Rich Dad Education Blog

When buying a commercial property, it is important to remember that it is the income that the property produces that creates its value and, therefore, the sales price. This is a numbers game. You are not just buying a piece of real estate; you are buying a business, and that business must make money! Banks like to finance businesses that are financially strong, possess good management, and carry minimal risk. While it is certainly necessary to perform a detailed financial analysis before purchasing a property, it is also necessary to possess the ability to perform a preliminary analysis in about a minute.

If you are doing a full analysis of a multi-family property, it is important that you know the five basic mathematical equations. There are also rules of thumb that can help you quickly determine how a property is valued relative to the market. The five ratios are:

1. The debt service coverage ratio
2. The cash return on investment (cash on cash return COC)
3. The capitalization rate
4. The total return on investment
5. The gross rent multiplier

Before you ask your broker to provide you with a full package so you can do this in-depth analysis, you may want to do a quick assessment. Brokers and sellers use what is called a “set-up sheet,” which provides basic information, such as asking price, address, number of units, gross revenue, and the terms of the transaction, especially if their loan needs to be assumed. As a general rule of thumb, your total operating expense should average between 40 to 60 percent of your gross income. Most well-run apartments with a property manager, leasing agent, and all other the costs included, with the exception of the debt service, will be running their expenses at 40 to 45 percent. If expenses are high, some may be running closer to 60 percent. If you split the difference, you will end up with 50 percent on an average. By taking your gross revenues and divide by .50, you will get a reasonable estimate of your net operating income, or NOI. Additionally, cap rates generally run between 8 and 12 percent. In some markets today, cap rates are so compressed, you may see them as low as 6 or 7 percent. Let’s keep this simple by using 10 as an average.

Now, let’s go back to that apartment and figure out if this asking price is even worth considering. Here is my step-by-step conversation:

1. “How many units are there?” The broker responds, “100 units”

2. “What is the average rent?” or “What is the gross revenue?” The broker responds, “About $500 per unit.”

Now you can multiply the number of units by the average amount of rent. In this situation, we would have a gross monthly revenue potential of $50,000 per month, or $600,000. To calculate our operating expenses, we would then take our potential gross revenue of $600,000 and multiply by .50. Our operating expenses would be estimated to run around $300,000, leaving us with $300,000 a year in revenue. We would then take our net operating income of $300,000 and divide by your purchase price of $3 million dollars, getting a cap rate of 10 percent. Now compare your results with the market cap rates. Are you close, are you too high, or are you too low? If the numbers are way out of line, a wise investor will move onto the next deal. As a buyer, please keep in mind that the higher the cap rate, the better the deal is for you!

Let’s recap:
1. Divide the gross revenues by two. The result is an estimate of your NOI.
2. Calculate the cap rate by dividing the NOI by the asking price.
3. Determine if the resulting cap rate is in line with the marketplace rates.

Remember that cap rates will vary with the condition and age of the building. The area or market you are in will also play a large role in determining value. This example is only a quick and very general method of determining approximate value. Before you make any final decisions, you will need to ask to see the trending operating statements for a minimum of the last two years, and the last 3 months of rent rolls to current. You don’t want to just see the yearly totals; you are looking for trends, or highs and lows, in either income or expenses. Keep in mind that most sellers usually start with a high asking price. As is the case with residential properties, you should look for motivated sellers and properties that need some type of improvement.

If there is a real value play, my opportunity may be increasing the income by increasing the rents, reducing the expenses, increasing the occupancy, thereby reducing the vacancies, adding vending machines, or installing or increasing the laundry capacity. It is important to know that for every dollar you increase your income or reduce your expenses, you multiply the value of your apartment building by approximately 10 times!

For more information, sign up for our Commercial Real Estate Class, which we offer on a monthly basis.