By Eddy Boudiwan and George Hill
In our last three articles, we have walked together up to the point of undertaking the analysis of an investment property. For you to know if a property would be a good acquisition, you need to understand how to evaluate the property.
The key metrics to be analyzed include (but are not limited to) the net operating income (NOI) and the area’s capitalization rate (CAP rate).
NOI is the income produced by a property after all operating expenses and before the mortgage payment. CAP rate is defined as the percentage return (yield) of a cash purchase on a property. Other fundamentals affect the CAP rate, such as sales in the immediate area, condition of the property and other factors. As the value of an income product asset equals NOI divided by CAP rate, it is very important to be in tune with the CAP rate of the submarket where you decide to buy. Fundamentally, you either attempt to increase income or reduce expenses, in order to increase your property value.
Let’s consider a scenario in which we purchase an investment property that generates an annual NOI of $10,000 and the purchase price for this property is $100,000. Based on the purchase price, you are receiving a 10-per-cent return, assuming no debt (mortgage to pay from your NOI).
Another popular rule of thumb states that, if the gross income of a property is less than 10 per cent of the purchase value, it may not be a lucrative investment. Do use this general guideline, but be mindful of possible other factors. The 10-per-cent rule simply does not take into account if the building is distressed, half vacant or if the rents are below market. These can be very effective opportunities for you to capitalize on and increase your NOI.
The seller’s goal is to maximize the NOI to fetch the best value for the property, so their proforma may not always be accurate. Your goal should be to reconstruct the income and expenses as the building is operating today and acquire based on this value – not on how it may perform in five years.
Accuracy in the income and expense analysis is very important. Validate rent amounts claimed on the seller’s proforma via leases and bank accounts. Get to know the rents in the neighbourhood. Review CMHC rent reports, Gottarent, Kijiji and Rentometer as general tools for validation. Speak with other investors and property managers in the area to validate your online findings.
Sometimes sellers attempt to reduce the expenses in order to increase the NOI, maximizing sale value for a building. Review the expenses and make adjustments where needed. Common traps you need to avoid are: vacancy rates, property management expenses and repair and maintenance standards. Dig deeper.
Always use market vacancy rate as an expense (three to five per cent for areas we invest in). Your building will not be rented 100 per cent of the time.
Property management costs should be accounted for between three and six per cent. In the event that you manage the property yourself, you should still account for this because the next buyer will. Or you may decide to expand and need a property manager in the future. Appraisers also allocate a percentage when evaluating a property.
The last items to account for are repair and maintenance. The market standard is approximately $750-$850 per unit/year. If you are buying a 10-plex, you can expect to account for $8,500 per year. This does not include any deferred large and immediate capital expenditures such as roofing or windows. You need to review these capital items and ensure that the selling price reflects them.
Current CAP rates in Toronto are around five per cent for some buildings; for each dollar overstated by the seller and missed on your NOI review, if it is not reduced, you will pay 20x for it in value that is not there currently ($1 divided by a CAP rate of five per cent); $10,000 missed immediately translates to $200,000 in value that you might overpay.
In our next article, we will provide an overview of the offer and due diligence stages.
Real Estate Rangers is a real estate investment team that locates, operates and maintains properties for investors. Eddy Boudiwan (eddyb@realestaterangers.ca) and George Hill (georgeh@realestaterangers.ca) are the co-founders of the company. They have partnered with Taft Forward Management as their acquisition arm. For more information, visit www.realestaterangers.ca
Real Estate Rangers is a real estate investment team that locates, operates and maintains properties for investors. Eddy Boudiwan and George Hill are the co-founders of the company. They have partnered with Taft Forward Management as their acquisition arm. For more information, visit www.realestaterangers.ca.
