Different Applications of the Real Estate Spread

PropertiesSept2015-1On the eve of yet another youth soccer season, I recently took my son to the sporting goods store to buy a new pair of soccer shoes. We narrowed the choice to three – a relatively inexpensive pair, a moderately priced pair and an expensive pair. And to my surprise (or shock), my son didn’t immediately focus on the most expensive pair. Instead, he began to ask questions about why there was such a difference in price. And this led to a whole discussion about cost versus benefit and choosing the appropriate tool – in this case, a shoe – to fit the need.

Most investors will secure a mortgage when purchasing real estate. While there are many reasons why the use of debt is commonplace in the world of real estate, the concept of positive leverage is at the top of the list. This concept, commonly known as “the spread,” compares the unleveraged or free and clear yield of the real estate to the interest rate of a mortgage that would be used to purchase the investment. The spread is the difference between the two rates and the greater it is, the better it is for the investor. So it should be no surprise that one of the most popular forms of analysis focuses on determining the spread. But, similar to my son’s shoe decision, there are several levels of this analysis – good, better and best. And, similar to the shoes, there is certainly a cost versus benefit decision that needs to be made when choosing which specific analysis to use.

Spread between the CAP rate and the loan constant The mechanics of this particular analysis are actually pretty simple. By now, you should understand that CAP rate is determined by dividing the purchase price by the net operating income. And while the concept of a loan constant may not be familiar, it is just as simple – divide the original loan amount by the monthly payment. I will use an example for each analysis to better illustrate the process. Suppose we are looking at a property that has a purchase price of $1.4 million and an NOI of $123,404 (for details on this calculation, see the Financial Strategies column in the November 2013 issue of Properties, available at (www.propertiesmag.com). The resulting CAP rate would be 8.81%. On the debt side, we can get a loan with a 75% loan to value, 8% interest rate and a 25-year amortization. The resulting loan constant would be 9.26%. And the difference between the two, or the spread, would be 0.45%.  Click here to read the rest of the article.


Knowledge is Power

PropertiesAugust2015-1A wise real estate Yoda once told me that all a real estate agent has to offer are two things – time and knowledge. And sales comparables are certainly at the front of the line when it comes to knowledge. Commonly known as ‘comps,’ individually, they can provide guidance when attempting to value a similar property. And collectively, comps can provide insight into pricing trends, sales velocity and buyer characteristics.

Back in the ‘old days,’ there were not many sources for this type of information. The most common method to collect them was trekking down to the county courthouse and searching through stacks of microfiche. How times have changed. The information superhighway has resulted in a staggering variety of sources for this same information. Some are free while others have a cost, either in terms of money or ‘goodwill capital.’ This month, we are going to discuss some of the most common sources for this vital but sometimes elusive information.

County auditor web sites The good news regarding county auditor web sites is that all 88 counties in Ohio offer the ability to view information down to the parcel level online. And the better news is that these systems are typically free. The bad news is that the individual county sites can vary widely in terms of searching functionality. For example, Perry County has a very robust system that allows users to perform broad-based searches based on a variety of characteristics, such as land use, transfer date and city. However, Cuyahoga County’s site is much more basic, allowing searches only based on specific name, address or permanent parcel number. And, although Cuyahoga County also offers a robust GIS system, if you are strictly searching for comps, this system is not the best tool. Click here to download the entire article.

Valuation of Real Estate Assets

President of NAI Daus Property Management Division
Twitter @IraKrumholz

Determining the value of a real estate asset is never an easy thing but the historic free fall in real estate values a few years ago and subsequent uneven recovery has made this task significantly more difficult. This month, we are going to discuss how a tumultuous market can impact the traditional approaches to determining value – cost approach, sales comparable approach and income capitalization approach. Before we do, a brief discussion of the three primary types of value is in order.

Market Value. This represents the most probable price, at a specific date, which a property should sell for after reasonable exposure in a competitive market under all of the conditions for a fair sale. There are a couple additional things to note. First, neither buyer nor seller should be under any duress, with both parties knowledgeable and informed. And second, the price should be based on the property’s highest and best use, which may or may not be the property’s current use.

Investment Value. This type of value is all about the value to a specific purchaser, with little regard to the larger overall marketplace. One example of this would be a purchase by an investor involved in a 1031 tax-deferred exchange. Motivated by the deferral of a tax consequence, a trade buyer is typically willing to pay more for a property as compared to a traditional buyer. Another example would be a property owner that controls almost an entire block of property, except for one parcel. The owner would typically be willing to pay more for that outstanding parcel as compared to a traditional buyer. Click here read entire article. Click here to read entire article.

Will property upgrades yield higher rental rates? Part 2

PropertiesJune2015-1Last month, we began a discussion regarding an analysis to compare a challenging decision that often faces a real estate investor – maintain the property as-is or upgrade the property with the expectations of achieving a higher rent.

If you missed last month’s column (and shame on you if you did), we set up the following scenario: an investor owns a single-tenant office building and the tenant’s lease is expiring. The tenant is interested in renewing their lease. But the building is located in a growing and attractive area, so the investor thinks a higher rental rate can be achieved if the building were to be upgraded and con-verted to a multi-tenant property. Last month’s column went on to detail the economics associated with each scenario and distilled the annual cash flows into T-bars, a tool that illustrates performance over a time horizon, for each.

The performances of the “as-is” scenario and the “renovate” scenario are illustrated in Figure 1. But before we discuss the actual analysis, a few items need to be highlighted regarding each scenario. First, both scenarios assume that the property is owned free and clear at the beginning of the analysis and the investor plans to re-finance in either instance, based on the anticipated stabilized income. For the “as-is” scenario, the refinancing proceeds are realized as pure income while for the “renovate” scenario, part of the refinancing proceeds will fund the necessary upgrades. Second, the “as-is” scenario will result in positive cash flow in year one, as any improvements associated with the tenant renewing will be borne by the tenant. But the “renovate” scenario will take 24 months to reach a stabilized occupancy as a result of the conversion to a multi-tenant build-ing. And third, the holding period for both scenarios is assumed to be 10 years. The cash flows illustrated in that final year for each scenario consolidate the year 10 income plus the anticipated sale proceeds (which are based on year 11 NOI) less the loan payoff. Again, all of the background information associated with each scenario was detailed in last month’s column and the first two T-bars in Figure 1 reflect the resultant cash flows on an annual basis.

There are two primary ways to analyze this type of decision – the easy but limited way and the hard but complete way. Let’s tackle the easy way first. Click here to download the full article. 

Will property upgrades yield higher rental rates?

PropertiesMay2015-1There are many decisions that real estate investors have to make during the course of their ownership of an investment property. And one of the most challenging is the decision to upgrade the property with the goal of attracting a higher rent versus continuing as-is at the current rental rate. This month, we are going to discuss an effective way to compare these two scenarios by using a couple of familiar financial tools.

You may recall that although IRR and NPV have different definitions, they can be considered “kissing cousins.” A formal definition of IRR is the percentage rate earned on each dollar invested for each period it is invested. The formal definition of NPV is the present value of the future cash flows netted against the initial investment. In “Alec speak,” IRR tells you how much the property will yield while NPV tells you how much more or less that you need to pay in order to hit the target yield. These measures are useful tools and we have used IRR and NPV for a variety of investment real estate analysis over the years. But this application is slightly different – we are not comparing one investment property against another but rather two different scenarios associated with the same property. This analysis is a bit complex so we will tackle it over two months. We will set up the model this month, while next month we will discuss the actual analysis utilizing our financial measures of NPV and IRR.

To help facilitate this, let’s consider an example. Suppose that we own a 20,000-square-foot office building that is fully leased to a single tenant. The property was built for the current tenant 15 years ago, the original lease term was 15 years with no options and the original loan on the property matched the lease term, so it will be fully paid off when the tenant expires. The tenant’s lease is to be expiring in six months but they have already proposed to renew their lease under the following terms: $8 per square foot net rent with 1% annual increases for another 15 years and they will take care of any costs associated with cosmetics upgrades.

However, the immediate submarket in which the property is located has experience steady growth, bolstered by limited opportunities for new development. Because of this, we think that there is a clear opportunity to upgrade the building to a multi-tenant facility and achieve a higher rental rate. Competing buildings are achieving net rents averaging $12 per square foot and increasing by 1% each year. However, the cost to convert and upgrade the property is estimated to be $45 per square foot and we anticipate that the lease-up will occur over a 24-month period, with 30% occupancy anticipated the first year and 60% occupancy anticipated the second year. The market vacancy rate is currently 10% and this is expected to hold over the anticipated holding period. Click to download the full article.