It's in the numbers: Buy and hold properties in MA (Part 3)
I’m back with the third post of my “It’s in the numbers” series!
Will this be the final of the series? I think not… I’ve begun looking into multifamily syndication, so hopefully in time I’d have some thoughts and experience to share on that area.
Taking a pause here. It dwelled on me this morning that I’d really come a long way from… nothing. I started from ground zero. Just feeling very grateful that my knowledge and experiences gained through time, and frankly, through others' helping and guiding me along the way are converging into a very meaningful path.
Whoever’s reading this, if you’ve shared a knowledge titbit with me, helped widen my perspective, perhaps passed a contact or even said a word of encouragement, thank you. :)
Now, onto the topic of buy and hold properties.
I don’t know about you, but before I was exposed to HGTV, my thoughts on real estate investing and being a real estate investor solely pertained to the concept of buy and hold properties. Got excess cash in bank? Why keep it in a saving account and earn meagre interest rates? Just buy something and sit on it! Everything appreciates!
Well. Told you I’d come from ground zero.
What is CAP rate
When you’re talking to an investor about buy and hold properties, otherwise also known as passive income properties, you’ll be talking about CAP Rates.
CAP Rate is simply a short term for capitalization rate. It’s yield potential of a property over a one year timeframe, assuming that the property is purchased with cash and not financed.
Why cash? Because we’re trying to standardize things here. If you include the terms of financing - of which everyone’s is unique - it’ll be hard to compare.
The formula is simple, and can easily be found online:
CAP Rate (%) = Net Operating Income (NOI) divided by Market Value, multiplied by 100%
Yes, the terms are self-explanatory.
Income = total rent collected. You could also count other sources of income that the property is generating, say renting out parking spaces, but for simplicity sake, let’s just do rents because that’s typical for 90% of cases.
Expenses = property taxes, condo fees, repairs, insurance, utilities (if you include that for your tenant)…. everything that you pay to maintain the property.
NOI = the final amount that you make after deducting all expenses. Take 1 - 2.
Market Value = value of property. Often what you pay for it.
What is a good cap rate
What makes sense for you might not make sense for your neighbor.
Everyone has a different take on their ideal CAP rate. Some investors aim for double digit CAPs; others are contented with a 4% because it beats putting it in a bank.
The better question: “What should be the expected CAP rate for this property”.
Know what should be expected, so you know if you’ve landed yourself a DEAL.
If you’d like a general sense for what’s going on across key US markets, CBRE has a pretty cool interactive CAP rate map as shown in the screenshot below. They’ve also got a handful of excellent reports that they release in their semiannual North America Cap Rate Survey page.
Screenshot from CBRE.
In this current (healthy economy, strong real estate) climate, Boston city properties are at or around 6%. Further out, in greater Boston, CAP gets a little higher at 7-8%. Further west, past the I-495, CAP gets close to 10%.
The above is a broad generalization.
Layer it with Trulia’s median sales price heat map:
Screenshot from Trulia’s Boston Real Estate Market Overview, on 2 April 2019.
Based on my observations, I’d say areas in red get a 5% CAP, orange 6%, yellow 6.5%, light green 7%, medium green 9%, dark green 11%.
What’s the correlation here?
Lesser demand neighborhoods = higher risk = stronger CAP
How do you determine the cap between a single family property, versus a 2-family, versus a 40-unit building?
I once thought that there’d be a different process when assessing CAP rates of a 2-family property as compared to a 20-unit building until David Eldredge of NAI Glickman Kovago & Jacobs taught me otherwise. Thanks David!
His email to me was enlightening. Here’s extracting our exchange:
My email to David:
“I was wondering if you could guide me as to how one should to go about evaluating the value of these commercial buildings. What ROI should I expect for smaller buildings that are 5 units, to larger ones that are 12 units? What if there’s a leasing company managing the rentals and we’d just take a passive role as landlord, what happens if lease is NNN?”
David’s reply:
“The first place to start with any investment property is to look at the numbers. While location, and condition are important considerations as well, healthy cash flow pays the bills. Be sure to get all the pertinent data from the owner regarding current and past expenses along with current income. Also make sure [you’re] including management expenses and replacement reserves when preparing your cash flow analysis. Once you have all that you can get the NOI (net operating income) for the building. When I'm analyzing a property for a seller I take the NOI and divide it by a presumed cap rate for that type of property in a given area to give me a value indication. Current cap rates in and around Worcester are anywhere from 5 to 10%. The higher the cap rate the better the cash flow. Lower cap rates are usually associated with high demand/low risk properties and the opposite for higher cap rate properties. Cap rate is more a function of the location and condition than the number of units. An example of the valuation exercise would be a 6 unit building with an NOI of $50000 in a good area with reasonable demand would command a cap rate of 8%. So $50,000/8% = $625,000 This exercise is commonly used for determining a potential sale value of a property. Determining an actual ROI is a little more involved as it requires looking at the cost of financing and closing costs and is a function of the amount of money an investor will put into a deal along with the holding period. Along with that there are before and after tax ROI calculations to examine. There are a few good property evaluation spread sheets available on the internet that will help you grind through the calculations. You can run different what if scenarios, to see how the numbers work to get you to your target.
The difficulty in today's market is that with demand being so strong for MF [multi-family'] property that cap rates continue be pushed lower and lower meaning the short term ROI is very small or non existent in most cases. Finding a decent property that you can buy and provide a decent ROI is an ongoing challenge for all investors currently.
If the leasing company is handling the management [then] that expense is entered as an operating expense in your cash flow analysis. Also, don't forget to enter a vacancy factor in your cash flow evaluation. This is usually a percentage of the gross scheduled income. 5% is usually the norm here.
A NNN lease means the tenant is paying all or a portion of the operating expenses such as repairs maintenance taxes and insurance to name a few. The income received by the landlord in these arrangements is generally net income so usual operating expenses are not considered as part of the cash flow analysis.
At the end of the day, your CAP is a reflection of what you want to do with your money.”
See what I mean when I said that I had some serious help along the way?
CAP is a function of risk,
and what you want to do with your money.
Of course, to an extent, the number of units in a building impacts risk as well. Higher number of units make safer investments in the long run, because having 1 out of 20 units vacant is no big deal, whereas having 1 out of the 2-fam property vacant would make you dig your personal funds to make up for mortgage.
Also, economies of scale! Repair and maintenance costs per building as a ratio of rent is lower for properties with larger number of units.
Getting a higher CAP on an investment property
Investors often don’t buy properties in top condition because paying a retail price without assuming risks mean that the return on investment is weak. Depending on the area of purchase, a weak CAP ranges from 4-7%.
There’s no secret here as to how you get a better CAP.
You assume risk.
Same concept as house flipping (my post here), except where flippers realize in their profit with one lump sum at the exit/sale of property, buy and hold investors work their numbers out for a higher CAP, or adjust it according to how they think their asset would appreciate over time.
starting a real estate investment portfolio
If you’re new to being a landlord, you may wish to start with a condo apartment unit - one that comes with a management office.
With these, you could ease your way into your new role while having the management office take care of time-consuming details like landscaping, snow shoveling, trash removal, well-testing and all sorts of external maintenance.
If you find that you could afford to be more involved, multi-families are the way to go. They are one of the most resilient asset classes out there. The main difference as compared to condos, is that multi-families come with land!
It’s the land that appreciates over time, not the structure.
Get a commercial unit, if you have the choice. I don’t mean buying a retail shop - commercial properties are those that come with 5 or more apartment units. They are financed differently than regular single-family, condo or 2-family properties.
Final words
If you plan on being a buy and hold investor, have your agent dedicate time to interviewing potential tenants and carefully screening them.
Rentals were my first transactions when I got my license. Without awareness of industry shortcuts, I spent a whooping 20 hours on 2 rental properties, staggering 45mins - 1hr showings and interview for each party. I hated going back to the units after a while, but in retrospect that was the right thing to do. I found my client rockstar tenants who not only took care of the place, one even paid 2 weeks in advance.
It made my client happy and relieved.
In a tenant-friendly state like MA, the wait was worth it.