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.
Continued from Part 16: Emily saw buildings as other people saw employees. She realized that every investment she owned had to pay its own way. She would work with a troubled building to increase its profitability, but if the resistance was too great she sold it without remorse. Sometimes you just had to cull the herd. Portfolio risk could be managed by keeping only successful buildings.
Besides portfolio risk, there was liquidity risk. Emily was worried about the marketability (from both the sale and the refinance perspectives) of a SFR with commercial zoning, on a busy street, occupied by a day-care center. She’d refinanced it once, but it was a struggle. An asset whose equity was difficult to harvest contributed little to the system Emily was developing. She’d learned to prefer apartments. Because she had a good reason to violate the Never Sell dictum, she didn’t think it applied to her. That was a part of Emily’s personality: if she had a good reason to do something, she didn’t think the rules against it applied to her. This time she was probably right. Other times, her audience wasn’t as receptive. “But officer, I was speeding because I’m late for work! What’s the matter with you? Didn’t you see me putting on my mascara when I ran that red light?”
Not being a dumb-bunny, Emily saw the buy-refinance-buy process as the matrix of the investment system she was developing. Everything revolved around that. She reached for her daily journal and began to write notes on the System (she’d begun capitalizing the name) and how, over time, it might work for her in practice.
Emily, as everybody knows, was a single woman without prospects. As such, she related strongly to something Don Corleone said in The Godfather. It was one of her favorite quotes: “I spent my whole life trying not to be careless,” Don Corleone said, “Women and children can be careless, but not men.”
She did not take that in a sexist way. She understood it to mean, “If you have a safety net (as did women and children in Don Corleone’s time), you can sometimes be careless. If you don’t, you can’t”.
Emily had no safety net. She could not be careless. There was no second income coming in. There was no one to rely upon if she got seriously ill. There was no one to clean the gutters or take the car in for repairs or wash the dog. However, if she had enough money she could hire a medical caretaker. If she had enough money she could replace her old car. The safety net, Emily understood, could be either an employed husband or a robust source of passive income. She hadn’t had anyone really interested in her in years, so prudence suggested that she “marry” her apartment building(s). The problem was, interest rates were moving, values were changing, and she had real concern whether she should buy her next building now (without regard to how interest rates might affect future values) or later, after rates climb and prices drop.
Teeter-Totter. Emily knew that the value of apartment buildings was heavily influenced by what the suits-behind-the-desk call the “risk-free rate”. In most cases that meant the interest rate on the 10 year Treasury note. She knew that if interest rates go down the value of apartment buildings (or almost any investment, really) goes up … and vice versa. It was like a teeter-totter: Rates up, values down. Rates down, values up. She had read that someplace, but couldn’t remember exactly where.
Change in Values. Emily knew the principle, but had no real idea of how much (or how little) a change in rates would affect values. One day, as an experiment, she penciled out a hypothetical purchase under two different interest rate scenarios, one low (arbitrarily, 4%) and one high (arbitrarily, 8%). Careful to leave everything else the same, she analyzed only how the change of interest rates might affect the value of a particular stream of income. She was pretty sure about the direction of the value change. Her hope now was to understand its magnitude. She understood that this approach was not limited to just the NOI from an apartment building. She expected it would probably apply to any stream of income.
Critical Numbers. There are three critical numbers that help determine the value of any stream of income. They are (a) the Net Operating Income (NOI), which is the starting number; (b) the capitalization rate (cap rate), which computes the value of the NOI as if it were an annual stream of income, and (c) the Debt Coverage Ratio (DCR), which determines how much of the NOI is available for loan repayment.
NOI. The formula for NOI is the annual gross scheduled income minus vacancy and credit loss minus fixed and variable expenses equals net operating income. For example, a gross scheduled income (GSI) of $100,000 might have a vacancy and credit loss of $5,000 (5%). The fixed and variable expenses might be $30,000. In this example, the NOI would be $65,000. (We’ll refer back to this paragraph several times in the next few minutes.)
The NOI is specific to the building being studied. It is the income left after all the expenses necessary to run the building are deducted. If there were no loan, the NOI would go straight into Emily’s purse. If there is a loan, the loan payments would come out of the NOI.
Cap Rate. The capitalization rate is computed from the NOI. The cap rate presumes there is no loan on the building. It can be thought of as the annual “interest rate” the building would pay on an all-cash purchase. The formula is NOI divided by price equals cap rate.
As a matter of fact, the cap rate is so similar to an interest rate that investment people often find them indistinguishable, in the same way the terms “mortgage” and “deed of trust” are technically different, but used interchangeably in the marketplace. This article treats interest rate and cap rate as synonyms.
Using the example above (see first paragraph of NOI, above), the NOI is $65,000. If the buyer paid $650,000 for the building, the cap rate would be 10% ($65,000 divided by .10). If his wife allowed him to pay $1,300,000 the cap rate would be 5%.
The utility of the cap rate is this: it allows the buyer to compare different investments: comparable buildings against each other; buildings against the earnings yield of stocks, or both against Certificates of Deposit at the local credit union.
If Emily could (she can’t, and wouldn’t want to if she could, just yet) pay cash for her next building, the first thing she’d need to know (at the most basic level) would be the cap rate: everything else being the same, she would reasonably buy the building with the highest cap rate.
DCR. Remember how the NOI reveals the yield to the owner on an all cash purchase? Well, the DCR tells the yield to the owner if she mortgages the property.
Emily thought that was pretty neat: the NOI tells you the cash-on-cash yield of an un-mortgaged property, and the DCR tells you what the cash-on-cash yield is on a mortgaged property. Emily thought that was pretty neat.
There’s a trick to using the DCR, but it’s simple: it’s the “parts” number. You’ve got to find the “parts” number, but it’s an easy simple division problem. Emily could do it in her head.
A common DCR is 1.20 That means that the lender will divide the NOI into six parts, apply five parts (5/6th) to the mortgage payment, and allow the borrower to keep one part (1/6th) as his cash flow.
Six? How do we get six? Simple. Divide the 1.20 by .20. If the DCR was 1.25, you’d divide 1.25 by .25. Basically, you divide the entire DCR (the 1.20 or 1.25 or whatever) by the two numbers to the right of the decimal sign. That’s how we get our “parts” number.
Still using the earlier example (above), the one with $100,000 annual GSI and $65,000 NOI, a DCR of 1.20 would yield $54,166 (5/6th of the NOI) available for annual debt payments and $10,833 (1/6th of the NOI) for annual cash flow to the borrower.
As another way of looking at it, Emily put the data into a chart. Sometimes it’s easier to see things in a chart format, and maybe it would help her to decide whether to buy now or later (when she expected interest rates to be higher).
The chart starts with a hypothetical NOI, applies a reasonable DCR, determines the likely loan amount, and generates a probably value for the property. The chart also shows her expected cash flow and the yield on her down payment.
Using these figures, she’ll try to answer the question of whether she should buy at current low interest rates or wait for a better time when she expects interest rates will be significantly higher and prices (necessarily) lower. All values are appropriately rounded.
Net Operating Income $100,000 $100,000
Debt Service @ 1.20 DCR $ 83,000 $ 83,000
Interest / Cap Rate: 4% 8%
Loan Amount: $1,450,000 $945,000
Down Payment @ 30%: $620,000 $405,000
Property Value: $2,000,000 $1,350,000
Annual Cash Flow: $17,000 $17,000
Yield on Dwn Pmt: 2.7% $4.2%
Wait for Rates to Go Up. This chart offers a few good reasons to wait. Emily wrote some down:
(a) One of them is the significant savings that could come by waiting. If Emily could buy a $2,000,000 property for $1,350,000 (a 32% savings), it would be hard to argue against postponing the purchase.
(b) In addition to the savings in purchase price / down payment, in the future when the 8% rates slip into the back half of their cycle and begin to decline, Emily could probably refinance and harvest enough money to buy yet another building. As rates go down, building values go up.
(c) Stipulating that Emily has the currently necessary $620,000 down payment, if she waited until the effects of the 8% interest rate she projects are in place, she could buy the same property for a down payment of a little over $400,000 and with the remaining $200,000 she might buy more units.
Don’t Wait: Buy Now. John Maynard Keynes, the English economist, wrote, “The market can stay irrational longer than you can stay solvent.” Emily has to recognize that current interest rates are irrationally low, and have been for most of a decade. If they continue (and nobody knows whether they will or not, but some people have called this period “the new normal”), it’s quite possible that the building she is now considering will appreciate beyond her reach.
As an example, if the NOI increased 5% a year for 5 years it would grow to nearly $128,000. Applying a 1.20 DCR at a 4% interest rate would bring the maximum loan to about $1,800,000. Now add an appropriate down payment ($770,000) and the projected value would be a touch over $2,500,000. There is no reasonable way Emily could grow her current down payment to $770,000 in five years. The building that she could buy now would be unaffordable then.
However, if mortgage rates remain at a hypothetical 4% and Emily bought today, in five years her $620,000 down payment would grow by $500,000 to a total equity of $1,120,000. In what other investment would it be possible for her to do that in five years? So even though prices are stupid high, if interest rates stay low a purchase today might look brilliant over the next several years.
Emily’s Conclusion. This was the type of decision Don Corleone hated: either choice could end very wrong.
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, BRE: 00957107 – MLO: 249261. If you are thinking of refinancing or purchasing real estate, Klarise Yahya can probably help. Find out how much loan the building will support. For a complimentary mortgage analysis, please call her at (818) 414-7830 or email [email protected].