Posted by John in SLC on January 22, 2004 at 21:11:33:
Can’t wait to see your multifamily article. I wish I had one to
sell right now…
Value play and location? - Posted by Kalei
Posted by Kalei on January 22, 2004 at 24:07:58:
First off, this is a great place for answers and advise. Most people I talk to about investing think sfr’s are the way to go.
My plan is to buy buildings with 65%-75% vacancy for 11%+ cap. increase to 85%-90% and sell for 10% cap. Since my investment is for probably less than a year, how important is location? Would you invest in a place with a population of 16,000 in a county of 90,000?
Re: Value play and location? - Posted by Marc in Portland
Posted by Marc in Portland on January 22, 2004 at 14:58:20:
> My plan is to buy buildings with 65%-75% vacancy for 11%+ cap. increase to 85%-90% and sell for 10% cap.
Certainly filling up properties is a great way to improve their value, but you misunderstand how cap rates work. They are based on things like the neighborhood, demand from other investors, mortgage interest rates, and, most importantly, the cap rates comparable properties are selling for.
They should also reflect the risk/condition of the investment, i.e., move a building from a good neighborhood to a bad one and the cap rate investors will insist on to compensate them for the risk will rise (price decrease). Conversely, take a building and put on a new roof, new plumbing, new parking lot (and other improvements that might not necessarily get reflected in the income right away), and the cap rate other investors would have insisted on to compensate them for the risk that they might have to spend the money to do these items will go down (price goes up).
But, if you don?t change the neighborhood or change the property materially, cap rate wont? be affected by the occupancy/income (although the will be). If buildings in your area are selling for realistic (based on present actual financials) cap rates of 11% at 70% occupancy, then that’s what the same building will sell for at 95% occupancy.
Example:
Buy A 70% Occupied Building at cap rate of 11%
$150,000 Gross Rent
$45,000 Less 30% vacancy
$105,000 = Effective Rent
$55,000 Less Expenses
$50,000 = Net Operating Income
11% Divided by Cap Rate
$454,545 = Purchase Price
Sell a 95% Occupied Building at a cap rate of 11%
$150,000 Gross Rent
$7,500 Less 5% vacancy
$142,500 = Effective Rent
$65,000 Less Expenses
$77,500 = Net Operating Income
11% Divided by Cap Rate
$704,545 = Purchase Price
So, yes, if you can improve the Net Oper. Income by filling up the property, raising rents, and/or cutting expenses, then you can charge more when you apply the 11% cap rate later. But you won?t be changing the cap rate unless you improve the property, the neighborhood improves, investor demand increases, or mortgage interest rates decrease…only one of those do you have much control over.
Later today, I hope to post a lengthy analysis of how rising interest rates MUST increase cap rates (prices decline). Something you should DEFINITELY watch out for.
> my investment is for probably less than a year,
Make sure you meet the IRS definition of ?holding? the property for ?investment?, not to just do a flip. If you flip it, you can?t do a 1031 exchange and will pay INCOME tax not Capital Gains Tax! Big difference for some people.
> how important is location?
Location isn?t as important as the market…are ALL the buildings with 30% vacancy, or only the one you want to buy? Have rents been going up or down the last three years (hint, they?ve been down in most areas of the US). Do you have to do anything physically to the building to attract the tenants?
Be careful.
Marc in Portland,
Apartment Broker.
Re: Value play and location? - Posted by Kalei
Posted by Kalei on January 22, 2004 at 16:14:45:
The cap rates for the comps are all around 10%+. And the occupancy rates were all @ tos 90%-100%.
I thought that a cap rate is just a reflection of asking price to net earings similar to a p/e ratio for stocks. I just assumed that it has a little flex in it because no two properties are exactly the same. And I think that 1% difference in cap is only $10,000 per $100k.
As far as the IRS 1031 exchange, if we owned the property in a SUB S CORP, don’t we only pay income taxes on the monies passed through to the investors?
Thanks
Kalei
Re: Value play and location? - Posted by Marc in Portland
Posted by Marc in Portland on January 22, 2004 at 18:44:32:
>The cap rates for the comps are all around 10%+. And the occupancy rates were all @ tos 90%-100%.
Where do you get your info? How do you know they got 10% cap rates on actual, real, verified income, or are you just guessing based on advertisements? Who’s rent survey are you using?
You don’t really get to SET the cap rate…the market more or less sets that for you. If you’re buying a building similar to others in your neighborhood and they all sell at caps of 10, but you are able to take a 70% occupied building that you bought for a 10-11% cap based on verified past earnings, fill it up, and you sell it for a 10% cap, you make some money provided all the other buildings in the area are STILL sellling for 10% caps then. If they are selling for 11% caps, then you will likely not make money. That’s what I meant by “be careful.” It’s a risky time to try this simply because cap rates will increase with interest rates.
> I thought that a cap rate is just a reflection of asking price to net earings similar to a p/e ratio for stocks.
Well, not quite. Here’s how you compute cap rate: Net Operating Income divided by the Purchase Price (or, to set the purchase price, NOI divided by the cap rate (assumes you know it).)
Here’s how you compute the property’s P/E ratio, according to Dr. Ed Leamer, professor of real estate at UCLA and the author of a study last year regarding calculating your home’s P/E ratio to determine if you might be in a bubble: Purchase Price divided by Net Operating Income. It is the inversse of Cap Rate.
So, I’m selling a triplex right now that I project has a Leamer P/E of 15.6 at the asking price. But the cap rate is only 6.41%. That’s about the highest I’ve seen as I usually sell larger buildings with P/E’s in the 12-14 range and caps of 8-9%, and I wouldn’t pay over an 11 (under 9% cap) or so.
I analyze this stuff for a living and if I were you, I wouldn’t buy squat right now at the top of the market. I’d wait for interest rates to go above 7.5% and then stabilize…prices will get a lot softer because buildings which have declining cash flow in this economy will no longer be able to still look attractive because of low rates. Don’t be getting any short-term loans for awhile…I wouldn’t do less than a 7 year ARM UNLESS you are planning to sell it promptly.
> As far as the IRS 1031 exchange, if we owned the property in a SUB S CORP, don’t we only pay income taxes on the monies passed through to the investors?
Yeah, that’s the idea if you don’t do the exchange. You’d at least have to pay the capital gains tax of 15% + any your state has (mine has 9%). If you get taxed at your regular income tax rate, it may be higher depending on how much money you make.
If it were me, I’d wait until rates stabilize then buy to hold, not flip.
See my post regarding 2004 multifamily investment risks which I will post this evening. (1/22/04)
Marc in Portland