Orange County Investment & Commercial Property

When it comes to buying or selling an income-producing property, the first part to consider is the market value for the subject property. The valuation of apartments can be complex and aspects of value that make one apartment different from the next vary greatly. Some include gross rents, vacancy, expense ratios, the responsibility for the payment of utilities (landlord or tenant), the potential for condominium conversion, condition of the property, or the location to the beach or downtown areas, just to name a few.

Appraisers use three different methods to estimate the value of all types of real estate. They are the income approach, the sales comparison approach, and the cost approach. The sales comparison approach is considered the best method for appraising single family homes. The cost approach is used to appraise special purpose buildings such as churches, schools and marinas. The income approach is used to estimate the market value of income-producing properties such as office buildings, shopping centers and apartment buildings. When adequate financial data for recent sales of similar income-producing properties is unavailable, appraisers may utilize all three approaches. Though we could spend an extensive amount of time on each approach, considering our limited space I will only focus on the income approach, as it is the best tool to figure out a value for apartment buildings.
The income approach is used when reliable financial data is available for recent sales of similar income properties in a given market place. A property’s net operating income and sales price are used to calculate a capitalization rate for the sale of each similar property in a given area or market place. If sufficient sales of similar income properties are available, a market cap rate can be determined by averaging the cap rate values from the individual sales.
The appraiser first estimates the annual potential gross income for a property. This involves estimating how much rent each unit could generate in the current market place. The rental rates being charged by the current owner may be too low or high and may not reflect potential market rental rates. Appraisers study the current market place to estimate potential rental rates. The appraiser then calculates an effective gross income for the property by reducing the annual potential gross income by a vacancy allowance amount. We are very fortunate in San Clemente and Dana Point as our vacancy rates are incredibly low for 2-4 unit properties, typically in the 2-5% range. Miscellaneous income such as parking fees, laundry and storage are added to the income. Operating expenses are deducted from the effective gross income to determine the annual net operating income for the property. Once the net operating income is determined, a capitalization, or “CAP” rate is calculated for the property. Most of the 3-5 units sold within Dana Point and San Clemente in the last year have been within a 4-7% CAP rate. Below is a 4-unit example that may help explain how this is determined.

4-units
Gross income per month is $5,500
Annual income is $66,000
Annual expenses at 15% are $9,900
Net operating income (NOI) = $56,100
$56,100 / $910,000 = .06 CAP rate

Given this information we could see a market price ranging from $850,000 to $1,125,000, depending on condition of the property and the location. I hope this helps you better understand how to value your investment property.

If you are interested in finding out the value of your property or purchasing another, please give us a call. We are here to help you better understand the market and assist you with a sale or purchase. You can reach Josh or Doug at 949-498-7711 or email us a income@echelberger.com.

Greetings!

I hope you all had a great time with your family and friends over the holidays. As 2012 begins, I want to share with you a few quick stats from last year regarding investment property in Dana Point and San Clemente. Since 2008, we have seen a steady increase in the amount of 2-4 units being sold, with last year bringing in the highest total – 69 between the two cities. Dana Point had 23 properties transfer ownership while San Clemente had 45. This was an increase of 5 properties sold over the previous year and 29 more than 2009. Nearly all of the properties sold in Dana Point last year were duplexes (17) while San Clemente saw more 3-4 unit properties (25) sell overall. The average sale price for all income property during the last year was $725,000. More accurately, the average price per square foot worked out to be $261. This is lower than in 2010 when the average was $279, or $778,000 most likely due to the higher amount of short sales and bank owned properties that sold in 2011. Almost half (10) of the units sold in Dana Point last year were sold as a short sale or bank owned property. San Clemente saw about 1/3 (16) of units sold as a short sale or bank owned property. Average asking rent for 1 and 2 bedroom apartments has remained steady for the last two years, and vacancy rates have remained relatively low for both cities, leading to a limited time between tenants. Last year the average amount of days that a property was on the market before it sold was 114, which was nearly identical to 2010 at 112. Typically this number can be dramatically reduced if the property is priced right, marketed effectively, and doesn’t have any major defects, or issues.

Overall, the investment property market is moving along quite well as investors are continuing to look for a solid return on their money without the fluctuation found in many other types of investments. As always, we are here to help you if you have any questions. We continue to offer a free property analysis to anyone who owns Investment or commercial property in South Orange County. We are looking forward to a great new year and wish you and your family the best in 2012.

-Josh Cunningham and Doug Echelberger

Any Commercial real estate professional should be familiar with the term Capitalization Rate (or “Cap Rate” for short). Unfortunately, for both experienced investors and new investors alike, the true meaning of cap rate is often misunderstood. The goal of this article is to explain Cap Rates in a way that everyone can fully understand, and internalize, both their meaning and their value to investors.

Before we discuss exactly what the Cap Rate is, let’s explore why having an investment metric like Cap Rate is important…

Why Cap Rate is Important

Let’s say you are buying a property, and you want to know if the property is a good investment. What information would you ask the seller to determine if the property were one that you should buy? For many investors, the first question that comes to mind is, “What is the cash flow of the property?”

Note: For those not familiar with the term “cash flow,” it is the amount of money the investor will have left over after collecting the monthly income from the property and paying all the expenses (including property taxes, insurance, maintenance, mortgage, etc). So, a property with a $5000 per month cash flow will allow the property owner to pocket $60,000 per year.

While this seems like a reasonable question from the perspective of a potential buyer, there is one major problem with asking what the cash flow is on a property: the cash flow is going to be different for each potential buyer. This is because the cash flow is directly affected by the expenses associated with the property; the higher the expenses, the lower the cash flow. And, while a number of the expenses associated with a property will not vary depending on the owner (property taxes, insurance, maintenance, etc), one key expense item will almost always change dependent on the specific buyer; the debt service payments (mortgage payments). The debt service payments are going to be directly related to the interest rate on the loan, the amortization period, and the down payment amount. Because two buyers will likely use different financing mechanisms, one is likely to have higher debt service payments than the other and since cash flow decreases as expenses increase, the one who has higher debt service payments will have lower cash flow as well. Because my cash flow will likely be different than your cash flow on the same property, it doesn’t make sense to determine the value of the investment value of the property using this metric. This goes for several other popular metrics used to determine the investment value of the property as well – cash-on-cash return, total return, etc. That’s because these investment metrics are also specific to the buyer’s particular circumstances (debt service payment, tax bracket, etc). So, if none of these metrics is a good measure of the value of the investment independent of the specific buyer, what is?

That’s where the Cap Rate comes in!

The Cap Rate is a measure of a property’s investment potential, independent of the specific buyer. Regardless of who is evaluating the property, the Cap Rate will remain the same, therefore two investors can do an apples-to-apples comparison of the same property using this measure.

Hopefully you have a clearer picture why the Cap Rate is an important metric when evaluating a property, but you still have no idea what it means…let’s get to that now…

SO WHAT DOES THE CAP RATE MEAN?

In a nutshell, the Cap Rate is equivalent to the return on investment you would receive if you were to pay all cash for a property.

Here’s another (longer) way to look at it…

Most investors understand the basics of return on investment (ROI) for simple investments, like a Certificate of Deposit (CD). And most investors have a pretty good sense of what is a good return on investment. For example, with a typical CD, you might get a 3% return on your money. So, if you were to invest $100,000 in CD for one year, you would receive a 3% return (or $3000) at the end of the year. Likewise, if you were to invest $100,000 in a stock market S&P fund for one year, you might expect to receive about a 6% return, or $6000 (assuming the S&P returned its long-time average amount in that year). People are very used to thinking about return on investment in this way – a simple return percentage that indicates how much your invested money will earn for you each year.

Unfortunately, calculating return on investment for a property is a little more complicated. This is because unlike with a CD or investing in the market where you pay for the total value of the asset up-front, with a property investment you often only pay for a portion of the asset up-front and the rest of the asset is paid for using a loan. For example, to buy $100,000 property, you may only have to put up $10,000. Because of this, figuring out the return on a property investment is more complicated.

This is why using a Cap Rate is so helpful. Cap Rate assumes that you pay for the entire property up-front (just like the CD or stock market fund), and indicates your return on that property investment. In addition to allowing you to compare one property to another, Cap Rate also allows you to compare a property investment to other investments. For example, if a $100,000 property had a 10% Cap Rate, the property would return $10,000 per year to someone who paid all cash for the property.

 Important: You should keep in mind that the Cap Rate isn’t necessarily the amount a real-life investor will make on a property. Because Cap Rate assumes that an investor pays 100% up-front for a property, and because investors rarely pays 100% up-front, the actual return will differ from the Cap Rate of the property. In many cases, the actual return will be higher than the Cap Rate (one advantage of leverage).

How is the Cap Rate Calculated?

Now that we know what the Cap Rate means and why it’s important, let’s discuss how it’s calculated.

The cap rate is calculated as follows:

Cap Rate = Net Operating Income / Property Price

Note: For those not familiar with the term “net operating income” (or “NOI”), it is the amount of money the investor will have left over after collecting the monthly income from the property and paying all the expenses except for the debt service. Because the debt service amount should be the only property expense that is directly affected by the specific buyer, the NOI will be the same for all potential buyers.

As an example, let’s say that a specific property has the following characteristics:

Purchase Price: $900,000

Income per Month: $10,000

Expenses per Year: $40,000

Here is the cap rate for our example property…

First, calculate NOI:

NOI = Annual Income – Annual Expenses

= (12 x $10,000) – ($40,000) = $80,000

Then calculate Cap Rate:

Cap Rate = NOI / Property Price

= $80,000 / $900,000 = .09 CAP

WHAT IS A GOOD CAP RATE?

This really depends on the area of the country you’re examining. Along the California coast in Orange County, the average Cap rate may only be 4 or 5 % where the average Cap rate inland could be 8 or 9%. Similar to the value of single family houses being based on the prices of comparable houses in the area, the value of investment properties is usually based on the Cap Rate of comparable investment properties in the area. So, if the average Cap Rate in your area is 6%, you should be looking for at least a 6% Cap Rate for your property. Though this formula does not address issues like average appreciation, market conditions, or saturation of properties on the market, it is a great tool to start with when evaluating an investment property.

As always, if you have any questions regarding Cap rates or investment property in South Orange County please contact us at (949) 498-7711.

This month I wanted to share some of my thoughts on gross rent multipliers and how they are sometimes used by local agents to price an Investment property. I thought I had put together a good argument for why using a GRM does little to show how a property is actually preforming, until I stumbled on a blog written by ReSheets.Com that did a much better job then I could. Below is their blog post from September of 2010 that does a great job detailing the pitfalls of the gross rent multiplier as a tool for analyzing Income property. Be sure to check out their site for some great tools for analyzing Commercial and Investment property.

Gross Rent Multiplier (GRM): Love it or Hate it

Posted on 09. Sep, 2010 by Perry Paolini

What’s it take to be remembered forever? A good name? A well-worded turn of phrase? In the case of Henry Wadsworth Longfellow, probably both: There’s nothing in this world so sweet as love, And next to love the sweetest thing is hate! When it comes to the Gross Rent Multiplier, all financial students must learn: there is nothing sweeter to hate.

We’ll start with the benefits of the GRM: it’s easy.  The Gross Rent Multiplier is simplythe ratio of price to gross rents!

GRM is a quick estimation of investment value, often considered a “back of the napkin” calculation, however when dealing with multi-million dollar investments, it isabsolutely essential to understand all risks involved, and GRM falls very short of a due diligence calculation.  As investors/consultants/brokers/very-near-future-moguls we must reconsider the words of Walter Capital, and make every investment a smart investment. That’s not to say don’t take risks, in fact quite the opposite! Risk is our reward, but you must be smart about it.

Solely relying on Gross Rent Multiplier is like jumping out of a plane and hoping your backpack doubles as a parachute, and not the other way around.

The following example is GRM in practice:

If you have a 10 unit apartment building where all tenants pay $1,000 per month, and the market dictates the Gross Rent Multiplier should be around 10 times the gross rent, then the estimated value of the building is $1,200,000. See Below.

But, and this is a big butt (er…but), Gross Rent Multiplier does not account for any operating factors.  Although it’s easy to love a high or low GRM (depending on where you’re standing: buyer or seller), GRM is often misleading and therefore amanipulative ratio.

GRM’s macro look at a property does not account for the following examples of operating factors: vacancies, regulations, operating expenses including taxes, insurance, utilities (all of which can vary widely from property to property)… how old is this place?… how safe is this place?… where is this place again?… to name a few.  Any of these factors can skew the actual value of a property greatly.

Assume you are given the opportunity to invest in Property A with gross rents of $140,000 per year and Property B with gross rents of $120,000 per year. Both properties will be sold for $1,200,000.  If we base our decision solely on Gross Rent Multiplier, Property A with a GRM of 8.57 ($1,200,000/$140,000) sounds like a better investment than Property B with a GRM of 10.00 ($1,200,000/$120,000).  Let’s add a few variables before we make our wise decision:

Yes, Property A has the better GRM (10.00), but Property B is far more efficient when it comes to operations of the property; efficient enough to overcompensate for the $20,000 lesser Gross Potential Rent.  By factoring in Property B’s efficient expense ratio (35%) and vacancy rate (5%), you’ve just got a better investment; and imagine that, the CAP RATE (6.18%) sums it up nicely.  We’re glad you didn’t base your decision on the Gross Rent Multiplier but returned to the highly useful Cap Rate.

So never let anyone say “I told you so,” because you back of the napkin’d a GRM!  Instead take two minutes to educate yourself on a property, it’ll pay off in dividends (or $2,490 per year if you run into this example – for two minutes?  We don’t even charge that much).

To assist you in your continuing growth out of Freshman status and up to speed with the big leagues, I have included a FREE GRM calculator and matrix.  Play with the numbers, learn it, love it (I mean hate it), and then forget it, really…

Download our free GRM Calculator & Matrix

I thought I’d include this breakdown as it may help you understand how a property can work well as an Owner/User property and still bring in a healthy amount of income.

Of all the income property listed for sale right now, how do you know which one is worth the price? Some people look for the highest gross income, while others want a higher-than-average CAP rate, and that’s all they consider before buying.  At the Echelberger Group, we believe it is our goal to find you the best investment property available and explain why it’s the best based on your own personal investment goals.

Every month, we will spotlight a property for sale and analyze it to show why we believe it to be a good investment, whether long or short term.  All properties are not created equal, and some may be better suited for one type of investor over another. In this month’s spotlight, we will focus on a property that works best for someone who desires an owner/user type of property.

This property is perfect for someone who wants to live by the beach and have a house that shares no common walls with the other units. The front unit is a single story house that has been recently updated with new appliances and is move-in ready. It is a 2 bedroom/2 bath, with an additional room that can be used as an office.  It could also function as a vacation home for someone who lives inland and wants a costal home during the summer months.  The income generated from the 3 units located behind the main house would be just enough to cover the mortgage on the entire property if you put 30% down at purchase.  Below is a financial summary based on the main house being used as an owner/user unit.

103 Avenida Aragon

Owner/user unit with 3 rental units

Purchase price = $699,900

30% down = $209,970

Loan amount = $489,930

30 year fixed rate of 6.5%

Estimated payment = $3097.

Rental income of 3 rear units = $2925.

Mortgage amount after rental income = $172.

This property summary does not include insurance, reserve accounts, maintenance, or other property expenses. For an in depth report on this property, please email us at Income@Echelberger.com