At a Glance – Does the Deal Make Sense?
In this week’s blog we identify ways of looking at deals upfront from various angles to see whether the investment could work before investing further time and money into the transaction
The decision whether to invest in an income generating property can be complex and the parameters set by individual buyers does vary. It is the responsibility of the buyer to establish their objectives and criteria when sourcing property. However, there are some initial steps that a potential buyer can take immediately to assess whether the investment deal makes sense – based on set goals.
When buying an income property for a portfolio, it is essential that the investor keeps their purpose for investment top of mind. Most buyers have a longer-term goal of achieving financial independence. An income property must assist in building wealth and create a future income stream, otherwise known as passive income.
The two key criteria we always look at for a property:
- The income on the property in terms of the amount brought in after payment of all expenses
- The property’s equity potential, in other words the amount left over once consideration has been given to the cost of buying including financing and capital expenditure. This is the profit on the overall purchase price.
QUICK METHOD FOR VALUATING A PROPERTY
To do a quick calculation on the value of the property you need to be familiar with certain terms:
- Capitalisation “Cap” rate for a property: This the percentage return on investment required for a property
- Net Operating Income “NOI”: This is the annual income after taking consideration for all expenses relating to the property
- Property value: At what price does the property work as an investment?
The formula for the value of the property is quite simple:
Value = NOI/Cap Rate
For example: If the property’s net monthly income is R100 000, your annual NOI (the figure to work with) is equal to R1.2 million. To calculate the value on a property with a required Cap Rate of 12%
Value is calculated as follows: R1 200 000 (NOI) / .12 (Cap Rate) = R10 000 000
The purchase on this property would then be R10 000 000
The higher the cap rate, the better the income return on the property. Rode (https://rode.co.za/) and various other publications do publish from time to time the standard cap rates for particular types of properties. An average cap rate is usually around 10%. Cap rates above 10% are usually required in more risky assets. Lower Cap Rates – below 10% occur in more solid, high value assets with strong leases in place.
If a property’s Net Operating Income divided by the purchase price comes to 10% or a specified cap rate for that area, the property may be appropriately priced. Most often an investor will set a target Cap Rate, and work their offer price around that amount.
Note that, when obtaining Net Operating Income, it is essential to ensure consideration for all expenses that must be deducted from the Gross Income on a monthly basis. For certain properties, a percentage can often be used as a ballpark deduction on Gross to get an estimate of NOI. Rode and various other publications do also publish average operating expenses for various types of property.
What is equity?
Equity is essentially your worth. In other words, your assets minus your liabilities. One of the objectives for investment is to increase the value of your property investment and thereby grow wealth.
There are essentially four ways to increase equity through property:
- Buying the property at discount to market value. The principles of value investing apply here. The key is to ensure that you buy beneath what the property is worth. A buyer should establish upfront their discount price (the discount on actual property value they want to achieve) when putting in an offer. If the Seller is willing to accommodate their discount value – it may be a good buy.
- Increasing the value of the property. This can be achieved by undertaking improvements on a distressed property (the buy-and-flip principal) or perhaps by buying a property that currently has a large vacancy rate and taking steps to reduce the vacancy or improve the property to improve the tenant profile. There are various ways to force an increase in value through adding value.
- Property appreciation. This is a passive method of increasing property value over time and is based on market trends.
- Settling the mortgage bond early to reduce interest costs.
In summary when looking at a property at first glance, the investor can do the following:
- Set some financial goals and criteria. At what cap rate do you want to buy in the area? What property discount value do you want to achieve? What equity percentage do you want to make out of the property?
- Find some properties listed in the market to analyse.
- Gather information on the property. Gross rental? Monthly expenses? Cost to renovate? Vacancies and vacancy rate?
- Create an income snapshot. In particular look at the Cap Rate and the Net Income after Finance. This is especially important as this is the actual amount of money you will collect net of all other expenses including finance. How much you actually earn from the property on a regular basis?
- Compare various properties against the income snapshot
- Create an Equity Snapshot. What is the current discount you will pay when compared to the property value? What potential value increase can you obtain through adding value, asset appreciation (inflation taken into consideration) etc.
Having looked through the equity and income snapshot a buyer should be in a more comfortable position to decide whether to proceed and at what price the deal makes sense. Usually, an actual offer to purchase will include a due diligence to test all the assumptions made in the offer.