My Banker really really loves me! Wanna know why?

First I wanted to share with you that couple of weeks I was humbled and honoured to receive 3 awards from my good friends Don Campbell and Richard Dolan of the Real Estate Investment Network (REIN). The first one was for ‘Multi-family Investor of the Year (we added 53 units to our portfolio in 2013) and the second one for Top Player of the Year. However the most meaningful award I won was the ‘Leslie Cluff Memorial Award’ for helping others achieve their goals. It’s an award people vote for. Knowing I made a difference is some small way in someone’s life is a fantastic feeling of joy. I fundamentally care about people and I have come to understand that my success materializes as I help others succeed, including helping some of my students to take action and buy their first multi-family properties.

2013 MF Investor of the Year PICTURE

In this post, I want to share with you my positive experience this week with my banker to highlight the importance of building your relationships and reputation in the multi-family world, especially with your banker.

As you may recall, if you’ve been following my blog, back in March 2013, I took possession of a great little 15-unit apartment building. I have completed the ‘stabilization’ phase that is I’ve maximized the income and reduced expenses and improved the property’s condition and accordingly significantly increased the property’s value.  I increased rents by 17% and spent $70,000 in improvements. This was a conventionally financed loan, that is a non-CMHC insured loan, with an interest rate of 4.75%, open for one year. Now that the property is fully stabilized I am ready to refinance it with CMHC based on the higher value and at an interest rate of probably around 2.7%.  Accordingly, earlier in the week I took my financing application to the lender.

I’m not going to lie to you, creating your own financing application is a lot of work. The binder that contains the application and supporting documents was over two inches thick,

BUT WHAT A BEAUTY THAT FINANCING APPLICATION WAS!

Not only was my application pretty much perfect, but also it put my banker in such a good mood that I got a royal treatment from him. What do I mean by royal treatment?  Because of how well the application was put together, he pretty much had nothing to do in order to do to send it over to CMHC.  Here is what my banker did for me in response:

  • He hugely sped up the processing of my application by by-passing the regular steps, namely he did away with the standard proposal letter that I normally would have to sign off on;
  • Although he had 5 or 6 other applications in line before mine to send over to CMHC, mine was immediately put on the top of the pile… Hey, for him it was a low hanging fruit requiring practically no effort on his part. So instead of my banker requiring two weeks to go through my application before sending it to CMHC, it only took three days;
  • He also used his discretion to waive his processing fee, which would have been around $4,000. Because I’m refinancing, this fee would have been refunded to me in any case. Still though, I would have to come up with the funds upfront.

What this shows on the part of my banker is a high degree of trust in me because of my previous dealings with him and because of the quality of my financing applications. I have several loans with this lender and I have never defaulted on any of them and my properties are well managed.  The relationship is well established!

Now the good news is that once this application gets to CMHC, it will once again put me in a favourable light because it’s designed to also make the CMHC’s underwriter’s job to analyze my deal very very easy and instil trust.  This too will save me a tremendous amount of processing time at CMHC’s end.  I expect to get a response on this application within the first two of January versus perhaps four weeks in the normal course of things. In a refinance situation such as this one, the time factor is not so important. But if this were a purchase financing application subject to a financing condition, time would be of critical essence and speeding the approval process would greatly alleviate the related stress of removing this condition.

Let me tell you a little about how I put my financing application together.

First, I put all the documentation in support of my application neatly in big binder with tabs to separate the various sections. Remember, the binder was about two and a half inch thick! I had a table of contents so that every piece of information was super easy to find.  Every number and piece of information was supported.  What I wanted to avoid is to get a bunch of calls from my banker telling me my application is missing important details and documents.  By creating a highly professional financing application, it puts me in a higher class of borrowers/investors.  That’s what you want!

But the extra mile was also in that I put the entire re-financing application on a flash drive in addition to providing a hard copy. Not only that but I literally wrote the lender’s submission and it was on the flash drive in Word format so that the lender did not even have to re-write it and could amend if necessary.  He submitted it as is to CMHC with only a few minor changes.

THAT’S WHY MY BANKER LOVES ME!

Again, putting such an application together is a lot of work. Even for me!  I used to be one of the underwriters However, what an empowering feeling it is. Most multi-family investors won’t bother doing this hard work. As a matter of fact, many of them will use a mortgage broker. Well! There is a big cost for using a broker.  The broker might charge you 1% of the loan amount in fee to put such a financing application together. In my case, this would represent a fee in excess of $10,000.

My job as a so-called ‘EXPERT’ in the field multi-family investing is to ‘instruct and inspire’ and I would add ‘empower’.   It sometimes seems to me that investing in multi-family properties is the exclusive domain of a few select investors.  As a former multi-family underwriter and INSIDER  I reject this exclusiveness.   Accordingly, I choose to share my knowledge openly with those willing to commit to making the required efforts to purchase multi-family properties.

My mission is to:

Make multi-family investing accessible to the every day Canadian real estate investor’.

If you want to learn how to invest in apartment buildings in Canada I’d love to help you along your goal in 2014 as I have done for many of my students who took my live Multi-Family Investing Blueprint Live Event in the past.

DON’T WAIT ANY LONGER TO BUY YOUR FIRST MULTI-FAMILY PROPERTY.

 MAKE IT HAPPEN IN 2014!

 My next live experiential training event is scheduled for June 20, 21 and 22 in Edmonton. Click HERE if you want to know more about it, listen to or read testimonials from past students or if you want to register for it.  I keep improving the curriculum every year and my students have systematically rated the training event 9 out of 10 in terms of satisfaction.  In any case, I give you a 100% satisfaction guarantee because I’ve giving you the exact same tools I use.

I wish you a very Merry Christmas and Happy New Year and success in all areas of your life.

 

Are Multi-family Properties Recession-Proof???

It’s been just barely over a month ago that a new international financial crisis was averted following the US government 2-week lockdown and the raising of the debt ceiling until early next year when once again Congress has to raise the debt ceiling.

THE CRISIS HAS BEEN AVERTED, AT LEAST FOR NOW…  BUT FOR HOW LONG?

I got to tell you I don’t consider myself a worry wart but I’m concerned about what I’m seeing with regard to the international financial system and I’m darn happy I chose to invest in apartment buildings because if done right it can be an excellent hedge against financial volatility.

And I sure am no economist either, although I have always found macroeconomics quite fascinating.  But somehow, it just does seem right for the US whose currency is the world’s reserve currency, to keep printing money at will, which is what economists call ‘quantitative easing’, to keep their economy afloat.

I hate to say it but my 87-year old dad who has little education (he was a lumberjack) was right! He’s been asking for years where is all this money coming from? What value is there to back up this money? The subprime mortgage crisis and ensuing deep recession certainly proved him right!

And then, if you look at the sovereign debt issue in Europe, it’s anything but resolved.  Bottom line is that there are a lot of dark clouds in the financial world that could turn into a storm at any moment.

So yes! I’m worried somewhat! The truth is I did not particularly enjoy the real estate ride during the 2009 recession, which, as you will recall, was the worst since the Great Depression of the 1930s.

In December 2008, just a few weeks prior to the beginning of the recession I took possession of 24-unit apartment building.   2008 was certainly a bad, bad time to get into multi-family investing.  The first thing that hit me in my market was the City of Edmonton increased property taxes by a whopping 34% within months. There was the first hole in my cash flow.  Then of course as the recession worsened oil-related jobs fled the province and oil workers went back to Nova Scotia or Ontario or wherever they came from and vacancies increased drastically overnight. There’s another hole in my cash flow. Of course with higher vacancies come higher repair and maintenance expenses because when your suites become vacant, well that’s the time to fix ‘em up a little to attract tenants. Third hole in my cash flow and 2009 and the recession had just begun.  Oh yes and when the vacancy rate doubled, then the large, and often times institutional landlords such as REITs (Real Estate Investment Trusts) with significantly bigger financial means than me, started giving rent discounts to attract tenants to their vacant suites.  So I had no choice but to follow suit and start lowering my rents too as an incentive to tenants to rent my own vacant suites. What’s that? Fourth hole in my cash flow now… That nice positive cash flowing multi-family property is now looking like a Swiss cheese big time now!

OUCH!!!

I forget to tell you that if I had closed on that 24-suiter only a few weeks later, around the end January 2009, the interest rate on my loan might have been perhaps close to 2.0% lower than the 4.76% rate (5-year term) I ended up getting.  You may remember that within weeks of the beginning of the recession, interest rates dropped significantly.  (See graph below, courtesy of Calum Ross)  The additional cash flow that I could have had from a lower interest rate sure would have been nice and plugged up a few holes in my Swiss cheese cash flow.

I’m not going to lie to you, 2009 and 2010 were not much fun. But looking back, I now realize the very important lessons I learned and I’d like to share the key ones with you in today. I’m actually very grateful for that challenging experience because it’s made me a much better real estate investor and if my concerns over the international financial situation ever materialize, I feel my investors and I are well protected as a result of implementing those lessons.

LESSONS LEARNED

1)   Don’t over pay for the property

OK! This goes for any real estate asset you purchase and, although I put it down as a lesson, I cannot say I have overpaid for this property. As a matter of fact, I obtained financing for 84.4% of the purchase price, which is very rare for a CMHC-insured loan where the maximum LTV is 85% of the lending valueas determined by CMHC’. The emphasis is on the fact that CMHC practically always uses a value that’s lower than market value in calculating the LTV.   You always end up having to put down somewhere between 20% to 30% down.  As we’ll see below in lesson #2, more money down is not necessarily a bad thing. On the contrary. The point here is that if you overpay and there is a market correction in terms of values, it might be a while before you recover the over-paid portion.  We certainly experienced a market correction as values definitely decreased during the recession, although not much. You really need to know your market well.

I’m personally aware of a few investors that have defaulted and lost their properties because they speculated on the value and they bought based on future value that never materialized instead of current value.

2)   Lesson #2:    Don’t over-leverage your financingI’m not sure this was necessarily a mistake I made, that is to take a loan a close to 85% LTV. However it’s certainly not something I intend to do again.  Right now, my average LTV on all my properties is around 70% and I don’t intent to ever exceed 75%.  This is a much more comfortable position to be in in the event of market volatility.  A lower LTV means you have a lower loan amount, therefore a higher risk tolerance for higher vacancies and a greater cash flow to carry you through tougher economic times.  I like a break-even vacancy rate of at least 20%. The worst vacancy rate I suffered during the recession was around 9%. This means 91% of my suites were still generating an income. I like to sleep at night…

3)   Lesson #3:    Be ready to intervene as needed

When I faced higher vacancies I have to admit I may have been a little slow in reacting at first.  My suites were in good condition and yet I wondered why they did not get leased up more quickly. Then I started looking at the marketing my property manager was doing. As part of the management fee, it is his responsibility to advertise vacant suites. I soon discovered that my manager’s ads were not very good.  You cannot blame him because managing properties is a very tough job. The ads contained very brief property descriptions that did not mention the surrounding amenities or the walking score (http://www.walkscore.com), and especially the ads had no pictures…  So I then yanked away the marketing from my property manager and took it over. I started writing detailed ads myself on various online websites and included lots of pictures. The result was an immediate decrease in  vacancy rates by almost half.

4)   Lesson #4:   Be realistic about your return projections

Right up until the recession, that is during the preceding economic boom, we had extraordinary returns in excess of 30% per year. In Alberta, rents increased by close to 40% between 2004 and 2008.  That’s right! There’s no rent control! Rent increases, though, are limited to once per year to whatever the market can bear. Because of the multiplier effect whereby the value of multi-family properties is directly derived from the ‘income approach’, which means that for every dollar in increased net operating income (NOI), the value of the property appreciates in value by approximately $15, our returns were fantastic. Frankly, I went in into this deal with expectations of high returns and because of the recession these high returns did not materialize.  The good news is that our tenants kept paying the mortgage down and the property appreciated in value. Not all was lost. Still though, the property generated around a 12% annual return, albeit mostly a combination of mortgage pay down and appreciation. Not a bad return when considering it occurred a deep economic slump. Imagine what the return will be when times are good like now…

5)   Lesson # 5:     Be patient!

Well, I guess that’s it hey! Success does not happen overnight and patience is a virtue! This is probably the biggest lesson of all.

I stuck with it and I just renewed the mortgage on this 24-unit property for another 5-year term at interest rate of 2.62%.  A drop of 2.14% from the 4.76% rate I got just before the recession began.  Needless to say the impact is significant. Basically, this means an instant increased in net cash flow of $2,100 per month. Plus, the annual principal pay down will double.

Patience pays off, indeed…

Not only that, but since I purchase this property a new LRT (Light Rail Train, or subway) has been built within a few blocks of it and it will come into operation in the spring.  According to studies, the proximity of the LRT could lead to a value appreciation of 10% to 15%.  In addition, a new arena for the hockey team the Oilers will be built over the next 5 years, along with a huge retail and condo development attached to the arena. In all, it is expected that perhaps as much as 5 billion dollars will be spent in redevelopment in the area causing a significant revitalization of the area and further value appreciation and drawing quality tenants looking for a great urban lifestyle.

The current vacancy rate is extremely low. I figure it must be around the 1% mark. In other words, we’re fully leased and just in the last few months I’ve been increasing my rents, some suites by as much as 7%.

SO ARE MULTI-FAMILY PROPERTIES RECESSION-PROOF?

I personally believe so if they’re structured properly using a risk assessment and mitigation approach. For sure, my training as former CMHC underwriter come in handy.  You cannot completely eliminate risks, but you certainly can manage them to a great extent.

Yup! I’m definitely worried about the possibility of another financial crisis.  But no matter what happens, my investors and I are well protected because at the end of the day, if done right, apartment buildings remain a low risk and safe investment asset, and I like this! It may not be a get rich quick scheme but every now and then as the real estate market cycles go up and down you get a big lift (multiplier effect) and it more than makes up for lost time.

I hope this post has been insightful. Please, feel free to leave me some comments  and/or ask me questions.

Cheers!

Is your banker lying to you?

Hey folks!  October already! My three children are back to school and I have a bit more free time to start blogging again.

As you may know if you’ve been following my blog posts over the last 6 months or so, I have some students of mine that have taken action and purchased their first apartment building. As I have been working with them and coaching them I shared with you some of the lessons they’ve learned in the course of their first multi-family transactions.

I’ll be interviewing them in the next few weeks and share these interviews with you.

I’m really really proud of my students because it’s not easy to get into multi-family investing. It takes a lot of courage. I can tell you from personal experience and from what my students have recently gone through, there are many sleepless nights involved in the process.  All these questions you have to figure out.

Where is the money going to come from? How much do I need? How much financing can I get? Is it a good deal? Am I over-paying? Etc. 

You have to dig in and do a thorough job when completing your homework.

One additional level of difficulty multi-family investors may face when they gather the necessary information for their deal is sometimes they’re given ‘WRONG INFORMATION’ by the people who are supposed to be professionals in the business SUCH AS LENDERS!

That’s right! I had a student that unfortunately was somewhat misled about the personal net worth requirement to qualify for his loan.  Lucky for him I knew the rules.

All right! I suppose I’ve got to be careful about what I’m about to say in the next few paragraphs, but do mortgage brokers and bankers sometimes REALLY LIE to real estate investors?

I don’t really want to get into an academic discussion about the meaning of ‘lie’ but suffices to say that over the years I’ve observed professionals in the multi-family financing world purposely ‘WITHHOLDING‘ information from investors, often times for self-serving reasons.

There you go! I think I put it in a politically correct and non-offensive way!

In the case at hand, my student had an accepted offer on a 20-unit apartment building and he was in the process of conducting his due diligence, which I was helping him out with. He was also seeking CMHC-insured financing and had contacted several lenders accordingly. While speaking to one of the bankers about the borrower qualification criteria, specifically about the personal net worth requirement, the banker indicated that he needed 50% of the loan amount in personal net worth to qualify. Initially, my student was blown away by the lender’s response as he could not qualify on this basis and he now had an accepted offer and the clock was ticking to move the deal along. But my student having recently graduated from my 2-day live MF investing training event knew better and argued he thought he only needed 25% of the loan amount in net worth to qualify.

Who do you think was right? 

My student of course!  A week later that the lender called to apologize…

I’m not quite sure how to explain this blunder, especially since this particular lender processes an important volume of CMHC-insured loans. I have yet to have a chat with that lender to get an explanation.  I like to think it was an honest mistake.  I promise to find out though…

When it comes to what amount of personal net worth is required for a loan, conventional lenders – that is private lenders, or lenders that do not have their financing insured by CMHC – each have their own rules and it’s a matter of asking each of them individually what their qualifying criteria are. It’s not uncommon for a large number of conventional lenders to follow CMHC’s guidelines in this regard. It’s their prerogative.

When it comes to CMHC-insured loans, however, CMHC has its own set of guidelines which are published on their website.  For your benefit I’m attaching a link to these guidelines (http://www.cmhc.ca/en/hoficlincl/moloin/mupr/upload/Reference-Guide-63885_w.pdf).  On page 4 of the guidelines here is what it says about borrower net worth requirement:

‘CMHC requires that the borrower have a net worth equal to at least 25% of the loan amount, with a minimum of $100,000.’

I don’t know about you but to me the above is pretty clear! It’s 25% of the loan amount with a minimum of $100,000.

I don’t want to get into how the net worth is actually calculated because it’s not the purpose of this article. My goal here is to stress that investing in apartment buildings is so different than investing in smaller properties you really need to know the financing rules BEFORE YOU START INVESTING.  As I have often said in the past, you should only work with people with concrete experience in multi-family properties for starters. This will save you much grief and make your deals go more smoothly.

Here is the thing:

Bankers don’t expect you to know those rules.

Hence the reason you should take the time to learn them. It’s not that hard! And when you do, here is what’s going to happen:

  • it’s going to help build your self-confidence
  • it’s going to build your credibility with the bank

Bottom line is that it’s going to help you take charge and be in the driver’s seat.

Another area where often information is  ‘WITHHELD’ is when mortgage brokers push hard for conventional financing (i.e. non-CMHC insured) without presenting the alternative of having the loan insured by CMHC, thus paying a significant lower interest for the loan.  You should always look at both alternatives. It’s also a factor of what investing strategy you’re using at the time.

Again, multi-family investing is a complete different game than investing in small rental properties of 1 to 4 units. You have to take a significant amount of time to do your homework and learn the rules of engagement, as it’s all going to go long way to help you avoid costly mistakes and achieve success and financial freedom. Please, also remember that MF investing is not for the faint of heart either. It’s not easy! Otherwise, everyone would be doing. But the reward is worth it because the financial leverage is unparalleled for such a low risk investment vehicle if done right.

When you take the time to do your homework, then nobody can pull the wool over your eyes and you become an educated and sophisticated investor.

To your success in all areas of your life.

P.S. Make sure to leave a comment. Thanks!

 

Common mistakes novice Multi-family investors make!

Since my live training event (Multi-family Investing Blueprint) held in Edmonton this past May, I’m very happy to report that a couple of my graduate students have been taking action and have put offers on apartment buildings. One of them even closed on a deal a few weeks ago. After the live event, I always provide one on one coaching to graduates when they take action and as such I saw a common mistake novice investors make which I want to share with you in this blog post.

Working with non-specialized multi-family (MF) team members

If you’ve seen me speak on stage or read some of my previous blog posts, you’ve probably heard that I always stress the fact the multi-family investing world is a VERY, VERY SMALL WORLD with very few players in it. MF investing is a highly specialized realm. Accordingly, it’s critical that you protect your reputation at all costs as there’s little margin for error. So whether it’s your realtor, mortgage broker or lender, your property manager, building inspector, etc.,

YOU SHOULD ONLY WORK WITH PEOPLE WHO HAVE

EXPERIENCE IN MULTI-FAMILY INVESTING!’

Believe me, working with experienced MF specialists will significantly reduce your stress level going into the deal and help you look better with the mortgage lender, hence raise your credibility and build your reputation.  The experience of buying your first apartment building will be very stressful, regardless. If MF investing were easy, everybody would be doing it. But it’s not! So knowing it’s going to be challenging you want to put all the chances on your side upfront by only working with specialist who can guide you through the process.

Despite my advice, here are a few mistakes my students have recently made:

One of my students, who closed on his deal a few months ago, ended up working with a mortgage broker who does very few MF deals every year. When I found out who the broker was, I immediately remembered him in a negative way from my days as a multi-family underwriter at Canada Mortgage and Housing Corporation (CMHC).  His financing application packages were always incomplete when they got to CMHC and his files sat on underwriters’ desks for a long time waiting until all required information was supplied to us so we could begin the risk analysis of the deal.  I can only imagine the stress the investor (purchaser) endured as financing approval was delayed due to incompleteness of the application and he had to ask for time extensions to remove conditions in order to keep the deal alive. If the purchaser ever refuses time extensions, the deal dies right there and then.

You see, unprofessional brokers will be quick to get a ‘commitment fee’ from the investor to ensure they get paid for the work they do and to ‘HOOK’ you as a client. Once you’ve committed to a broker, it’s harder to switch to another one when you’re dissatisfied with them because you’ve already given that broker all your financial details and supporting documents. You’ve already spent a fair bit of time working with this broker. In this particular case, my student (the ‘managing partner’) had raised funds from about 9 investors to complete the purchase. However, the broker offered to the lender that all 10 investors be on title and provide their personal guarantees on the loan. My student is a highly paid doctor with high net worth sufficient to qualify alone for the loan without additional personal guarantees. But once 9 additional guarantees had been offered, there was no taking them back.  As a result, the managing partner had to go back to his investors and ask for their personal guarantees, which he had not anticipated. Then, one of his 9 investors dropped out completely.

In the end, my student found a new investor and closed on the deal and he’s happy with the property despite the huge stress he went through.

Another student of mine chose to work with a realtor that had no prior experience with multi-family properties. When he contacted me he had put an offer on a property 3 or 4 weeks before and the timelines for the offer were very wrong and the realtor did not appear to be very responsive in keeping his client up to date and proactive about obtaining required due diligence documents from the vendor.

The conditions in the offer were as follows:

  • 45 days from acceptance of the offer to do a physical inspection and complete due diligence process based documents provided by the vendor
  • Closing date within 90 days of acceptance of offer

Essentially, all conditions had been collapsed into one big condition to be waived within 45 days acceptance. This was not right!

Keep in mind, the offer structure is always subject to negotiations and the vendor and purchaser may agree to whatever is mutually satisfactory to both parties.  The offer structure may also vary based on market conditions and how long it takes to obtain financing and engineering reports, etc.. However, in the industry offers are generally  structured as follows:

  • 5 to 7 business days from acceptance of the offer for satisfactory inspection (‘walkthrough’) by the purchaser;
  • 10 business days from receipt of due diligence documents from vendor***
  • 30 business days from acceptance of offer to obtain financing, satisfactory engineering, environmental, property condition report, appraisal and other searches;
  • Closing within 90 days of acceptance

Again, the above structure is not cast in stone but conditions should be sequential by priority. For example, the inspection, or walkthrough, should always be the first condition. Basically, an investor must first be satisfied with the physical inspection of the property before asking for due diligence documents from the vendor or seeking financing. If property condition is unsatisfactory to the purchaser, then he or she can either negotiate the price down or walk away from the deal. There is no need to waste anybody’s time if you’re not happy with the property…

In the case of my student’s deal, his offer had been accepted 3 weeks prior and he was waiting for due diligence documents from the vendor without having even seen the property and without knowing what condition it was in. In addition, he had not received any documents from the vendor to verify the income and expenses and his realtor was not keeping him up to speed as to when he’d be getting the documents. The realtor had not called or anything. It’s the realtor’s job to keep his client informed, lead him through the offer process and push to get documents from the vendor. That’s how they earn their commission.

As you can see, working with non-professional of the multi-family business can make your investing experience extremely unpleasant and could cost you a lot of money. It’s very simple to ascertain whether someone has sufficient experience: simply ask them how multi-family deals have they done in the last year. If the answer is not many, then you need to look for someone else to work with.

To your success in all areas of your life.

 

POST #14 – Don’t Get Hung Up on Cap Rates!

What are Cap Rates?

 When it comes to determining the value of real estate assets there are three basic approaches used: the Cost approach (often referred to as the replacement cost approach), the Sales Comparison and the Income Approach.

Cap rates are used within the Income Approach to convert the anticipated net annual income stream into an indication of the capital value of the property. Hence this method is also referred to as the income capitalization approach. The basic theory of the Income Approach to value is that:

the value of a given property is the present worth of all the net income that the property will produce for each year of its remaining useful life.

It goes without saying that in order to use the income capitalization approach, the first step is to determine what is the income of the property or net operating income (NOI). This is the property’s income before financing costs or mortgage payments. It’s critical to accurately verify with utmost accuracy the NOI. The basic steps to follow in the Income Approach are detailed as follows:

  1. Estimate the total annual gross income that the property is capable of producing less allowances for future vacancies and bad debts.
  2. Estimate the total annual operating expenses.
  3. Calculate the net annual operating income (see table below).
  4. Apply the market cap rate to the property

You will note that valuation methods are called ‘approaches’. The point here is that valuation is not an exact science by any means. These methods are approximations of value only and no more however you can be sure that the banks and CMHC will rely heavily on the income capitalization in determining the value of your property.

How to calculate the Cap rate?

In the example in the table above we know the property generates an annual NOI of $110,000. In order to calculate this property’s cap rate the next step is to divide this NOI by the sales price for this property which, in this case, we’ll assume is $1,7M:

Property’s Cap Rate:  $110,000 ÷ $1,700,000 = 0.0647 x 100 = 6.47%

In other words, the NOI of $110,000 represents 6.47% of the capital value of $1.7M. Another way of looking at this would be to say that this property provides a return, or yield of 6.47% NOI of its purchase price before mortgage payments.

Keep in mind this is this property’s specific cap rate and if we want to know what is the market value of this property we now need to apply a market-derived cap rate to this property’s NOI.

The market-derived cap rate is simply the average cap rate for comparable properties that have recently sold in the market place using the formula above. For example, if the average market-derived cap rate is 6% and we apply it to the NOI of $110,000 we now get a market value of $1,833,333. High cap rates mean low value and conversely low cap rates translate into higher values.

Accordingly, an investor must be very familiar with the average market cap rates in any given market and monitor the market cap rates on an on-going basis.

Other things you need to know about cap rates:

Cap rates may also serve as indicators for a few things:

  • Market risk or a property condition risk:  A savvy investor will want to be compensated for taking on a higher risk by paying less for the property, hence buying the property at a higher cap rate;
  • Demand:  A high demand for properties in any given will tend to compress cap rates downward whereas low demand may have the opposite effect;
  • Property’s performance: Compare your property’s cap rate to the average and gauge your property’s performance. Is it within the range of current market cap rate for comparable properties? If not, find out why and explain discrepancies.

Here is a little trick to calculate either the cap rate or the value of the property. In both cases, however, you need to know the NOI. Please, meet my uncle IRV:

 

 

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I   = Income or NOI

R = Cap rate

V = Value / Purchase Price

If you divide the NOI (I) by the cap rate (R) you’ll get the property’s value. If you divide the NOI by the purchase price (V), you’ll get the cap rate.

Bits of wisdom

  • Verify each number in the income & expenses. Numbers must be reliable – Let the numbers tell you the story, not your emotions.
  • Don’t get hung up on cap rates. Make sure you have a positive cash flow after mortgage payments.

I hope this short article helps demystifying Cap rates. Please, don’t hesitate to leave me comments.

Success in all areas of your life.

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