S.E.C. Real Estate Observer

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PART II:

In Part I of this article, “Pricing Real Estate The Key For Results,” the term “Cap Rate” to structure an income property value was noted as well as the ability to utilize “creative formulas” to structure a property; acquisition should there be a question as to the price/value of the property. First an overview as to what is the “makeup of a Cap Rate” will be presented, and will then be followed by a sample illustration of two “creative formulas” that I personally had the ability to apply to a successful transaction.

“Cap Rate” A Tool For Valuation:

Most practitioners know that income property value can be determined by the application of the “Cap Rate,” which is “Income” divided by “Rate” equals “Value.” However, where does Cap Rate come from? Is it “PFA” (plucked from air)? And, some may look at what Cap Rates properties have been selling for historically. But, there is no such thing as a consistent historical Cap Rate that can be applied on a regular basis. Why? Because the Cap Rate is “subject to change.” Change in the Cap Rate typically occurs as interest rates on loans change, up or down; and also, based on the risk for a particular property class or property location. Thus, the calculation as to the mechanics of “developing a Cap Rate” is illustrated below:

First, one needs to know what the mortgage constant is likely to be. The mortgage constant is the “annual debt service” divided by the amount of the original loan. For example, if an investor plans to have a loan amounting to 75% of the value of a property and if the loan dollar amount is $750,000 at a 7.5% interest rate for an amortization term of 25 years, the annual loan payment will be $66,096

Calculation of the loan constant:

Take$66,096 annual debt service divided by the principal amount of the loan of $750,000 = 0.0881 constant. To proof it, if you take the loan of $750,000 X the 0.0881 constant = $66,906 the annual debt service, thus, the mortgage constant is the “level of payment” to satisfy the mortgage over the mortgage term.

Development of the Cap Rate: Calculation:

Therefore, as illustrated, the required/desired Cap Rate will change as the interest rate changes. In the case noted above, if the property is in a “good” location and of “good quality,” one could consider the Cap Rate to be 8.11 % based on the noted loan terms, but if there is a risk factor to be considered, the “Cap Rate” could be increased to 10.1%, etc. if there may be some potential risk with the property. The risk factor can be at “any rate” the potential purchaser deems to be applicable (if any).

Thus, one needs to realize that the Cap Rate is not fixed or static, but will change depending on the terms of financing and one’s perception of any pending risk. The “debt service” factor is that percent of NOI that is needed to satisfy the debt service, and the equity factor can be higher or lower, depending on what the investor considers to be applicable. Thereby, the higher the mortgage constant due to interest rates and mortgage term, the higher the Cap Rate must be to satisfy the loan and investors return on and of investment. Ideally the Cap Rate should be at least 0.5% above the interest rate for positive leverage and cash flow.

Seller’s Price vs. Buyer’s Terms: This illustration is taken from and “actual” transaction based on a transaction I completed for a buying partnership using two creative formulas that I learned from Barney Zick (deceased), CCIM and former S.E.C. The illustration deals with “a high down payment” as requested by the seller and the formula known as the “No double down payment,” and also a “performance mortgage” relating to structuring the mortgage payments to allow for a situation where the rents may be low, and the NOI will not justify the owner’s value; however, the seller will not accept a price offset due to the lesser income due to the lower rental rates.

This illustration represents the actual transaction data for a 40-unit apartment property; the owner was willing to carry back the purchase money loan:

“No Double Down Payment Formula:”
Owner’s Value: $800,000
Buyer’s Value: $600,000 based on the NOI
Owner Down Payment Request $200,000
Buyer’s Down Payment: $120,000 proposal

The reason for the lower down payment was that the partnership stated that there was some deferred maintenance in the property and, if we gave the seller the requested down payment and then put in dollars to cure the deferred maintenance, we in fact would be putting in a double down payment. We advised the seller that we would set aside the difference of $60,000 from what the seller requested as a down payment and we would place the $60,000 in a reserve account that we could draw upon to cure the deferred maintenance as tenants turned over the units. The Seller had agreed.

“Transaction Negotiation and Financing:”

The seller was offered our $600,000 purchase offer so as to be in line with the NOI; the owner had rejected that offer. We countered the owner stating that we would be willing to go into contract and accept his sale price providing that he would raise the rents, and upon reaching our target NOI, we would close on the property — the seller declined that proposal. We did a market study, and also retained a property manager to complete a “rental survey” to confirm that the rents in fact were below market, and that was the case. Then we countered to the seller as follows (and the seller had accepted this proposal):

Mortgage Structure: Two mortgages were structured; the First Mortgage of $480,000 was based on what the partnership considered to be a fair price of $600,000 for the property, and a Second Mortgage of $200,000 was structured as a “performance mortgage” based on the difference between the $800,000 seller’s value and the $600,000 buyer’s value.

We offered to structure the transaction with “two mortgages” (a first and a second) as illustrated:
OFFER TO SELLER:
Purchase Price: $800,000
Down Payment: $120,000
First Mortgage: $480,000 (standard mortgage terms at 10% interest)
Second Mortgage: $200,000 (performance mortgage 20 year term at 10%)

Performance Mortgage Formula: Structured terms of the Second Mortgage of $200,000:
*(a) No payment to be made until we could bring the rental level up to reflect the “market rents” (however, the unit rental rates would be subject to “annual adjustments” to take into account an increase in real estate, taxes, insurance, utility rate increases and cost of living adjustments); this would allow the partnership the benefit of maintaining the constant value of dollar buying power.

At such time as the unit rental would achieve the level that would provide for an effective NOI, payments would begin on the second mortgage; however, regardless of where the rent level was, monthly payments would commence at the end of the 7* year of the mortgage term, and any remaining unsatisfied principal would be satisfied as a “balloon” payment at the end of the mortgage term, and interest “was not to accrue.” (NOTE: We had advised the seller that this mortgage formula could impact his tax status and should be reviewed with his accountant.

Net Result of the Transaction: By applying the terms of the purchase agreement, and by the application of the I.R.R. “Return on Investment” calculation, the partnership “in reality” had acquired the property at the partnerships’ market value of $600,000; and on paper, the owner had a “face value” contract of $800,000.

Although the Cap Rates at that time (in 1980s) were being quoted up to around 14% , conventional interest rates were quoted around 12%; our negotiated mortgage interest rate with the seller was 10% with negotiated terms, and we actually purchased the property at a face value of a “7% Cap Rate.” The partnership held the property for 5 years, never made a payment on the second mortgage, and sold the property at an 8% Cap Rate with a value of $1,400,000 ($600,000 above the original contract price and $800,000 above the I.R.R. original purchase value), and yet left room in the transaction for the new purchaser.

THEREFORE: Although it was earlier stated that one must consider the “effective Cap Rate” at the time of purchase, the opening remarks of this article also stated that one could consider a seller’s offering price if the seller would be willing to accept the purchaser’s terms (the partnership could have decided to forgo the initial transaction but, seeing the potential value along with the application of “terms,” made the acquisition.

The key issue to keep in mind is that it is important to know the “principles of client counseling” and to not only have an understanding of the “basic investment financial understanding” e.g. APOD (Annual Property Operating Data) analysis and Cap Rate calculations, but also to acquire the knowledge of “creative formulas.” The Society of Exchange Counselors offers a series of counseling and formulas educational courses; refer to the S.E.C. Education website for course information.