How to evaluate value investment property?

[LawrenceMak]

I know the answer is likely going to be "it depends", but how would you evaluate the following property:

- Net cash-flow of $4,000 / month (gross revenue minus property tax, condo fees + utilities etc)

- An average appreciation in the area for the past 5 years of 5-8%



What would you pay for such a property assuming you had the cash?



A few people I've asked say "it depends" but can't really articulate the formulas or factors that it depends on.



Any advice or general rules of thumb is much appreciated.



Thanks!

 

[Thomas Beyer]

Using a 6% CAP rate of a $48,000/year NOI ( net operating income) I arrive at a value of approx. 800,000, more or less. More if big city ( or land locked city like Vancouver) and reliably growing revenue stream, less if small city with higher vacancy potential and possibly declining revenue stream.



Unclear is how accurate the $48,000/year is, as several costs, such as R&M and property management are not mentioned in your question. As such it may only be $36,000/year and as such the value would be $600,000, or if $30,000 around $500,000. There may also be upside in undeveloped land or the right to build additional floors which would increase the property value beyond a strict NOI evaluation.



Far more information, such as property type (office building ? retail store ? horse farm ? duplex? condo ?), city size, growth of area, deferred maintenance (old roof ? needs paving ? elevator broken ?) .. is required for a better answer !

 

[KevinSolomon]

Assuming 50% operating margin, I would pay $500k. I wouldn't go higher than $750k. My priority is return of capital before return on capital.

 

[Matt Crowley]

Critically, you want to divide the NOI by the cap rate when you have ascertained the normalized income. Specifically, you will need to take an in-depth look at the deferred maintenance and also the current level of deterioration of the property.



Cap rates are property type specific and will be influenced by the underlying useful life.



Your Realtor should be able to provide the cap rates. From that you get your market valuation.



The value of the investment to you is an entirely different issue.



- can you improve rents by updating the property & fixing problems?

- can you pull cash out with a refinance after the renovations are completed?



When I look at the value of the investment, I look to a few other indicators:



- cash on cash return

- debt credit ratio (NOI/debt service)

- cash invested in property after normalization

- internal rate of return (compounded annual rate of return). Run this one without a mortgage then with a mortgage.

- safety factor: how long will the renovations take? How large is the underlying risk factor? Is there any way to get the current owner to complete any compliance issues before you take possession?



I think you are on the right track...yes, it depends.

 

[3canctheayr]

I think folks ought to consider adding in some risk factor, especially in many high priced areas;



ie. interest rates are at all time lows & what are the odds they stay this low given where they have been historically?

If they go up, how much should you factor in for that possibility?



A 6% cap rate is fine when you can rent money at 3%, but it sure will suck when money costs 6, 8 or10% to rent.

Can the price you pay for a building handle a stress test if money gets expensive down the road, or the prices of investment properties drop, because cap rates are rising...?



On the other hand, if inflation really comes home to roost, having a good building should hedge against that......

 

[Thomas Beyer]

[quote user=3canctheayr]when money costs 6, 8 or10% to rent.


That is extremely unlikely.



Assume for now the new normal is far lower interest rates for far longer. Perhaps a but higher than today, but some indication is US 30 year mortgage rates are 4%, or 3% for a US government bond. 10 year GofC money is 2.5%. In that environment interest rates will NOT go up a lot, and if so very very VERY slowly.



If you assume interest rates go to 10% buy in cash only.

 

[3canctheayr]

None of us really know what interest rates are likely to do, when or why.....However, I agree the likelyhood of high interest rates soon, is probably low.

The US and other govts have waaaay too much debt to afford higher rates. The economy is also pretty crappy in most areas, so high rates are probably unlikely.



However, the point was to assess the odds of these things and also stress test the numbers to see if they can handle high rates in case it happens, then also factor those things into the evaluation



Most buildings being sold today can't support rates much higher than about 5% or so. A crap load of landlords went belly up in the early 80's when rates spiked & property values collapsed.

 

[Thomas Beyer]

[quote user=3canctheayr]None of us really know what interest rates are likely to do, when or why.
Oh yes, we do.



[quote user=3canctheayr]Most buildings being sold today can't support rates much higher than about 5% or so. A crap load of landlords went belly up in the early 80's when rates spiked & property values collapsed.


That is true, but high interest rates also would lead to collapsing stock markets and super high unemployment.



If you believe in such an environment you should not invest into anything, i.e. stay in cash, or get a very low or no mortgage for a piece of real estate in a big city where there will always be tenants.

 

[REQRentals]

Janet's Yellen louder than ever that she is going to raise rates



But she never does.



Even if we assume low but gradually rising rates there seems a disconnect.



Is a 6% cap realistic on a smaller asset in a big Canadian City ? This also appears to be a condo as it mentions condo fees as an expense.



In a few previous discussions investors were having trouble finding more than 4% on a self managed duplex in Calgary/Edmonton.



Toronto condos sell like hotcakes to investors at cap rates well below 3%. I understand it is worse in Vancouver.



I would not think it necessary to get into "crash theory" or 10% interest.



Just figure owning something that makes 3% or even 4% and rates going to 5%.



Consider Thomas Beyer's 3 course meal analogy.



It seems like starving yourself all day hoping to gorge on the "chocolate waterfall" at Golden Coral.

 

[Thomas Beyer]

Note that in the stock market sell off over the last few weeks the talk of stimulus has re-emerged, and interest rates have gone lower. The flight to safety continues.



So if you are truly worried about rising interest rates buy in the US where you can get 30 year rates, or get ten year terms in Canada (for a premium, of course).



Personally, I go variable wherever I can can or 5 years for larger mortgages as money is plentiful and cheap.



Canada, especially W-Canada, especially bigger cities or metro-areas in AB and SK will do very very well. Alberta will be a province with 6M people by about 2040, bigger than BC, for example. In such a province prices will not fall.



Now with oil at US$80 there might be some buying opportunities in this red-hot market as panicked sellers exit. btw US$80 is Can$90.



Europe has weak growth. Japan has weak growth. Even China is weakening. In such a lower growth world interest rates will not rise much, in fact might fall further.



Borrowing at 3-4% for assets that yield 5-7% makes sense to me in a growing oil/gas/coal/potash/corn/beef/baby/water/grain producing region like AB or SK.



Even Quebec is on a pro-growth, pro-fracking, pro-oil-refinery, debt-reducing, less-union-rights, sensible-pension course (if ever so slowly at first) and may emerge before Ontario as a growing province again. Ontario will see the light eventually, post-Wynne. Look what happened in SK post-Wall: it emerged from a socialist province to an economically leading province in a few short years.



Canada is a great place to invest. It will be home to over 100M people in 2100 !

 

[LawrenceMak]

For the record, this is a live/work condo in the greater-Toronto-Area in a highly sought after area steps from the lake. (Residential condos in the same development are going for $1M to $2M+).



It appears that some of the "it depends", depends on the location as well, and not the simple ROI or cap-rate.



So if it is in property in the area is in higher-demand, does this help or hurt the evaluation? As an investor, how would you factor in the possible appreciation?



Thanks for the insight.

 

[KevinSolomon]

[quote user=LawrenceMak]For the record, this is a live/work condo in the greater-Toronto-Area in a highly sought after area steps from the lake. (Residential condos in the same development are going for $1M to $2M+).


For the record, this is irrelevant to me as an investor. I'm not looking at a residential condo. I'm looking at a rental property.



[quote user=LawrenceMak]So if it is in property in the area is in higher-demand, does this help or hurt the evaluation?


"Higher demand area" only matters to a seller. It doesn't matter to me as an investor.



[quote user=LawrenceMak]As an investor, how would you factor in the possible appreciation?


My price already factored in everything that is important to an investor.



Go to any financial institution with an investment property and talk about boosting the price because the property is in a "high demand area" ("potential for explosive growth" is another phrase sellers like to use). They won't care either.

 

[Matt Crowley]

[quote user=KevinSolomon]For the record, this is irrelevant to me as an investor. I'm not looking at a residential condo. I'm looking at a rental property


Property type is never irrelevant. Building type, especially materials used in construction, influences the useful life and amount of cyclical expenses that will need to be incurred. Cyclical expenses are rarely accounted for in any pro forma.



[quote user=KevinSolomon]"Higher demand area" only matters to a seller. It doesn't matter to me as an investor.




You can own a high rise in downtown Edmonton or outside the Anthony Henday ring road. Location is extremely relevant. At 2% vacancy rates, it doesn't seem relevant if downtown sells for up to $3 / SF and outside ring road sells for $2 SF for one bed and $1.65 SF for two bedroom. It seems like a wash when you calculate NOI. But it's not. A downtown asset is premium and will be less sensitive to vacancy rate changes. Rental rates can reasonably receive a higher growth rate assumption.

 

[REQRentals]

Really interesting location.



I have lived and worked on the lake at Bay & Queen's Quay since 1983. Consistently since '97.



It is really nice here but they are building a lot of condos. Certainly a high supply location.



Lots of commercial buildings also going in down here. Massive infrastructure spending.



They just did a overhead bridge to Union Station so it is possible to walk throughout the downtown core without ever going outside in winter. In the summer every week brings a different waterfront festival.



Best place to live in a City that is growing ever more affluent in my view but they are sure building a lot of condos.



That being said you are not going to net 3% cap down here particularly from a larger suite..



Between $ 1M and $ 2M is a pretty big range.



Steps away from the lake is also a red flag and for that money you can jump off the balcony and be wet.



If you tell me what complex and size it is easy enought to pull comps off MLS



Cannot disagree with Thomas of it being good to get 5% to 7% cap (I thought it was 6%-7% the last time I made this point but who is counting)



Only problem is nobody seems to have the true 5%-7% on good assets here.



On the Toronto waterfront will never see 5 % cap or anything close.



Love to live here though.

 

[LawrenceMak]

[quote user=REQRentals]Really interesting location.
Specifically, it's in the surrounding cities, not in Toronto proper.



[quote user=REQRentals]If you tell me what complex and size it is easy enough to pull comps off MLS


That's the main problem. Comps in the area for this type of unit (live/work) is 5 years old. The only thing we have to base the appreciation on, is the surrounding residential condos (condominium townhouses) from the same builder, that averages around 5-8% / year.



By "steps from the lake", i mean throw a baseball from your front door and you hit the lake.




I also mention the lake, because the actual lease-rates of the surrounding residential condos are around $3k+ / month and go quickly. In other words, vacancy should be low if priced decently.

 

[REQRentals]

More interesting still.



Port Credit would be my bet. Perhaps Burlington or Oakville. The population growth in these areas (the 905) is supposed to exceed that in the downtown core. Demographically the west side is more affluent than the City, the east not so much.



http://www.fin.gov.on.ca/en/economy/demographics/projections/



The rest of the conclusions drawn in the study I would leave to your better judgment.



Is it a pre-construction contract if there are no comp sales ? There is an active secondary market trading pre-construction contracts so you can likely still find someone who is trading them to get an idea of prices.



If it is an initial developer offering what release is it ? What did the previous releases sell at ?



What the 5 year old ones are selling for is a good indication of where the price will likely settle after the "new" wears off if they are comparable in size and amenities.



In 5 years after the warranty expires (how long usually people plan to hold new) you will be in the same position. What will be the premium for a 5 year old unit vs a 10 year old one ?



Generally when you buy a pre-construction contract you pay a premium from current market depending on the length of time to occupancy - Like a premium on a futures contract. Following the analogy you have to beat the premium by the delivery date to come out ahead. It is not sufficient that it simply increase in value from current market. Obviously if it comes out at more than the contract price you are golden and that is how a lot of people have made great money. That is also how the premiums have risen consistently higher



What will the 5 year old ones be worth in 5 years or whenever you intend to sell ? That would be the first point of critical analysis.



Same with the rents.



If other units that are comparable but 5 years old are getting 3K why would you be getting over 5K which you would need to net 4K per month ?

 

[3canctheayr]

[quote user=LawrenceMak]For the record, this is a live/work condo in the greater-Toronto-Area in a highly sought after area steps from the lake. (Residential condos in the same development are going for $1M to $2M+).



It appears that some of the "it depends", depends on the location as well, and not the simple ROI or cap-rate.



So if it is in property in the area is in higher-demand, does this help or hurt the evaluation? As an investor, how would you factor in the possible appreciation?



Thanks for the insight.





That area has definitely been sought after in the last decade. One question I have is - will it stay that way? Prices have climbed at double digits for many years. Can they continue? Appreciation is a nice bit of icing on the cake, but should never be counted on in an investment, especially if you are financing most of it. Appreciation can be a double edged sword sometimes One factor I always apply is how much +ve cash flow will the property provide after financing, op/ex, and maintenance/wear & tear has been calculated. I also put in a risk factor if interest rates were to rise down the road. If it cash flows a decent number after all that, then good. If not, can I make changes to it that will improve the revenue/cash flow and/or appreciation? If not, Next!

 

[LawrenceMak]

Out of curiosity, how does one come up with a cap-rate, of say 6%?



Is it based on similar properties in the area? Or is it based on yourself as an investor, that you could get 6%+ somewhere else (stocks, other cities), so anything less than that isn't worth it for you?



I guess i just don't understand how one could find a property with a 6% cap-rate (only NOI, not appreciation) in the GTA.. Either that, or i haven't found it yet!



(I'm also a beginner, so does cap-rate only talk about NOI and never considers the appreciation?)



Thanks for your tips!

 

[Thomas Beyer]

[quote user=LawrenceMak]cap-rate, of say 6%?
A rule of thumb. Lower in a big city, higher in a small city.



If it were that simple everyone would be doing it and be a millionaire.




Buying an apartment building, like flying a Boeing 747, or juggling, or playing the piano, in principle is easy.


However, like flying, juggling or playing the piano, it takes a few years to learn, and many more years to master !


It is a skill and time intensive activity !


Buying a building is not that simple (i.e. price/door or CAP rate) as
it may look as many, often very time-intensive factors have to be
considered such as:

a) CAP rate

b) price/door

c) what is behind the door i.e. condition of suite

d) what is in front of door, i.e. condition of common areas

e) rents today

f) immediate rental upside

g) long term rental upside

h) balconies ?

i) suite size or price per sq ft

j) views ?

k) macro-location, i.e. future of city/town

l) micro-location i.e. suburb or local area pluses and minuses

m) condition of major elements like roof, boiler, windows, balconies

n) interest rate on mortgages

o) cash per door i.e. cash-to-mortgage

p) availability of 1st and 2nd mortgage money

q) condo conversion abilities / potential

r) who pays utilities

s) potential future tax increases or decreases

t) ability to lower operating expenses

u) curb appeal

v) `feel` of suite / attractiveness

w) competition from new construction

x) competition from existing buildings

y) in-migration

z) new jobs coming (or leaving)


.. maybe I forgot 3 or 6 more ..


one of these elements overlooked .. and there goes $100,000 or $1M in potential profits !!


Yes, you can do it yourself, and many have, or you can join with experts !

 

[LawrenceMak]

My gosh! So many things to consider.



At least when I eventually get into this industry, the barrier for entry for others will be higher.



Based on your other posts, I suppose the next step, is to start small with something and then gain experience before I move up the ladder!