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Commercial Property Investment Crash Course

Posted On Friday, 09 April 2004 02:00 Published by eProp Commercial Property News
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A crash course in considering an investment property.

Sapoa CEO Neil GopalGross Rent = Yearly gross rental income from all units

Gross Income = Gross Rent - vacancy factor + other income (for example, laundry)

Net Operating Income (NOI) = Gross Income - all expenses EXCEPT DEBT SERVICE!

Cap Rate = NOI/Sales Price

Cash Flow = NOI - debt service

Here's an example property:

Sales Price: R90,000

Gross Rent: R400/unit * 6 units * 12 months = R28,800
Vacancy: 10% vacancy = (R2,880)
Other Income: Laundry = R500

Total Gross Income: R26,420

Gas = R480
Electricity = R300
Management = R3,274
Taxes = R1,160
Insurance = R750
Water = R2,400
Maintenance = R3,000

Total Expenses: R11,364 (43% of Gross Income)

You know you are in the ballpark on expenses if it's between 40-50% of gross income.

Net Operating Income: R15,056

Cap Rate (NOI/Sales Price): 16.7%

Cap Rate stands for "capitalization rate," and it is basically the yield on your investment if you bought a property with all cash. In this case, if I took R90,000 of my own money and bought this property, then every year I would receive R15,056, which is a yield of 16.7%.

The reason you can tell this is a good deal is because you can borrow most of this money at a substantially lower rate (8-10%). Basically, anything that has a cap rate in the teens is a good deal. What you typically find is that in any one particular market, the cap rate doesn't change a whole lot. In a well-established neighborhood with high demand, you'll probably be hard pressed to find a cap rate above 10% (which leaves a very thin spread when you borrow money at 8-10%).

By taking the average cap rate for a particular area, you can quickly determine the market value of a commercial property (NOI/cap rate = value). So if the property you just bought was in a place with an average cap rate of 15%, then the market value would be R15,056/.15 = R100,000.

Note that this type of appraisal only works with commercial or multi-unit apartments. With single-family homes, emotion enters the equation and you need to pull comps of past sales.

To complete the above example, if you borrow R82,500 at 12% interest for 20 years (this is the actual amount you are borrowing, but you are still not sure what the rate and term will be because you are assuming a loan that was originally made for 3 properties, and it's currently being restructured, so I've used this high rate and short term as a conservative estimate), we get:

Debt Service: R908 * 12 months = R10,896
Cash Flow: R15,056 - R10,896 = R4,160 (R347/month).

One final useful calculation is the actual return on investment, or ROI. This is the amount of money you are getting for your out-of-pocket expense. In this case, you are making a down payment of R7,500, and receiving R4,160 a year. This is an annual ROI of 55.5% (the astute observer will notice that if you can structure a deal where you put no money down then your ROI is infinity.... )

If you continue to play with the numbers, you can see why there can be such a great difference in a cap rate of 10% and a cap rate of 15%. In this example, since you are borrowing money at 12% interest, any increase in cap rate above 12% means that that percentage of the purchase price goes right into my pocket. So we have 16.7% - 12% = 4.7%, and 4.7% of the R90,000 purchase price is R4,230. This is very close to the annual cash flow that was calculated above.

Thus ends our commercial property investment crash course.

Please note that this should not be construed as investment advice. Always speak to a professional property practioner to determine if an investment property is a good deal.

Last modified on Sunday, 25 May 2014 22:12

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