As real estate prices fall, the income you get per dollar invested rises. This means greater cash flow and the ability to deliver bigger dividends to your investors.
Dividends (or distributed net income) are usually the main attraction for investors in real estate investment trusts (REITs), and they can be the key benefit you offer to equity investors in your next project.
Let’s see why you might want to shift your emphasis to distributed net income in today’s market.
A Bird in the Hand
Will Rogers said it: “More important than the return on your capital is the return of your capital.” During the bull and bubble market, the conservative approach reflected in that statement was very much out of fashion. In today’s market – where so many speculators have lost money – that sentiment is well received once again.
Often, when you pay a dividend (or distribute cash flow) to your equity investors, you are, in effect, returning a piece of their original investment. In fact, in private partnerships, early distributions are typically treated as return of investment capital. So you and your equity investors typically get to defer taxes on distributions for a while.
The investor in an income property gets…
- A lower risk investment, as he is buying into an investment that “pays for itself” and because pieces of his investment are returned sooner
- Possible tax advantages on early distributions
- Completely passive income
- The expectation of additional gains through amortization
- The potential for additional gains from leveraged appreciation
A steady stream of income and the possibility of capital appreciation later, with relatively low risk, is an attractive offer, especially in a marketplace that is otherwise highly volatile.
Key Terms for Evaluating Yield
When you consider income property, there are a few terms you should be familiar with: potential gross income (PGI), gross rent multiplier (GRM), net operating income (NOI), and the capitalization rate (or “cap rate”).
Potential Gross Income is just as it sounds. Imagine you have a 10-unit building with market rents of $1,000 per unit. Your PGI is $10,000 a month or $120,000 a year. If you have laundry machines too, and you figure an average revenue from them of $25 per unit, your PGI is then $10,250 per month or $124,000 per year.
Gross Rent Multiplier is a ratio. It’s the purchase price of a property divided by the annual PGI. So if you pay $620,000 for the abovementioned property, you’re paying five times PGI. Your GRM is five.
Net Operating Income is the most important number in all of real estate. It’s your PGI minus vacancy and collection losses minus expenses. Period.
Capitalization Rate is the most quoted number in commercial real estate. It tells you how much income you are getting per dollar invested. Here’s the formula: NOI divided by purchase price equals the cap rate.
Now let’s look at a few key details about using these numbers correctly.
Base Your PGI on Current Numbers – Not Projected or Inflated Figures
When you’re a buyer, work with the lower of actual numbers or market numbers. Here’s what I mean.
Let’s say a seller has that 10-unit building we’re talking about. Two units are vacant. He says you can raise the market rent to $1,100 a month for all the units so that soon you’ll be getting $11,000 a month in rent, plus the $250 in laundry. So, according to him, you should base your offer on a PGI of $11,250 a month or $136,000 a year.
Don’t do it.
Base your offer on current numbers. If he can get $1,100 a month, why doesn’t he? When using the PGI, use the current rents per the owner’s current leases. The only time you wouldn’t do this is if he’s artificially inflated the rents.
For instance, say he has illegally turned the property into a boarding house, renting by the room. You have no intention of using the property that way. So, just because he’s getting $500 per room or $20,000 per month, don’t use those numbers unless you want to operate an illegal boarding house. Instead, use legit market numbers.
If the property would normally have a PGI of $124,000 and in this location you figure a GRM of five or less would be a good deal, then your max offer would be $620,000. If you accepted his numbers based on illegitimate usage, you’d be prepared to pay nearly twice that – even though you were using the same GRM.
Verify the NOI
In commercial property, cap rate is the most common way of determining value and justifying asking and offering prices. But a true cap rate depends on a true NOI – and NOIs are fudged more than government budgets in an election year! To get an accurate gauge of a property’s NOI, you must insist on getting proof from the seller for his numbers, and you must be prepared to do a little number crunching yourself.
Let’s say the seller of our 10-unit building claims he gets NOI of $100,000 a year. Right away, you’d have a strong suspicion he’s overstating the income. After all, you know the PGI is just $124,000. So to really end up with $100,000 in net, his lost rent from vacancy and his expenses would have to total no more than $24,000 – or about one-fifth of his PGI.
As a rule of thumb, you’ll find most apartment buildings have expenses in the neighborhood of 40 percent to 50 percent of the PGI. Add in rent losses due to vacancy of 5 percent to 10 percent of the PGI, and you usually have total expenses and vacancy totaling 50 percent to 60 percent of the PGI. That leaves the rest – 40 percent to 50 percent – for you as net operating income.
So if we assume expenses and vacancy to reach a total of 60 percent of PGI, your NOI would be the remaining 40 percent. Take 40 percent of $124,000 and your NOI is $49,600. If you insist on a minimum cap rate of 8 percent (8 cents in net income for each dollar you invest), then the maximum you would pay for this property would be $620,000.
You would have arrived at that number as follows: NOI/cap rate = maximum offer price… or $49,600/.08 = $620,000.
That can give you a good, quick estimate of what you might pay. But when you get to the offer stage, you’ll want to base it on the actual numbers.
Get Key Docs and Take All Expenses Into Account When Gauging NOI
Ask to see the last few years’ tax returns for the property (or the seller’s schedule E if he owns it in his personal name), bank statements, profit and loss statements, and general ledger. Request current leases and verify them. In your projections, use a conservative vacancy rate of 8 percent to 10 percent. Don’t accept overly cheerful projections of 3 or 4 or even 5 percent. That will just increase the estimated NOI and, hence, your offer price.
Request recent utility bills paid by the owner. Estimate what your property taxes will be based on your purchase price and local millage rate (a tax rate) when determining your NOI. Don’t use his tax rate, since yours will likely go up substantially if you’re buying the property at a higher price than he paid years earlier.
Make sure you account for all expenses you’re likely to incur. If the current owner cuts the lawn and shovels the sidewalks, budget to have someone do that for you. If he manages the property, budget to have someone manage it for you, including handling bookkeeping and taxes.
In other words, base your NOI on having a professionally managed property and not one where you have to do a lot of the maintenance, handyman work, and management.
There is a good deal more to look into when evaluating NOI. I’ll go into it further in future articles. But we’ve just looked at some major points that can help you gauge a true PGI and NOI. When you can do that, you can look for the best priced properties with the highest legitimate cap rates and lowest GRMs in any given area.
Then you can structure deals where you offer investors healthy current yields of 6, 7, 8 percent and more, as well as the prospects for capital gains though amortization and long-term appreciation.[Ed. Note: Justin Ford is the author of Main Street Millionaire, a value-focused real estate investment program. At ETR’s recent Profits in Paradise Wealth-Building Summit, 14 of the world’s experts in wealth – including real estate specialists Dave Lindahl, Marko Rubel, and Jim Fleck – divulged their biggest secrets to churning out cash. Take advantage of their proven money-making strategies with ETR’s Profits in Paradise DVD Library. ]