates and interest rates are low values are high, and vice versa. 

Streams of Income: A Brief Discussion

BOND:  Bonds are debts of a company. If an investor buys a bond, the institution that issued the bond owes her a stream of interest payments during the holding period and a total return of the face amount of the bond when it matures. Simply put, if held to maturity a 6% bond will provide the investor with a 6% return.

The operative phrase was “if held to maturity”. The value of a bond may vary widely between time of purchase and redemption due to changes in interest rates. (This is called “interest rate risk”.) For example, if our 6% bond paying $60 annual interest was purchased for $1,000 the owner would receive a 6% interest rate. If she wished to sell before the bond matures, she’ll have to accept whatever the market value of the bond is at that time. And the market value is heavily influenced by the then-current interest rate. That’s only reasonable. Would you buy a bond paying 6% if that same money could buy an equivalent bond paying 8% interest? Well, neither would anybody else. So if she wanted to sell her 6% bond early, the one she paid $1,000 for, and the market interest rate was 8% she could only get $750 for it ($60 divided by 0.08).

But it goes both ways. If rates dropped, say to 4%, then (everything else being equal) she would get $1,500 for the bond. The math is $60 divided by 0.04). The Stream of Income delivered by a bond is its interest payment. 

STOCK: Stocks are shares of ownership in a company. A stock’s stream of income is different than a bond’s because corporate tax rates affect management decisions.

There are multiple ways to value a particular stock, but some folks prefer to use the stock’s dividend. The dividend comes out of earnings. It is the only cash return the investor receives over the holding period. It is often (but not always) one of the major reasons a particular stock was purchased. Everything else being the same, when a stock’s dividend is increased the price of the stock generally (but not always) goes up. The Stream of Income delivered by a stock is its dividend. 

INCOME PROPERTY:  Unlike bonds, where what you get is a contracted sum each payment period, or stocks where your dividends are from (variable) earnings, income property has a flow chart from gross income through to net income. It’s only the net income that is ultimately important. Here is how we get from gross income to net operating income. 

1:  Gross Scheduled Income (GSI)

     Minus Vacancy and Credit losses

     equals

2:  Effective Gross Income (EGI)

     Minus Fixed & Variable Expenses

     equals

3:  Net Operating Income (NOI)

     minus

4:  Debt Service

     equals

5:  Before Tax Cash Flow (BTFC)

The Stream of Income delivered by income property is its Net Operating Income (line 3).

The NOI is the sum you could hide in your unmentionables drawer at the end of the year if you had no mortgage on the property. That’s important: if the property carries a mortgage, the payments (“Debt Service”) come out of the Net Operating Income and reduce your cash flow.

When valuing income property the banker will capitalize the NOI. The formula is: NOI divided by cap rate equals property value. 

Capitalization Rates

You know that interest rates fluctuate.  It may not seem like it because we’ve been at historical lows for a number of years, but in the early 1980’s we were at or near historical highs, and nobody thought they would change then, either. But they do change. For the last thirty-five or so years, interest rates have been trending down. That is an important thing to remember, because declining capitalization rates (think interest rates) are a prime driver in making asset values go up.

Cap rates work on the Teeter-Totter Rule: (1) as cap rates (interest rates) go down, values go up; (2) as cap rates (interest rates) go up, values go down.

Here is how it works. If an investor bought a perpetual stream of income that gave him $100 every year, how much would the market value that stream of income? If cap rates (again, functionally almost the same as interest rates) were 10%, the value would be $1,000. ($100 divided by 0.10 equals $1,000).

Time goes by and the stream of income remains at the contracted $100 a year, but market cap rates rise to 20%. How much is that annual $100 check worth now? $100 divided by 0.20 equals $500. The value of that stream of income has fallen from $1000 to $500 because it is capitalized at a higher rate. Rates go up, values come down. It’s a Rule.

Alternatively, what if interest / cap rates did not go up, but instead declined to 5%? What would that investment generating $100 in annual cash flow be worth then? $100 divided by 0.05 equals $2,000. Another Rule: rates go down, values go up. These last 35 years of declining rates made rich the investors who (a) had assets going into the declining rate period or (b) bought assets during the decline. Change in market cap rates will significantly affect the value of any investment. If cap rates go up, values go down. Alternatively, if rates go down, values go up. 

Synergism

We have noted that the two drivers of value are (a) net streams of income and (b) the rate at which they are capitalized. We’ll begin this section with a quick review of how changes in net income and / or cap rates might impact values.

Simple Stream of Income Example: An apartment building has a NOI of $50,000. You buy it at a 10% cap rate, paying $500,000.  You bring the rents up to market levels and the NOI increases to $65,000. Nothing else changed. At the same 10% cap rate, what is the new value of the apartment building? Answer: $65,000 divided by 0.10 equals $650,000. You increased the net income and the value of the building increased.

Simple Cap Rate Example: Review: Remember that 6% perpetual bond we discussed earlier? It was a $1000 bond paying $60 annual interest. The interest rate was 6%. Assume market interest rates change. Now a buyer can purchase identical bonds paying 8% interest. If that 6% bond were sold at a price that reflected an 8% yield to the new buyer, what would that price be? Answer: $60 divided by 0.08 equals $750.

Oh, no! I made a mistake! Market rates did change, but instead of going up 2% they went down 2%! They are now at 4%. What is the value of the 6% bond? Ans: $60 divided by 0.04 equals $1,500.

So have we established that values can be enhanced by either (a) increasing the net income (Stream of Income example) or (b) lowering the cap rate (Cap Rate example)?

What if both happen at the same time? What if you increase the property’s net income while cap rate are declining? This is where the supercharged effect comes in. If you can increase an investment’s net income and capitalize the higher income at a lower cap rate, the investment’s value just shoots right up like a rocket.

Example: Remember that apartment building you bought for $500,000 and over the next year raised the net operating income (NOI) to $65,000? What would happen to value if during that period cap rates dropped to 8%? What would be the new value of that apartment building when $65,000 annual net income is capitalized at 8%? The value would go up:  $65,000 divided by 0.80 equals $812,500. Values can increase (a) if the net income goes up or (b) if the present income is capitalized at a lower rate. If both happen at the same time, values can go up a lot. 

CAUTION:  This is not a one-way Charlie. Investments can go wrong for a variety of reasons or sometimes for no reason at all. We’ve just discussed the buttered side, but this piece of toast also has a dry side. If net income decreases, or if cap rates go up, the value of your investment will go down. If both happen at the same time, it could be an unwelcome development.

Next month we’ll begin with Using the Debt Coverage Ratio. With little more than the NOI and the DCR the investor can figure a reasonable fair market value, the maximum loan the income will support, the down payment and other stuff. All of that is a little more “insider” than is really appropriate for a new-investor-in-training, so it was held until later in the annual review. 

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 Info@KlariseYahya.com 

If you’ve missed some of the prior articles, basic guidelines on successful investing are in my book “Stairway to Wealth” available at www.LuLu.com