Political uncertainties

November 2007

Cap rates, ROI's, and other mysteries

Calculator and scratch pad. Original image at http://www.3poundsofrealestate.com/category/investing/

A special language
At one time or another, you may become interested in buying a property that will provide you with an income as opposed to giving you a roof over your head. If and when this happens, you'll become faced with a series of abbreviations -- such as ROI, NOI, LOI, NCND, and, of course, ICI -- as well as jargon like cap rate, due diligence, cash flow, debt servicing, and common elements.
As you may already be aware, I do have a separate website ( http://www.iciniagara.com ) that focuses on this area of non-residential real estate, but its emphasis is on the underlying theory and aspects of what's commonly referred to as the Industrial, Commercial, and Investment segment of the business I'm in. But, although I've touched on this topic in one or two of my previous newsletters, perhaps I can devote this current one to a run through the terminology that is seldom associated with buying and selling single family homes.
So then ...

Spelling out the abbreviations ....
In the order they appear in my opening paragraph, they stand for Return On Investment, Net Operating Income, Letter Of Interest (or Intent), Non-Circumvention and Non-Disclosure (or, particularly in Canada, a shortform of it, CA, which translates into Confidentiality Agreement), and, as my second paragraph shows, Industrial, Commercial, and Investment real estate.

.... not to mention the jargon
Making sense of cap rate and the other phrases I've mentioned calls for somewhat lengthier explanations, although they also involve use of the various abbreviations.
Indeed, the whole "special language" rests on an essential difference between buying/selling a place to live in and one that's intended to make you money (or, on certain occasions, to lose you some!).

A more objective process
Choosing a home invariably involves some emotion and subjective judgment. You're unlikely to let your budget be the all-determing factor. Saving a few dollars will probably not win the argument in favour of a place that you simply wouldn't feel comfortable owning. There has to be a right feel to it and, if there isn't, you'll keep looking until you find somewhere else that's not only within your means but also meets your needs and want.
In (sharp) contrast, however, looking for an income property is -- or ought to be -- what can be called a bottom line exercise. Emotion has far less of a part to play. The ruling factor needs to be objectivity. What will you get for the money? How good is the value? What rate of return will you earn? How much of a risk will you run? What profit can you realize -- when and why?
All of which amounts to the application of due diligence, -- and the more thorough it is the better.
And herein enter the concepts of ROI and cap rate, not to mention NOI.
It really doesn't matter what the type, size, or use of a property happens to be. Whether you're considering something as simple as a duplex or talking about a large undertaking (such as a manufacturing organization or the likes of an hotel or shopping mall), they all have expenses that have to be paid out from the sales revenue or the rent/lease payments you receive. The result is an NOI and this can be translated into ratios between the selling or purchasing prices, which allow you to compare apples to apples (or even oranges to lemons).

Cap rates demystified
The figure is arrived at by expressing the return on the investment (ROI) as a percentage:

NOI divided by Investment multiplied by 100 = cap rate

Example: $10,500 / $140,000 x 100 = 7.5%
Example: $16,800 / $280,000 x 100 = 6.0%

This cap rate figure can then be used to determine the merit/correctness of asking and offered prices by, as it were, turning the figures on their heads. In fact, you can calculate at least two other figures:

a) Value = NOI divided by cap rate multiplied by 100
Example: $20,000 / 8 x 100 = $250,000
Example: $24,500 / 7 x 100 = $350,000
b) Net Income Multiplier (as it's called) = 100 divided by cap rate
Example: 100 / 8.5 = 11.76
Example: 100 / 6.5 = 15.38

It may look and seem complicated, but it's really only simple arithmetic and lets you "shop the market" for the kind of outlay and return you'll be comfortable with.
For example, if you have $300,000 available and want to net $30,000, you need a 10% cap rate ($30,000 / $300,000 x 100). However, you may find that the most you can get is an 8% cap. This would mean the NIM will be 12.5 (100 / 8) or, if you will, either your NOI is going to reduce to $24,000 (8% of your $300,000) or, if you want to earn $30,000, the price will have to go up to $375,000 ($30,000 x 12.5).

NCNDs and LOIs, etc
Once you're involved in "the big stuff," the due diligence exercise usually becomes extensive and calls for the seller to release a lot of information that they don't want to reveal to anyone except a possible buyer and his/her/their financial and legal advisers. Thus, if an MLS listing exists (which isn't all that common a practice), it rarely includes anything more than a general description of the property/business/whatever and the details will be made known only upon an undertaking that they will be held in the strictest confidence. Moreover, the brokerage representing the seller will want to protect their own privacy and avoid any risk of a competitor knowing the details and bringing an alternative potential purchaser to the table.
This need for a "just between us" relationship is covered by a Non-Circumvention (no "going around us") and Non-Disclosure ("don't tell another soul") agreement that has to be signed by both parties to a potential sale and purchase and legally binds them to its clauses.
By the nature of things, a formal Agreement of Purchase and Sale tends to be delayed until the buyer knows enough about the property and can (intelligently) make an offer. Given this, the starting point (after completion of an NCND agreement) frequently takes the form of a Letter Of Interest (or Intent) that establishes the buyer's willingness to seriously consider taking ownership over. Only after sufficient due diligence (which, if all goes well, will eliminate the chance of any surprises) will the lawyers be charged with the task of preparing the official paperwork -- which will almost certainly run into a lot more pages than a residential purchase involves.

Nothing to it!
Despite the complexities, an ICI transaction isn't, after all, fundamentally different from any residential sale. It still requires the existence/emergence of a willing seller and a willing buyer. It also calls for the same end result of a win-win situation -- or ought to do so.
It will, of course, take longer and will often require a Proof of Funds (Does the buyer have the money?) and a thoroughgoing analysis of Cash Flow (what and when does the money come in and when does it have to be paid out?). But, in a sense, these have their analogy in a residential sale (by way of Financing and Home Inspection conditions), don't they?
Neverthless, all told, the ICI field is an exciting part of the real estate business. There's a more protracted learning curve, but it's certainly an interesting one.