First Commercial Poperty For Me... IS THIS A DEAL?

Question

hey everyone,

so i went to go see a property in jersey city, NJ on sat. It was my first walk through with a property. It was an amazing experience for me. But I wanted to run the numbers with some of you guys because I might be too close to the property. I need an objective view :D

Income and Expense Statement 2008
Total from rents $45,118.40
Expenses: Mortgage=$3,261.52
Homeowners Insurance: $4,200.00
Electric Bill: $267.08
Water and Swear Bill: $2,456.00
Heating Oil: Oil City: $2,185.20

Its a 5 unit building coded as an apartment.

This the numbers he sent me. And from what I've been researching the rent average for the area $900-1200.

The owner said he owes $330,000. He said he wants his initial investment of $113,000 back. He bought it in 12/7/2006 and I dont think he put in 113,000 given the amount he's had the prop and how much he still owes. he could have just been inflating his initial investment because he knows we'll shoot low. We are getting his mortgage statement sent to us. Motivation: He lost his job.

He had it appraised in dec of 08 for $550,000. Caps in downtown jersey city are 4-6% because of the big condo conversion boom there. This prop is at 5.9% cap rate with the current NOI and appraised price.

I have 2 buyers lined up who are coming in all cash. What do you think I should offer and what should I sell to buyers for? I was thinking offering $360,000 in hopes of negotiating at somewhere around $380,000 and selling to buyers at $400-425,000. Thanks in advance for any info.

Charles

Colleen Sheridan · Answer

One of the things you also need to study is your "exit strategy". Simply put, if something in your life went terribly wrong and you were forced to sell the property again quickly, could you at the very least get back what you paid for it.

This seems to be a pretty thin deal to me. Have you factored in all your closing costs, such as transfer taxes, attorney's fees, title search and insurance, etc. Are you sure you have all the expenses? I didn't see trash removal, snow removal/landscaping if required. Did you check if the real estate taxes are coming up for revaluation anytime soon? Sometimes it is hard to pass along all the expenses that go up, so your net actually can go down. I agree with Will too, sellers ...well I won't say lie, but they have selective memory when it comes to the warts and wrinkles.

Charles Kagahastian · Answer

i feel like there is extreme upside in the rents. Rents could be raised to about a $1000 per unit with some improvements and it'd still be below the market rents in the area. I feel like an experienced investor would be able to bring this property to its full potential. The guy who owns it doesn't know what he's doing really.

There's big development in downtown jersey city. This area is not as nice as downtown however.

If I was looking at this as if i was gonna keep it i would project out 2-5 years and within 2 years i could raise rents right below market and make this prop. run smoother and bring in more money.

say i brought rents to 1250 per unit. where market is around 1400. I'd increase scheduled income to 75000 and if the rule of thumb half of that goes to expenses i'm left with 37500. The cap rates are currently between 4-6% because of the huge condo boom in downtown jersey city. If i sold at 6% cap rate with a 37500 NOI i'd sell for $625000? Am i wrong in assuming this?? Am i not being realistic at all?

Charles Kagahastian · Answer

"The difference between the return assuming 100% financing (which we know nobody gets these days) and your actually financing is the return on your capital, not the return from the property."

- written by Jon -

Jon, can you explain this statement. I feel like it's very important and I don't quite fully understand it. Thanks for all your help guys!

Jon Holdman · Answer

When you invest cash into a deal, some of the return is from the deal itself, and some is from your invested cash. Almost any deal with "cash flow" if you pay cash for it. But that doesn't make it a good deal. You still have a ton of expenses, and all the hassle and risk of a real estate investment. You need some means of evaluating the deal independently from whatever financing you put in place to acquire the deal.

In the commercial world, "cap rate" is often used as a metric to evaluate deals. The cap rate takes the annual NOI, which is defined as collected rent less actual expenses, and divide that into the purchase price. That generates a rate of return. The difficult part of this calculation is the NOI. Sellers lie. Their agents lie. Even if they tell the truth, their records or memories can be inaccurate. Or, they can do things that make the NOI higher in the short term. Most commonly, deferring maintenance. Less commonly, tricks like showing you a lease that has one amount, but having a verbal deal with the tenants for a lower amount.

So, a common rule of thumb is to assume 50% of the rent will go to expenses. More correctly, 50% of the scheduled rent will go to the actual expenses, vacancies, and capital items. Capital items don't occur every year on every property, but when they do they can really break your wallet.

However, you still want to look at the property for anything that makes the expenses higher. For example, I've looked at a property where vacancies were 30%. Another where maintenance alone was over 50% of the rents. In those cases, the actual expenses are much higher than 50%.

The cap rate ABSOLUTELY MUST be higher than the interest rate you're paying if you finance the property. Otherwise, you're borrowing money at one rate, and investing it at a lower rate.

If the cap rate is high enough, you'll earn a decent return. If the cap rate on a deal is, say 10%, and your interest rate on your loan is 7%, then you would earn the 3% difference. If we're talking a million dollar deal, and you have no money into the deal, you're going to make 3% of a million, or $30,000 a year. So, that's the quality of the deal.

Now, consider putting in a down payment. Say you put 25% down and get a loan of 75%. On the 75% of the deal that's financed, you still earn the 3%, or $22,500 a year. On the 25% where you've put in the cash, you earn the full 10%, or $25,000. That makes a total of $47,500, better than the 100% loan case by $17,500. That difference, $17,500, is the part of the return that's generated by your cash, which the original $30,000 is the part that's generated by the deal.

Another way to do the math is a "cash on cash" return. In my example, you've invested $250,000 (neglecting costs, which you must not in real life.) Your annual return is $47,500. The cash on cash return is $47,5000 divided into $250,000. That's a 19% return. Very nice.

Jon Holdman · Answer

That adds up to scheduled rent of $3816 a month. I'll revise my break even price to $286,816.

The calculation is simple. Assume 50% for all expenses, capital items, and vacancy. See the Rental Property forum, where this is discussed and debated at length. After allocating 50% for all expenses, that leaves $1908 in NOI. If you use the entire amount for a payment, and use 7% and 30 years for the terms, you get a loan amount of $286,816.

Putting in a down payment, or even paying 100% cash, may make you get some cash each month. But, it doesn't change the quality of the deal. The difference between the return assuming 100% financing (which we know nobody gets these days) and your actually financing is the return on your capital, not the return from the property. By assuming 100% financing, you make the deal stand by itself.

This calculation is essentially the opposite exterme of calculating a cap rate. With a NOI of $22898 a year (I could care less what the seller or his agent claims, unless they say the expenses are more than what I calculate), I get a cap rate on a $400K price of 5.72%. Better than CDs, but only slightly. Certainly less than the rate you would pay on a loan.

Charles Kagahastian · Answer

Jon,

I would be assigning the contract. I have an options contract revised by my attorney.

Thanks for the reply. The owner is charging below $900 on average per lease.

Prior to Sept '08

Unit 1: $910.84
Unit 2: $576.52
Unit 3: $600.56
Unit 4: $837.16
Unit 5: $806.52

Starting in Sept '08

Unit 1: $937.25
Unit 2: $593.23
Unit 3: $617.97
Unit 4: $861.43
Unit 5: $806.52

I just found out it is rent-controlled...

Jon, would you be so kind as to explain a little more how you calculated your break even.
The buyer would be coming in all cash so his cashflow would be above the $100/unit/month rule.

Any help would be greatly appreciated. Thanks!

Charles

Jon Holdman · Answer

Are you going to actually close on it, and then sell it to your buyer? If so, buying at $380K and selling at $400K doesn't leave you much room, after your closing costs. If you can assign it, and walk away with the $20K (taxable), that's pretty good. That assumes you have a buyer lined up and ready to pay.

As a rental, its a loser at $380K. Based on the stated rents, and your $900-1200 estimate, I'm guessing the scheduled rent at $900/unit/month. That's $4500 a month or $54,000 a year. With the actual of $45118.40, that puts your vacancy (actual or economic) at 16% vs. the expected $900 a month. That seems quite high. Based on the $900, I calculate break even at $338,192.

Rent: $4500 Expenses: $2250 NOI: $2250 ($27,000/year) Payment: $2250 ($338,192, 7%, 30 years) Cash flow: -0-

To get the expected $100/unit/month in cash flow, you'd need to be under $263K for a purchase price.

Charles Kagahastian · Answer

Also, one of my buyers wants a cash flowing property and was wiling to pay $200,000-$300,000 for a 2-3 family. This is a 5 family...

First Commercial Poperty For Me... IS THIS A DEAL?

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