Monday, August 10, 2015

An Expanded Valuation for Commercial Properties

- The Gordon Growth Model


The two most common methods to value an income producing property is to look at the Gross Rent Multiplier (GRM) or the Capitalization Rate (Cap Rate). The purpose of this analysis is to define these common valuation methods and expand on the cap rate method.

Gross Rent Multiplier

The GRM is calculated by dividing the purchase price by the annual gross scheduled income.

Formula:

Formula:


The GRM method is an easy way to compare properties because the numbers cannot really be manipulated, unlike net income. Even if the property were vacant, calculating a gross income using market rents is relatively easy. There are times that a real estate agent might overestimate gross income or pro forma income, but generally speaking, the gross scheduled income is a straight forward number. When comparing groups of properties, the lower the GRM, the better the deal, generally. The downside to this method is that it does not take into account the costs to own the property which includes normal expenses, maintenance, and vacancies.

Capitalization Rate

The cap rate is calculated by dividing the net operating income (NOI) by the price.

Formula:

Formula:


When searching for properties in the various databases such as the Multiple Listing Service, Costar, or Loopnet, a parameter could be that the only acceptable property would be properties with a greater than 8% cap rate. When a prospective property is found, you then re-create the net income calculation.

Example: $1,000,000 Purchase Price


Sellers Operating Statement
Adjusted Operating Statement
Gross Income:

Property Taxes:
Insurance:
Utilities:
Maintenance:
Vacancy Allowance:
Reserve:
Management:

Net Income:
Capitalization Rate:
$100,000

$4,500 (Seller’s Tax Amount)
$2,000
$3,500
$10,000




$80,000
8.00%
$100,000

$12,500 (1.25% of Purchase Price)
$2,000
$3,500
$10,000
$5,000 (5.0% of rents)
$2,500 ($250/Door)
$3,000

$61,500
6.15%

If your search parameter was to only see properties with an 8.0% cap rate or above, this property would show in the search results and after due diligence, the cap rate would end up being too low. Many buyers and sellers look at the above adjustments and argue that the vacancy allowance was too high or that they were going to manage the property themselves. These are valid comments and removing the management expense would result in a higher NOI, but the adjusted operating statement is how a bank would look at it and even though your expenses, as a buyer, would be lower. It is important to think about your financing options when considering what to pay for a property.

Capitalization Rate – Gordon Growth Model

In financial theory, a perpetuity is a set of cash flows that will continue into infinity and the formula is identical to the formula defined above for the cap rate method. The valuation method treats the income received by the property as income that will continue forever; however, there would be some amount of expected growth. As an owner of an apartment complex or office building, it would not be proper to assume that the cash flows from that building will remain constant into infinity.

The Gordon Growth Model is commonly used to value the intrinsic value of stock or firm.

Formula using Dividends:

Formula using Free Cash Flows:

rE = Required Rate of Return
G = Growth Rate
D = Dividends

Example:

rE = Required Rate of Return
G = Growth Rate
D = Dividends

Example:


As you might imagine, there were several assumptions made in the above example, but this is how cash flows are valued. This growth model is appropriate for real estate as well.

Net Income:
Cap Rate:
Growth Rate:
Value:
$100,000
8.0%
0.0%
$1,250,000
$100,000
8.0%
1.0%
$1,428,571
$100,000
8.0%
2.0%
$1,666,667
$100,000
8.0%
3.0%
$2,000,000

The key is to determine an appropriate growth rate.

In commercial leases, there are typically built-in rent increases. If you have a five unit retail center, long term tenants, and a 3% annual increase for each lease, a 3% growth rate might be appropriate. That could be overly optimistic, but for any piece of investment real estate, assuming a 0% growth rate is not intuitively valid. Even when leases do not have built-in rent increases, inferring a growth rate is valid, even if it is a nominal number.

By analyzing income properties with this method, there would be more opportunities available and the valuation would be more accurate. However, it should be noted that banks would not finance a property using a valuation done with this method. The reason being is that a bank would be looking at a relatively short term period, 5 – 10 years. This valuation would help an investor decide on a good investment based on anticipated growth.

Wednesday, September 18, 2013

Paying Taxes After a Short Sale - 1099-C

From an investor perspective, when purchasing a short sale, one of the biggest concerns of the seller is whether they will owe taxes on the forgiven amount. We represent sellers and we represent buyers and we are buyers. This is the common concern in these situations. Answering this question clearly can mean the difference between a closed transaction or a dead deal.

Teresa Mears at MSN Real Estate wrote last year and described a situation where a homeowner completed a short sale, the lender wrote off $100,000 and the homeowner was stuck with a $20,000 tax bill. This illustration is technically true, but there are a lot more details that must be considered. Her article was written while Congress was discussing whether they would extend the Mortgage Forgiveness Debt Relief Act and Debt Cancellation last year. It was extended till the end of 2013. Now, they’re discussing an additional extension, but whether it will be extended or not is yet to be seen. If it isn't, there are other caveats to consider.

If you purchased a home for $500,000 with 100% financing in 2005 and you short sold the property in 2011 for $400,000, it is true that the lender could give you a 1099-C for $100,000. At the same time, you had a capital loss of $100,000 which counter-weighs, in some respects, the income that you would have to include on your tax returns. This is a simplified scenario and you should always contact your accountant when analyzing your options, but it goes to show that simply saying that you might get stuck with a hefty tax bill if you short sell your home is misleading.

The next caveat that should be analyzed is the insolvency exemption which can be taken if the seller can show they’re insolvent. This is done by using Form 982. For the most part, people are short selling their home because they are in distress. A loss of a job or some other debilitating situation might have occurred. This could cause the homeowner to use all of their resources in order to keep the house. In this instance, which is very common, the homeowner might qualify for the exemption and should bring this up to their tax professional. Remember, previous tax years can be amended in order to take advantage of this exclusion.

Toni McAllister with the Lake Elsinore-Wildomar Patch is calling for the law to be extended again. She quotes C.A.R. President Don Faught as saying, “To heap an unfair tax bill on top of the pain and emotional duress of losing a home is unconscionable.” The state legislature is also considering a law, Senate Bill 30 in which it would extend California’s supplement to the federal law with regards to mortgage debt relief. This is all good and fine but there are other considerations with regard to the simplistic view people seem to have about claiming the forgiven debt as income, as I have outlined in this article.

My personal opinion on the matter is that as trust deed investors here at FK Capital Fund, when you lend money on any type of asset or even if it is unsecured, you are taking an investment risk. At the same time, the homeowner is also taking a risk by borrowing that money. Sometimes when you take an investment risk, you win or you lose and both parties suffer which means that even the issuance of a 1099-C should be abolished. This would force lenders to be more careful when lending and would result in a more secure financial system in the process.



Tuesday, April 23, 2013

Investors and Homeowners…Be Careful with the Housing “Recovery”

Everyone working in real estate, buying real estate, or selling real estate has been commenting on the inventory shortage which has pushed prices upwards. Home prices in March edged up almost 12% higher than they were a year ago. The best advice that can be given is caution, especially for short term investors. I will cover the important aspects of that advice here.

Lack of Inventory
Do not buy a house just because it is the best property you can find. Too many investors are “settling” for properties because of the lack of inventory. This is a big mistake and will contribute to a new bust in the future. If you cannot find the right deal, do not jump into something that you’re not completely sure of.

Interest Rates
The low interest rates that have prevailed over the last 3 years will not last forever and slight increases will have a dramatic effect on prices and purchasing power. With current interest rates in the high 3% range, $1,000 could buy a $220,000+ property. In 2006, when interest rates were in the 6% range, that would only cover a $165,000 house. I foresee interest rates ticking up starting now, in an effort by the Federal Reserve to “slow down” the housing recovery.

Recovery Personal Credit and Increased Values
Buyers who went through a bankruptcy, a foreclosure, or a short sale are now getting back into the market which is putting more pressure on prices as demand increases. Here at FK Capital Fund, we are doing more loans than ever for borrowers who have had these problems in the past. The conventional market will follow and it will further heat up the housing market. Additionally, homeowners who have held out through the last several years with underwater properties are now able to sell their homes for ever-increasing prices.

Investors Have Made a Lot of Money
Part of the problem that led to the Great Depression was that regular non-investors were seeing the massive amounts of profits investors were making in the market. This made them want to participate. They were uninformed which distorted the market further and caused the eventual collapse. This is especially true now with “investors” calling us every day for loans that have never invested in anything before.

There are still quality investments to be made, but they should be made with an extra degree of caution.

Tuesday, April 16, 2013

The State of Private Money Real Estate Financing – April 16, 2013

The upturn in the real estate market has caused investors and fund managers to underwrite a little more cautiously, especially with talks concerning a new housing bubble already starting as seen here and here.

With the market languishing for so many years after the recession, underwriting a trust deed investment was simpler because it was hard to imagine prices could drop further.

Real estate prices in the Southern California market were already below cost. Though downward pressure on price was conceivable, the prices would eventually have to increase to the cost of building the property, at the very least. Thus, from an underwriting standpoint, it was much easier to analyze value and risk in a given trust deed investment.

Fast forward to today where we have had a 6% increase in home values nationwide, from February 2012 to February 2013. This makes the importance of analyzing true value more important than ever.

Investors are more numerous which has decreased annual yields and increased the maximum loan-to-value possible. These facts add to the risk of any potential investment. Less yield and higher loan-to-value makes the proposition less appetizing, but still a great investment if analyzed properly.

On top of that, these very same trust deed investors have expressed increased interest in the buying and selling of the real estate asset itself. This fact makes an investor even more willing to assume greater risk because they’re partially analyzing the transaction as if they might be purchasing the property themselves.

Overall, given the increased risk, private money financing is still readily available for quality transactions nationwide. Expect a more careful analysis of each potential transaction though. Knowing this can help borrowers and brokers alike in packaging their transaction for investor approval.

Wednesday, November 30, 2011

Hard Money Lenders: Some things you should know

Hard money lending in California is just as popular as it is in most other areas, particularly with property buyers. You might wonder why credit seekers would likely decide on private hard money lenders over traditional loan associations. You may often hear or read that private funders demand extra or that they are known to be a last option for funding.

The truth is that California hard money lenders offer many services that the banks cannot or will not. They approve more loans, in a timelier manner. They understand the needs of the investor, since most of them have invested in real estate. Many of them still do. Some of them are even considered specialists, a good choice for the rehabber or reseller. The fees that they charge are reasonable, for the most part, but to get the best deal, you should shop around.

You see, some states have regulations in place that protect consumers from unreasonable interest rates and penalties. There are a number of laws that affect the practice of hard money lending in California, but there is no cap on the interest they can charge; no maximum limit on fees. Once you start shopping, you will see that there is a wide range of charges. As with most other things, the easiest way to compare is online.

You will find that California hard money lenders are competitive. They want your business, so they advertise. One of the best ways to choose a provider is to simply evaluate their website. Look for the ones that detail their approval process, repayment plans and additional services. The more up-front they are about what they have to offer, the more likely it is that you have found a reliable legitimate source of funds.

You probably want to avoid anyone that charges an early repayment penalty. If you are reselling houses, your goal is to get the repairs done and find a buyer quickly. You lose money when a house is sitting empty. If you are doing rehab projects, you should look for a California hard money lender that specializes in rehab funding. They can provide funds for purchasing, closing costs and repairs, if the loan to value ratio is right.

Finally, you do not need to limit yourself to hard money lending in California, specifically. For many years, most private financiers only operated in small regions, so that they could drive to the property if they wanted and take a look around. Today, there are great companies that make loans nationwide.Check them out. They might be the best choice for financing your future projects.

Saturday, October 22, 2011

Trust Deed Investing vs. The Stock Market

Stock Market Trust Deed Investments
Collateral is
Un-secured
Secured by a Recorded
Deed of Trust
Collateral is
Un-insured
Collateral is Fully Inusured
Returns are Unknown Returns are Fixed
by Contract
"Paper" Serves as Collateral Tangible Asset Serves
as Collateral



Simple enough?



Tuesday, March 1, 2011

We Need More Foreclosures.....Unfortunately

Current rental prices are unsustainable with middle class income being driven down. This does not just apply to residential properties but, more importantly applies to commercial properties. Rents have leveled off and gone down some, but not enough. For every cent you pay per square foot, the prices that you charge have to change accordingly, mostly on the smaller end. If you walk down the street and into a flower shop, the flowers will be more expensive, mainly because of the rent that the owner must pay. The inflation rate is low, right? Prices are going up, not necessarily because of inflation, but mainly because of rental prices. Loan values were pushed up, property values were pushed up, and now the only way to force these prices down are foreclosures.

When a borrower obtains a commercial loan, the main factor that is looked at is the debt service coverage ratio. The basic principle behind this is, for every dollar that goes out, how many dollars come in? This is calculated using the net operating income (NOI). Here is a sample:

$50,000 gross income
$5,000 property taxes
$1,500 property insurance
$2,500 vacancy allowance (5% of gross)
$41,000 net operating income (NOI)

The vacancy allowance line-item has been historically 5%, but it has been ever-increasing, especially with retail or office space due to the fact that there are many vacancies. Some investors would require a 20% vacancy allowance, but for the purpose of this example, we're using 5%.

The typical debt service coverage ratio requirement is 1.25. For every dollar that goes out, $1.25 comes in. Using this example, the maximum gross mortgage payment on this property could be $38,500 per year which, at a 5% interest rate. A commercial bank would allow a maximum mortgage balance of $550,000.

This goes a bit deeper as the value is typically based on the capitalization rate of the property. The capitalization rate is a tricky number to determine, but a rule of thumb in the private money world is right around 8.0%. In the conventional commercial financing world, it would be 7.0% or less. To determine value using the capitalization rate, you would divide the NOI by the capitalization rate which, using an 8%, gives us a value of $512,000. Obviously no one would do a loan of $550,000 with a property valued at $512,000. Using a 7.0% capitalization rate, which would give us a value of $585,000 and an 80% loan to value (LTV) loan would be roughly $470,000.

Enough about the technical data, at least we have a basic understanding of valuations and debt servicing. As foreclosures mount and properties are liquidated, investors who buy these properties demand a higher capitalization rate which drives prices down. Consider this example; you own a property and when you received your loan, it was valued using a 6.0% capitalization rate. This gives you a target price per square foot of $2.00. If the property next to yours forecloses and an investor purchases that property, he has the ability to rent the property for $1.50 per square foot where he can out-compete with you. You must continue to try and rent the property for $2.00 per square foot. This is why we see so many "For Rent" signs on commercial properties, because they're unable to compete. This has driven down prices and forced more commercial owners into foreclosure, but that is not enough and that is why we need more foreclosures in order to get prices down to a reasonable level.