Posted by M on August 11, 2002 at 14:58:50:

n/t

Evaluating a Duplex - Posted by Mark Dowd

Posted by Mark Dowd on August 10, 2002 at 20:08:03:

I am looking at buying a duplex. There are no other duplexes around it in the neighborhood. Isnt it better to use the income approach to determine value rather than comps? If so, is the formula NOI divided by the cap rate? Will lenders/appraisers consider using this method when I decided to refin? It seems the value would be higher using this mehtod. Any thoughts?

Mark

Re: Evaluating a Duplex - Posted by Mike - Texas

Posted by Mike - Texas on August 11, 2002 at 20:10:20:

Mark

You do not have a choice of what the appraiser uses. Normally for a duplex it is income, cost comparables and replacement costs. Another consideration are you going to live in the unit? If so, this will inpact your financials by decreasing rents available.

Mike - Texas

Re: Evaluating a Duplex - Posted by Craig (IL)

Posted by Craig (IL) on August 11, 2002 at 07:32:47:

If your gonna be using a lender, the lender will be requiring the comparable sales approach. Of course, you have to figure income minus projected PITI and expenses in considering your offer.

Re: Evaluating a Duplex - Posted by JT-IN

Posted by JT-IN on August 10, 2002 at 23:42:53:

Mark:

Forget all the fancy mumbo-jumbo when it ocmes to 2 to 4 units, and use comps instead. These will be the closest to FMV. Of course, after completing the comps, be certain that it cash flows, as suggested; but definitely forget the CAP rate on the samller deals…

Just the way that I view things…

JT-IN

Re: Evaluating a Duplex - Posted by Dave T

Posted by Dave T on August 10, 2002 at 23:02:47:

Suggest you evaluate the property as you would any other rental property. Figure out what income the property will support, subtract your estimated operating expenses. The result is your net operating income (NOI).

Now divide your NOI by your projected debt service. The result is your debt coverage ratio (DCR). If the DCR is 1.25 or greater, then the cash flow is probably sufficient to support the property as a rental. If you have been conservative in your estimates, and still get a DCR of 1.25 or more, go for it.

But wait, how do you know what your debt service will be, if you don’t know how much to pay for the property? Since you already know the NOI, just divide the NOI by 1.25. The answer will be the maximum debt service that this property can support.

If you know what interest rates you can get on your financing, it should be a simple process on your financial calculator to solve for PV, when you already know the PMT, i%, and N. Solve for PV to figure out the maximum loan amount you can afford, then add whatever downpayment you plan to contribute to the financing.

Now you know how much you can afford to pay for the property and still cash flow. This may not give you the true value for the property, but the answer does give you a limit on what you can afford to pay.

Re: Evaluating a Duplex - Posted by jeff

Posted by jeff on August 10, 2002 at 20:33:20:

here is one of the articles on this site:

Crash Course In Commercial Real Estate

Here’s a crash course in commercial real estate investment 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

Gross Rent: $400/unit * 6 units * 12 months = $28,800

Vacancy: 10% vacancy = ($2,880)

Other Income: Laundry = $500

Total Gross Income: $26,420

Gas = $480

Electricity = $300

Management = $3,274

Taxes = $1,160

Insurance = $750

Water = $2,400

Maintenance = $3,000

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 is 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 return on investment, or ROI (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% (the astute observer will 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.

Thus ends our commercial real estate investing crash course.

Submitted By: Jim Beavens

Re: Evaluating a Duplex - Posted by Mark Dowd

Posted by Mark Dowd on August 11, 2002 at 17:56:04:

What if there are no other comparable sales on duplexes in the neighborhood?

Mark