You can still obtain financing based on future appraised value rather than current appraised value. Part Three of “How to Finance Investments” will focus on creating an accurate estimate of the current and future value of the real estate. As a result, you will be able to determine if you are paying a fair price, how the lender will evaluate your purchase price, and estimate the probability of obtaining a loan.
For income producing real estate, valuation is often tied to the Net Operating Income (NOI) and the Capitalization Rate (cap rate).
NOI is always calculated on an annual basis rather than a monthly basis. It gives people a more accurate picture of fluctuating revenues and expenses, and expenses like insurance and taxes that might come up only once a year.
Net Operating Income might be based on past performance or on future performance. If based on future performance, it is called “Pro Forma NOI.” The Net Operating Income is the bottom line after you take all operating revenues (rents, laundry fees, forfeited security deposits, late fees, etc.) and subtract all operating expenses (taxes, insurance, utilities, maintenance and repair, management fee, collection costs, etc.)
Some things are not considered expenses for purposes of the NOI calculation. Neither the principal, nor the interest, on a mortgage are NOI expenses. Yes, the interest is an expense for income tax purposes, but nothing about the mortgage payment is an expense for NOI purposes. Marketing and advertising and leasing commissions are not considered NOI expenses. The salary you pay yourself or your relatives is not an NOI expense unless you would have to pay a third party to do what you do. In addition, only the portion that you would have to pay a third party is a legitimate NOI expense.
Why are those points important? Many times people buy income producing property from unsophisticated sellers. The seller will often base their asking price on the “income” from the property. On several occasions in the past, I represented buyers in such situations. The seller included his own salary, his wife’s leased car, his own health insurance, and his mortgage interest, as NOI expenses. It meant that his “expenses” were much higher than they should have been for NOI purposes, and therefore his “income” was much lower than it should have been.
Many times, pro forma NOI paints a more accurate picture of the property. If the property has been vacant, or leased at below-market rates, your revenue is going to be more than the former owner’s revenue. Any lender will be repaid from the revenue YOU generate, not the revenue the former owner generated.
Don’t be afraid of pro forma NOI. Many people think “pro forma” means “I wish upon a star…” That’s not true. If you make reasonable projections about future revenue and expenses, you will be considered a sophisticated and respectable investor rather than an amateur.
Once you establish an NOI, the next step is the cap rate. In its most simplistic terms, a cap rate the “interest rate” you would like to earn on the purchase price for the property. For purposes of this analysis, you assume that you will pay all cash for the property.
If the purchase price is $100,000 and the NOI is (or will be) $9,000, then you divide the NOI by the purchase price ($9,000/$100,000 = 0.09) to arrive at the “cap rate.” In our example, the cap rate of “0.09” is a 9% cap rate. Using the “interest rate” comparison, if you invested $100,000 in a CD and earned $9,000 in the first year, your interest rate would be 9%.
When deciding whether to purchase a property or not, ask lenders and other investors what the current cap rates are for similar properties. Cap rates are not published anyplace. They are not set by anyone. It’s just what things work out to be in the market place based on what people are paying to buy property, and what that property’s NOI is.
Different types of properties might have different cap rates. A shabby run down rental house in a bad school district might have a cap rate of 12%. In other words, before anyone will buy that property, they will want to make sure they make a really good 12% return on their money if you assumed a cash purchase. A modest brick three-bedroom, two- bathroom house within walking distance of a great elementary school might have a cap rate of only 9%. In other words, an investor might pay a higher price for that property, compared to its NOI, because he or she would know that the property will be low maintenance and probably have very low tenant turnover. When the investor decides to sell, it will always be able to sell to another investor OR a homeowner. The shabby property might have only another investor as a potential buyer, so there would not be as much competition to drive the sales price upward.
Once you understand all of this, you can ask any potential lender about another underwriting requirement. Technically, this one is related to the appraised value of the property, which is legally supposed to be out of the hands of the lender. But, lenders look at a lot of appraisals, and have a good sense of prevailing cap rates for different types of properties.
Suppose the lender says, “We’re seeing cap rates of 9% for 3BR, 2-BA brick rental houses with little or no deferred maintenance (repairs that need to be made).” Warning: Buyers might be buying such properties on an 8% cap rate, but bank appraisers might be appraising based on a 9% cap rate. At least, that’s been my experience.
♦ In case this is starting to get mysterious to you, a lower cap rate means a higher value. Let’s suppose the NOI on two different properties is $9,000. Property One is shabby and run down and has a high cap rate of 12%. In other words, whatever the purchase price on that property, $9,000 must be 12% of the purchase price. When you do the math, it works out to $75,000. If you buy the property for $75,000 and have $9,000 of NOI, then your cap rate will be 12%. But, the other property is the brick home in the good school district. That cap rate might be 9%. The NOI of $9,000 will be 9% of the purchase price. Based on that, the purchase price will be $100,000. If two properties have the same NOI, the one with the lower cap rate will appraise for the higher value.
Once you understand these concepts, you can greatly improve the odds of getting financing for your purchase. You can look for properties that will appraise high (but can be purchased low) or you can control the pro forma NOI to increase the likelihood of financing. In other words:
- By examining the seller’s financial information and “recasting” it into the NOI format, you might be able to exclude expenses that the seller is listing for income tax purposes, not realizing those expense depress the market price.
- By knowing the current cap rates for similar properties, and the NOI, you can evaluate right away whether the lender will appraise the property for a value high enough to support your loan request.
- In your pro forma NOI, you can increase revenues by raising rents, or decrease expenses in some areas, and increase the NOI. That automatically increases the value.
- In your loan request, you can include expenditures that will not only increase rental revenues through higher rents, but will also decrease the cap rate because the property will be in a different “category.” In other words, the appraiser might use a well-maintained property cap rate instead of a shabby run down property cap rate.
I know this is a lot of information for many of you. But, once someone explains it and you understand the importance of these things, you are no longer gambling when you make a loan request. You pretty much know if the property will appraise high enough to support your loan request. Also, once you understand the basic NOI and cap rate concepts, they stay lodged in your brain forever. A little bit of learning now pays off huge dividends in the future!
Further, you should now understand the importance of creating a pro forma NOI spreadsheet and providing it to any lender. To repeat, it can support a higher appraised value, AND it signals you are no amateur! In lending, as in most of life, perception is the same as reality. If you are perceived as a sophisticated investor, you will be treated like a sophisticated investor. Only good things will come from that!