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Determining the Value of an Investment Property

A Primer on Determining the Value of an Investment Property

By Christopher Seepe

Determining the value of an investment property is likely the first thing you want to know, whether buying or selling it.  The following is a summary of the underlying tenets of that spreadsheet.

An income-generating property’s value is driven primarily, but not exclusively, by the amount of net operating income or NOI (income after expenses and before financing) it generates.

1.       First, determine the property’s potential gross income. This is all the income you expect to get if you have no vacancy or bad debt, including unit rents, parking, laundry, storage etc.

2.       You’ll inevitably have vacancies and bad debts (non-payment of rent) from time to time. Deduct this amount from your projected income. Even if the existing owner says turnover is once every five years, Canada Housing and Mortgage and all financial institutions will include a vacancy rate in their assessment of what they’ll loan you. This is usually 2% to 4% of income. You also want to be realistic and conservative in your projections, so factor it in.

3.       Determine all your operational expenses. Many realtors and owners do not include certain costs in calculating NOI that should be included. They may do this either because they don’t know the proper application of the Income Approach or they want the NOI to look better than it is. Leaving out certain costs can have a dramatic impact on property value. A $1,000 reduction of NOI can reduce property value by $16,000 or more.

Most often excluded in operational costs are property management and maintenance costs. The owner or realtor may say that the owner did all the work but this is irrelevant to CMHC and financial institutions. They will factor in these costs when determining how much they will lend you.

These cost values differ per geographic region and estimates differ between lenders but use 5% for property management fees and $750/unit for annual maintenance. These are negotiating points too between buyers and sellers as well as with lenders.

Other costs include realty taxes, insurance, utilities you pay for (common area electricity, etc.), rental fees (eg. hot water tanks), garbage pickup, janitorial, security, website, advertising, inspection and association fees, cleaning supplies, legal, accounting, commissions (for finding new tenants), landscaping/snow removal, pest control, and you may want to factor in a reserve for major repairs.

Don’t include one-time major costs such as replacing a roof, painting the building, re-paving the parking lot etc. These one-time “capital” costs are depreciated over time and are handled as a different line item in your financial statements.

Other types of investment properties, like retail plazas, usually pass on most of its operational costs to its tenants through CAM (Common Area Maintenance) or TMI (Taxes-Maintenance-Insurance)—also called Additional Rent—so NOI calculations are generally simpler.

4.       Deduct the operational costs above from your expected income to calculate your “true” NOI. For example, an apartment building with $110,000 in gross income and expenses of $48,000 has a NOI of $62,000.

Don’t be surprised when the buyer’s NOI numbers invariably come out to be less than the seller’s. This is often a fundamental part of the negotiation process.

5.       The key point about the Income Approach is that an investment property should be primarily priced according to how much profit it generates for the owner. That’s a major reason why a well-run 10-plex with all tenants at market rates could fetch more than a poorly-managed 20-plex.

6.       Now, the key calculation: divide the NOI amount by the “cap rate” you want in order to determine the approximate value of the property.

What is “cap rate?” That requires a course on its own. It can take a while to really understand what a cap rate means. Cursorily, cap rate is a ratio that expresses the relationship between a property’s current year’s net income and the value of the property. It is particularly useful in financially comparing two widely differing properties. However, it doesn’t factor in the state of repair of a property, its appreciation potential, location, geographic area growth potential, local area crime, tenant demographics and other value-impacting considerations.

Cap rate is expressed as a percentage, and assumes a cash purchase. This ratio is a blended value representing the amount of time for you to see a return of your investment, combined with the value of your return on investment over a period of time. For example, the former asks how long it will take before you get back your $250,000 deposit and closing costs. The latter asks how much money you will make, say, over 10 years.

How do you decide what the cap rate should be? This is the operative question and is arguably the most important step in establishing a value for a property. Two common ways (or sometimes both) that cap rates may be established by a buyer or seller is:

•        Compare cap rates of comparable types of properties that have recently sold in the area

•        What kind of return could you expect to get if you purchased some other type of investment, say stocks, bonds or term deposits?

A buyer will always look for the highest cap rate possible while a seller is looking for the lowest cap rate (do the math; this is the best way to make sense of this mathematical conundrum).

Capitalization rates vary widely for investors, especially regarding whether a property is in a major urban centre. A low cap rate in Toronto or Vancouver may be acceptable to a buyer if the property has great upside potential in raising the rents, lowering the costs or if the property is expected to appreciate in value over a short period of time.

Arguably, cap rates for investment properties range from 6% to 9%. In the last couple of years however, I’ve seen some go for under 4%, with the average being around 4.5% to 5.0%. 8% is exceptional in today’s market, with the major caveat that the property may have significant issues that must be factored into the cost.

Using the earlier example, divide $62,000 by the cap rate you are looking to achieve, say 6.0%. This example property has an estimated value of $1.04 million. If the buyer was demanding a price of $1.2 million (with a $62,000 NOI), then the cap rate would be 5.2% ($62,000 divided by $1.2 million).

Some investors will look at other types of investments they could put their money into and simply state that they want an “8 cap” before they will look at a property. This effectively means they want a property with a high NOI at a deeply discounted price (don‘t we all?). Pragmatically, this criterion could be achieved if the investor was willing to buy a distressed property that required further cash infusion to extract the potential upside. For example, fix the plumbing, replace the windows, and upgrade the furnace, thus reducing certain operational costs and making it possible to raise the rents.

Let’s say this cost the investor $40,000. Using a 6 cap, if you could reduce your electricity bill, for example, by $10,000 per year (which goes straight to your NOI bottom line), then you are effectively increasing the value of the property by $167,000 ($10,000 ÷ 6%). If you were also able to raise the rents by a total NOI of $8,000, then you add a further $134,000. With the right investment property, repairs and upgrades that reduce costs and/or lead to increasing rents can quickly get you back your investment, and rapidly build new value.

Chris Seepe is a commercial real estate broker and broker of record at Aztech Realty in Toronto, specializing in income-generating and multi-residential investment properties, retail plazas, science and technology-related specialty uses, and tenant mandates. (416) 525-1558 E: cseepe@aztechrealty.com W: www.aztechrealty.com

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