As there is a mix of investment sophistication  levels on this site I have opted to interject a review of the basics.  For you institutional investors…hang on we’ll have some information that we think you’ll find valuable in…later posts. 

 Below is a brief overview of NOI, CAP Rate, and NOI, CAP, and NOI Multiplier.

What is NOI?: Net Operating income

What does it measure?: Measures the revenue generating capacity from operations.

When is it important?: Two times: When you is sellin’…and when you aint. On a more serious note, NOI is the source of payment for debt service, and cash flow distributions to the owners.

Why it’s important:  It provides a way to measure the revenue producing capabilities of an asset excluding debt service considerations.

What’s the formula?: Current Revenue – Current Expenses (Exclude debt service, capital expenses.)

Example: Current Revenue, June 2009: $100,000.
Current Expenses, June 2009: $ 35,000.
NOI, June 2009 $65,000.

What is a Cap Rate?

The capitalization rate is what the yield as a percentage of the initial investment would be in year one if you acquired the property all cash.

Why it is important: First “sniff test” investors use to check out an available commercial property.

What is the formula? NOI/Sale Price = Cap Rate
Example: $65,000/$812,500= 8%.

What is NOI Multiplier?

How much each dollar of NOI would contribute to value if property was for sale.

Why we care: Knowing how much each dollar on NOI is worth helps us evaluate the impact of incremental increases in revenue and expense. (Great for rehab/repositioning!)

What’s the formula? Sale Price/NOI = NOI Multiplier
Example: $812,500/$65,000= 12.50 (Each dollar of NOI creates $12.50 of value.)

NOI, CAP, and NOI Multiplier Problems

A Portland Multifamily investment Property X had the following revenues in 2008:
• Rent $122,500.
• Extraordinary gain: harvest lumber on property $25,000.
• Pet rent $300.

Property X had the paid the following in 2008:
• Utilities, taxes, management fees, etc. $48,000.
• Cap Ex: Completely rebuild lower parking lot $19,000.
• Re-stripe upper parking lot $125.

QUESTIONS 1 & 2 are based on the information above.

1. What was NOI?    ANSWER:  $74,675  Note: The lumber revenue and parking lot expense were not operating related and were thus excluded from NOI.

2. What is the asset worth if we assume a 6.9 Cap% ?   ANSWER: $74,675 / .069 =  $1,082,246

QUESTIONS 3 – 4 are based on repositioning an 18 unit property we are buying for $1,200,000 at an 8 cap with a 5.9 % loan. Current Annual NOI is $96,000:

3. How much is each dollar of NOI worth? ANSWER: $1,200,000/$96,000 = $12.50.

4. How much more would the property be worth if we could raise the rents in 10 of the units $10/month? (Assume that a year has 12 months, all the units are increased at the same time for the full year…and that we could do this without increasing expenses…without any change in turnover.)  Answer: 10 units X $10 X 12 months equals a $1,200 increase in Annual NOI. Multiply by $12.50 = $15,000 increase in value!

Whether you’re a seasoned pro or a newbie…feel free to contact us:  503.577.1034 or rick@rosecitycre.com.

These equations apply whether your looking at Portland OR investments…or anywhere else too!

Profits from multiple sources

When investors buy  commercial real estate they are acquiring a revenue stream. Admittedly there are a few signature buildings that are so iconic that they are a “pride of ownership” acquisition, but most properties are valued solely for their future economic potential. There are four primary ways in which investors benefit from their acquisitions:  

1. Cash Flow

is the sum of: Cash In – Cash Out. The primary source of inflow cash is rent. Pet rent, late fees, laundry and owner contributions are also part of the cash in stream. Cash Outflows include taxes, expenses and distributions to owners.  

Owner types vary widely on the importance they place on distributions:  

• Residential Multifamily properties (2 to 4 units) and smaller Commercial Multifamily properties cast off little cash. Their owners tend to focus more on equity gained at the time of disposition.
• Investors of larger properties often use cash flows (distributions) as a primary source of spendable income. They certainly expect gains at sale, but they often will use that gain to step up in basis to acquire a larger asset in the hope of increasing the monthly cash-flow.
• The bane of all investors is the much dreaded Cash Call. When cash out ‹ cash in to the extent that operations are impacted, the property owner(s) are forced to add new equity to keep expenses current. Be aware that cash call inputs wreak havoc on IRR Calcs.
  Because of their focus on maintaining regular, dependable distributions, the owners of larger properties tend to have lower LTV loans. This doesn’t eliminate cash calls, but it does make operations inherently more stable, reducing the likelihood of requiring additional cash.

2. Appreciation

is Future Disposition Price – Original Acquisition Price. A 53 unit complex that is purchased for $3.2 million is 2007 appreciates $700,000 if it is sold for $3.9 million several years down the road.  

• Appreciation gains can occur from (external) market forces such as a downward trend in Cap rates, or from increases in rent relative to expenses due to high demand. (more…)

Study building costs to up cash flowBaltimore Business Journal – by Gary Anderson 

Optimizing your investment

 
Cost segregation, though known by many real estate owners, is sometimes overlooked.

It is a methodology used to reallocate certain building costs into separate identifiable components that can be depreciated over shorter lives. The primary purpose of a cost-segregation study is to reallocate as much building costs between land improvements and tangible property. The more costs allocated to tangible property, the greater the desired tax benefit. Tangible property creates tax benefits because it is depreciated over five or seven years while normal building costs are depreciated over 27.5 or 39 years.

A cost-segregation study may be performed for real estate already in service, for new construction and acquisitions. Generally, it is easier to analyze a building’s cost structure during initial construction or expansion since building plans are readily available and can be utilized to identify various components that may qualify as tangible property.

Costs that may be reallocated to land improvements consist of, but are not limited to, certain landscaping, sidewalks and fencing which are depreciated over a 15 year recovery period.

Costs that may be reallocated to tangible property include movable partitions, furniture, removable carpeting and wallpaper, certain fixtures and window treatments. Support systems that are needed to run certain equipment or machinery could be considered tangible property under certain circumstances.

There are several internal levels of cost-segregation studies ranging from a detailed engineering approach through a less formal rule-of-thumb appraisal. The Internal Revenue Service prefers the engineering approach since it will produce the most accurate results.

All businesses that acquire, construct or renovate real property would benefit from a cost-segregation study.

The real benefit of a properly documented cost-segregation study is the enhanced depreciation deductions it yields. A major advantage of the study is not necessarily that it produces more depreciation deductions, but that expenses accelerate more rapidly, producing a greater benefit due to the time value of money.

The ability to write off specific components identified as they are replaced is yet another advantage. For example, when a study is performed, the cost of the roof would be specifically identified. As the roof will eventually be replaced, the remaining cost could be written off.

One disadvantage of a cost-segregation study is the potential triggering of depreciation recapture and possible understatement penalties a taxpayer could incur for studies that are too aggressive in classifying costs. To avoid penalties and pass IRS scrutiny, the study must be objective and supported by contemporaneous records. Studies supported by an engineering study add credibility and produce the most accurate cost allocations.

Overall, cost-segregation studies can produce tremendous tax savings for those who build, acquire any business that builds, acquires or renovates property. The increased tax savings increase cash flow, which in turn, businesses can reinvest.

Gary Anderson, a certified public accountant and senior manager at Reznick Group P.C. in Baltimore, can be reached at gary.anderson@reznickgroup.com.