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Crash Course in Commercial Real Estate

by Jim Beavens   
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Here's a crash course in commercial real estate terms.

Gross 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 of one of the properties I'm currently in the process of buying:

Sales Price: $90,000

Income:
Gross Rent: $400/unit * 6 units * 12 months = $28,800
Vacancy: 10% vacancy = ($2,880)
Other Income: Laundry = $500
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Total Gross Income: $26,420

Expenses:
Gas = $480
Electricity = $300
Management = $3,274
Taxes = $1,160
Insurance = $750
Water = $2,400
Maintenance = $3,000
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Total Expenses: $11,364 (43% of Gross Income)

I know I'm in the ballpark on expenses if it's between 40-50% of gross income.

Net Operating Income: $15,056
Cap Rate (NOI/Sales Price): 16.7%

Cap rate stands for "capitalization rate," and it's basically the yield on your investment if you bought a property with all cash. In this case, if I took $90,000 of my own money and bought this property, then every year I would receive $15,056, which is a yield of 16.7%.

The reason you can tell this is a good deal is because I 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 I just bought was in a place with an average cap rate of 15%, then the market value would be $15,056/.15 = $100,000.

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 I borrow $82,500 at 12% interest for 20 years (this is the actual amount I'm borrowing, but I'm still not sure what the rate and term will be because I'm 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: $908 * 12 months = $10,896
Cash Flow: $15,056 - $10,896 = $4,160 ($347/month).

One final useful calculation is the actual ROI or return on investment (I usually call it cash-on-cash). This is the amount of money I'm getting for my out-of-pocket expense. In this case, I'm making a down payment of $7,500, and receiving $4,160 a year. This is an annual ROI of 55.5% (Notice that if you can structure a no money down deal, 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 I'm 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 $90,000 purchase price is $4,230. This is very close to the annual cash flow I calculated above. That ends our commercial real estate investing crash course.

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