Are mortgage Rates rising?
I get asked that question often. What do you see happening with interest rates in the next weeks / months / year? And is it a good idea to be looking to purchase a new Toronto home now or should we wait?
Right now historically speaking is the best time in the past 30 years to buy up or to just buy and become a home owner for the first time.
If you’re buying to fix up and sell for a profit then things are some what tougher to sell today since this has become a buyers market, but if your buying now and selling in a year only time will tell but overall the Toronto real estate market is stable. Anyone buying a new home in Toronto for the long term will never regret it. There are political talks going on now to open up the borders to Canada to allow more new immigrants to move into Canada to aid in these slower times, increasing the demand on housing thus increasing the Toronto property values.
I looked back at the Toronto area average home prices going back to 1980 when the average home price was $75,000 and interest rates were 14.5% up until today.
1988 the average Toronto area Real estate prices were near $300,000 with a interest rate at that time of approximately 11.5 %. Compared with the $345,000 average price of today and with interest of only 5%. This truly is the best time ever to buy or buy up.
Question #2,
Should home owners be locking in their mortgages or staying on variable rates.
My Answer:
Waiting and capitalizing on the absolute bottom will typically never happen for most of us. The day that the economy starts to show positive signs the market will adjust and home prices and interest rates will react before most can.
Having a variable rate mortgage right now will save you money but before signing that mortgage, make sure that at any time you can lock in at a fixed rate without penalties. I have studied mortgage financing and as a client of mine you receive free mortgage advice not only shopping for best rates but also receiving the best terms that suit you specific requirements.
The Bank of Canada will be meeting December 9th and we can expect another 1/2 point drop in interest rates to match the US. With the US overnight lending rate at a low of 1% to stimulate the US economy we shouldn’t expect much if any other reductions from the US in the near future. But some analysts say it could drop again, maybe another 1/4 in the year to come.
I recommend if you want to look at buying a new home or Condo in Toronto... get pre-approved now for a mortgage with a minimum 60 day agreement in writing. I suggest a variable rate at this moment but you should have the option to lock-in for a fixed term.
Once and If you find a home you like and have an accepted offer, you then can renegotiate and take advantage of the probable lower rates as of December 9th, “that is providing any accepted offer closing date comes after the week of December 9th 2008. If you can find a new home that you will be happy with for the long term right now buy it.
Please forward this to anyone you know who might be interested.
Check back, I’ll be updating this post with more specific details soon.
FRANK JONES, Salesperson
Royal LePage Real Estate Services Ltd.,
Johnston & Daniel Division, Brokerage
477 Mount Pleasant Road Toronto, Ontario Canada, M4S 2L9 telephone: 416.489.2121
www.Central-Toronto-Real-Estate.com
Sunday, November 2, 2008
Friday, November 23, 2007
Toronto Land Transfer increase. November 2007
Toronto City Council has approved a municipal land transfer tax that will be levied on top of the provincial land transfer tax. TREB worked very hard to oppose this tax and commends the efforts of REALTORS® on this issue. TREB took a strong position to oppose this tax as unfair in principle and refused to compromise. As a direct result of this strong position, City Council was forced to make a number of amendments to the City’s original proposal, including rebates for first-time buyers, a reduced rate, and grandfathering for existing transactions.
The City has not yet provided detailed information on administration or implementation issues. The following is based on currently available information.
What was approved by City Council? A second land transfer tax, on top of the provincial land transfer tax, at the following rates:
Residential:
0.5% of the amount of the purchase price up to and including $55,000
1% of the amount of the purchase price between $55,000 and $400,000
2% of the amount of the purchase price above $400,000
Commercial / Industrial / Etc.:
0.5% of the amount of the purchase price up to and including $55,000
1% of the amount of the purchase price between $55,000 and $400,000
1.5% of the amount between $400,000 and $40 million
1% of the amount above $40 million
When does this take effect? February 1, 2008.
Are existing transactions grandfathered? Yes. Any transactions where the purchaser and vendor have entered into an Agreement of Purchase and Sale for the property prior to December 31, 2007 will be rebated the full amount of the Toronto land transfer tax. The City has not yet provided clarification on how rebates will be administered. If your clients have concerns, they should check with their lawyer. Once the City of Toronto provides clarification, more information will be provided.
What about Agreements of Purchase and Sale signed after December 31, 2007 with closing dates before February 1, 2008? Purchasers with a Purchase and Sale agreement signed after December 31, 2007 with a closing before February 1, 2008 will not be required to pay the Toronto Land Transfer tax.
What about Agreements of Purchase and Sale signed after December 31, 2007 with closing dates on or after February 1, 2008? Purchasers with a Purchase and Sale agreement signed after December 31, 2007 with a closing on or after February 1, 2008 will be required to pay the full Toronto Land Transfer tax.
Where does this apply? The Toronto land transfer tax only applies to transactions within the City of Toronto. This does NOT apply to property transactions outside of the City of Toronto.
Are first time home buyers affected? First time home buyers of new AND re-sale homes will receive a rebate of the Toronto land transfer tax of up to $3,725 (this equals a 100% rebate on homes purchased for up to $400,000). The City has not yet provided clarification on how rebates will be administered. If your clients have concerns, they should check with their lawyer. Once the City of Toronto provides clarification, more information will be provided.
The City has not yet provided detailed information on administration or implementation issues. The following is based on currently available information.
What was approved by City Council? A second land transfer tax, on top of the provincial land transfer tax, at the following rates:
Residential:
0.5% of the amount of the purchase price up to and including $55,000
1% of the amount of the purchase price between $55,000 and $400,000
2% of the amount of the purchase price above $400,000
Commercial / Industrial / Etc.:
0.5% of the amount of the purchase price up to and including $55,000
1% of the amount of the purchase price between $55,000 and $400,000
1.5% of the amount between $400,000 and $40 million
1% of the amount above $40 million
When does this take effect? February 1, 2008.
Are existing transactions grandfathered? Yes. Any transactions where the purchaser and vendor have entered into an Agreement of Purchase and Sale for the property prior to December 31, 2007 will be rebated the full amount of the Toronto land transfer tax. The City has not yet provided clarification on how rebates will be administered. If your clients have concerns, they should check with their lawyer. Once the City of Toronto provides clarification, more information will be provided.
What about Agreements of Purchase and Sale signed after December 31, 2007 with closing dates before February 1, 2008? Purchasers with a Purchase and Sale agreement signed after December 31, 2007 with a closing before February 1, 2008 will not be required to pay the Toronto Land Transfer tax.
What about Agreements of Purchase and Sale signed after December 31, 2007 with closing dates on or after February 1, 2008? Purchasers with a Purchase and Sale agreement signed after December 31, 2007 with a closing on or after February 1, 2008 will be required to pay the full Toronto Land Transfer tax.
Where does this apply? The Toronto land transfer tax only applies to transactions within the City of Toronto. This does NOT apply to property transactions outside of the City of Toronto.
Are first time home buyers affected? First time home buyers of new AND re-sale homes will receive a rebate of the Toronto land transfer tax of up to $3,725 (this equals a 100% rebate on homes purchased for up to $400,000). The City has not yet provided clarification on how rebates will be administered. If your clients have concerns, they should check with their lawyer. Once the City of Toronto provides clarification, more information will be provided.
Wednesday, October 24, 2007
No Phantom Offers October 24th 2007
PRESS RELEASE, October 24th, 2007
PRESS RELEASE
Buyers Assured – No Phantom Offers
There has been considerable press lately on Phantom Offers in our marketplace. There is a growing perception by many that the Offer process presently followed by our industry is flawed and could lead to problems. RE/MAX Hallmark Realty Ltd. can no longer wait for the Toronto Real Estate Board or RECO to show leadership on Phantom Offers, and therefore has instituted the following company wide policy – effective immediately to deal with this perception.
Company Policy:
In Offer situations when RE/MAX Hallmark Realty Ltd. is representing the seller in multiple offer scenarios, it will be the company wide policy of RE/MAX Hallmark Realtors to disclose the name and company of all Realtors (in writing),
who have registered an offer on the property to any participating co-operating broker when requested.
When requested, this information will be provided to any co-operating broker either in writing before Offers are being presented of after completing of transaction.
Founded in 1980, RE/MAX Hallmark Realty Ltd. is a leading brokerage firm in Toronto, with over 450 sales professionals working out of 6 offices and over 2.5 billion in real estate sales annually.
Ken McLachlan, Broker of Record – RE/MAX Hallmark Realty Ltd.
read more www.www.chaplin-estates.ca or www.yonge-eglinton.ca or
www.central-toronto-real-estate.com
PRESS RELEASE
Buyers Assured – No Phantom Offers
There has been considerable press lately on Phantom Offers in our marketplace. There is a growing perception by many that the Offer process presently followed by our industry is flawed and could lead to problems. RE/MAX Hallmark Realty Ltd. can no longer wait for the Toronto Real Estate Board or RECO to show leadership on Phantom Offers, and therefore has instituted the following company wide policy – effective immediately to deal with this perception.
Company Policy:
In Offer situations when RE/MAX Hallmark Realty Ltd. is representing the seller in multiple offer scenarios, it will be the company wide policy of RE/MAX Hallmark Realtors to disclose the name and company of all Realtors (in writing),
who have registered an offer on the property to any participating co-operating broker when requested.
When requested, this information will be provided to any co-operating broker either in writing before Offers are being presented of after completing of transaction.
Founded in 1980, RE/MAX Hallmark Realty Ltd. is a leading brokerage firm in Toronto, with over 450 sales professionals working out of 6 offices and over 2.5 billion in real estate sales annually.
Ken McLachlan, Broker of Record – RE/MAX Hallmark Realty Ltd.
read more www.www.chaplin-estates.ca or www.yonge-eglinton.ca or
www.central-toronto-real-estate.com
Saturday, June 30, 2007
Have your heard! 100% increse in land Transfer Tax
Stop Toronto Land Transfer Tax: Your Help is Crucial
June 2007 -- Your help is needed! The City of Toronto wants to charge a second land transfer tax that would NOW double the current provincial land transfer tax. This could impact real estate markets, YOUR business, and YOUR CLIENTS. The proposal is moving forward quickly so it is critical that City Council hear from REALTORS® and their clients NOW. City Council will vote on this in mid-July.
Options to Help Fight Toronto Land Transfer Tax
1. Encourage your clients, friends, family and colleagues to email the Mayor and City Councillors with their opinions. It is VERY important that the Mayor and City Councillors hear from REALTORS® AND the general public. As a REALTOR®, you likely have many contacts that will be impacted by this tax who may appreciate being informed. CLICK HERE and an email that you can send to your contacts will be opened with a message that will include a link to make it easy for them to email the Mayor and City Council (You only have to add your contacts' email addresses). Alternatively, you can click here for a flyer that you can print to hand out or download to email.
2. TREB is asking you to once again send an email voicing your concern about this proposal to the Mayor and all City Councillors by CLICKING HERE (even if you previously sent an email)
• (An email with the Mayor’s and all City Councillors’ email addresses already added will be opened. You just have to add your opinions and send the email). Once you have sent your email to Toronto City Council, see below for information on other ways you can help.
3. Send an email to your MPP: Click here to go to OREA’s special web site that will look-up your MPP and supply you with an already drafted letter to email telling them to take action.
• OREA is assisting TREB’s efforts on this issue by asking all Ontario REALTORS® to send an email to their provincial politicians. The provincial government has the power to intervene on this issue and prevent the City of Toronto from imposing this tax.
4. Attend the Toronto City Council meeting in July:
City Council is scheduled to vote on this proposal at their meeting scheduled for July 16, 2007. Anyone from the public is allowed to attend this meeting to OBSERVE (As previously noted by TREB, public deputations were heard by the City's Executive Committee on June 25th, 2007). It is important that the public gallery be full with people concerned about this proposal because this helps to send a strong message to City Councillors and the media that the public does not want this tax. TREB encourages you to attend this meeting and to inform your clients about it.
Meeting Details:
Location: Toronto City Hall, 100 Queen Street West, Council Chamber
Date/Time: July 16, 2007, 9:30 a.m. - Please note that this is the start date of the City Council meeting, but these meetings often run for multiple days and it is not yet known at what point the land transfer tax item will be debated. TREB will provide more detailed information once it becomes available.
More Information
Under the City’s proposal, Toronto homebuyers would have to pay a second land transfer tax at rates identical to those currently charged by the Province, as follows:
0.5% up to $55,000
1.0% for value between $55,000 and $250,000
1.5% for value between $250,000 and $400,000
2.0% for value above $400,000
TREB has been fighting against this proposal. You can view TREB’s formal comments to the City here. You can also view, listen, and watch media coverage of TREB’s positions on this issue here.
06/26/07
June 2007 -- Your help is needed! The City of Toronto wants to charge a second land transfer tax that would NOW double the current provincial land transfer tax. This could impact real estate markets, YOUR business, and YOUR CLIENTS. The proposal is moving forward quickly so it is critical that City Council hear from REALTORS® and their clients NOW. City Council will vote on this in mid-July.
Options to Help Fight Toronto Land Transfer Tax
1. Encourage your clients, friends, family and colleagues to email the Mayor and City Councillors with their opinions. It is VERY important that the Mayor and City Councillors hear from REALTORS® AND the general public. As a REALTOR®, you likely have many contacts that will be impacted by this tax who may appreciate being informed. CLICK HERE and an email that you can send to your contacts will be opened with a message that will include a link to make it easy for them to email the Mayor and City Council (You only have to add your contacts' email addresses). Alternatively, you can click here for a flyer that you can print to hand out or download to email.
2. TREB is asking you to once again send an email voicing your concern about this proposal to the Mayor and all City Councillors by CLICKING HERE (even if you previously sent an email)
• (An email with the Mayor’s and all City Councillors’ email addresses already added will be opened. You just have to add your opinions and send the email). Once you have sent your email to Toronto City Council, see below for information on other ways you can help.
3. Send an email to your MPP: Click here to go to OREA’s special web site that will look-up your MPP and supply you with an already drafted letter to email telling them to take action.
• OREA is assisting TREB’s efforts on this issue by asking all Ontario REALTORS® to send an email to their provincial politicians. The provincial government has the power to intervene on this issue and prevent the City of Toronto from imposing this tax.
4. Attend the Toronto City Council meeting in July:
City Council is scheduled to vote on this proposal at their meeting scheduled for July 16, 2007. Anyone from the public is allowed to attend this meeting to OBSERVE (As previously noted by TREB, public deputations were heard by the City's Executive Committee on June 25th, 2007). It is important that the public gallery be full with people concerned about this proposal because this helps to send a strong message to City Councillors and the media that the public does not want this tax. TREB encourages you to attend this meeting and to inform your clients about it.
Meeting Details:
Location: Toronto City Hall, 100 Queen Street West, Council Chamber
Date/Time: July 16, 2007, 9:30 a.m. - Please note that this is the start date of the City Council meeting, but these meetings often run for multiple days and it is not yet known at what point the land transfer tax item will be debated. TREB will provide more detailed information once it becomes available.
More Information
Under the City’s proposal, Toronto homebuyers would have to pay a second land transfer tax at rates identical to those currently charged by the Province, as follows:
0.5% up to $55,000
1.0% for value between $55,000 and $250,000
1.5% for value between $250,000 and $400,000
2.0% for value above $400,000
TREB has been fighting against this proposal. You can view TREB’s formal comments to the City here. You can also view, listen, and watch media coverage of TREB’s positions on this issue here.
06/26/07
Friday, March 23, 2007
Yonge Eglinton Urban Plan
Have you seen the plan for Yonge Eglinton?
The Yonge-Eglinton Centre, along with a number of other areas, has been identified as a location where the City would like to encourage major investment and accommodate some of the anticipated growth.
The goal of the Yonge-Eglinton Centre review is to bring forward new Secondary Plan policies and Urban Design guidelines to direct future development in the Yonge-Eglinton Centre in a manner which is compatible with the existing surrounding Neighbourhoods.
Yonge-Eglinton Focused Review, Five Key Initiatives for the Yonge-Eglinton Centre • Compatible built form and exceptional urban design.
Here is the link to download the PDF, just copy and paste into your URL.
www.toronto.ca/planning/yonge_eglin/pdf/yongeeglinleaflet_crop_screen.pdf
I believe this will only add much more value to homes in the area. Of course that will come with a price. Traffic!
What are your thoughts.
The Yonge-Eglinton Centre, along with a number of other areas, has been identified as a location where the City would like to encourage major investment and accommodate some of the anticipated growth.
The goal of the Yonge-Eglinton Centre review is to bring forward new Secondary Plan policies and Urban Design guidelines to direct future development in the Yonge-Eglinton Centre in a manner which is compatible with the existing surrounding Neighbourhoods.
Yonge-Eglinton Focused Review, Five Key Initiatives for the Yonge-Eglinton Centre • Compatible built form and exceptional urban design.
Here is the link to download the PDF, just copy and paste into your URL.
www.toronto.ca/planning/yonge_eglin/pdf/yongeeglinleaflet_crop_screen.pdf
I believe this will only add much more value to homes in the area. Of course that will come with a price. Traffic!
What are your thoughts.
Are you thinking of selling or buying a income producing property?
What's it Worth? Calculate Your Capitalization Rate
by Frank Jones
How do you know what a commercial income property is worth? How do you know that you can get your desired return on your investment? Is there a way to calculate the maximum you can pay for an investment and still achieve your investment goals? This article will answer these questions and more about valuing income property.
Many real estate investors determine the value of an income property by using the capitalization rate, a.k.a the cap rate.
Example:
Say the property has an NOI "Net Operating Income" of $125,000, and the price is $1,500,000.
$125,000/ $1,500,000 = 8.33% cap rate “rounded”
This does not tell you what your return will be if you use financing. Also it doesn’t take into account the different finance terms available to different investors?
What the cap rate above represents is merely the projected return for one year as if the property were bought with all cash. Not many of us buy property for all cash, so we have to break the deal down, to find the cash on cash return on our actual investment using leverage.
Now calculate the debt service to finance the investment, subtract that from the NOI, and calculate the return.
In order to correctly find the cap rate and get equal comparison, you must know the correct income and expenses for the property, and that the calculations of each were done in the same way.
A wide range of cap rates for property types with different risk and management requirements, which may or may not apply to the property you are looking at, and certainly does not take into account your own return requirements compared to the Market Cap Rate . So what do you do when you've found a property that looks promising, and the Seller tells you the cap rate is 11.1% and you better act fast? How do you know if it is worth pursuing?
What's it worth to you?
The real question is not how much I (or another investor, or even an appraiser) value a property at. Nor is it the value from a cap rate estimated in the market. It's the value at which YOU can attain YOUR investment goals, that is reflective of YOUR borrowing power, and gives you an intelligent starting point for the analysis.
I promise you if you learn how to do this, it will give you a leg up on 90% of the investors out there. Critical to this calculation is that the NOI is figured consistently with industry norms. The generally accepted definition of NOI is:
Gross Income - Operating Expenses = NOI
Please note that the operating expenses do not include debt service or the interest component of debt service. Obviously, the income and expenses must be verified, or all calculations that flow from them will be flawed. Verifying the income is usually easier than the expenses. Rent roll analysis and a contract contingency for tenant estoppel letters at closing can settle the income stream conclusively.
Your Realtors normal due diligence includes verifying with third party suppliers as many of the expenses as possible. But take care evaluating the operating expenses to uncover any anomalies that exist under the present ownership.
Owners often take a management fee that may or may not be market based; maintenance expenses may or may not include labor charges; items such as "office expense," "professional fees," or "auto expense" may or may not be property specific.
In short, before accepting the NOI presented, understand what is behind the numbers. This is known as "normalizing" the numbers. You can also tweak the numbers to reflect the way you will own and manage the property.
No two investors will own and operate a property the same way. It is entirely possible for two investors to look at the same property and come up with two different NOI, and two widely divergent values, and both are right.
That's why appraisers use comparable sales, replacement value, and the income approach as part of a three-pronged method in estimating value. They make the appraisal representative of the market conditions and the typical requirements of investors and lenders active in the market.
The third method, the income approach, is usually given the most weight. That method is also known as the "band of investment" method of estimating the present value of future cash flows. It addresses the return required on both equity and debt, and leads to what can be called a derived capitalization rate.
Deriving your cap rate
After you are reasonably certain that the NOI is accurate, Find the derivative capitalization rate. It requires two more pieces of information: You have to know the terms of financing available to you and the return you want on your investment.
We then use these terms for both debt and equity to indicate the value at one precise point in time--the instance of when the operating numbers are calculated--to derive the cap rate that reflects those terms. (The value in future years is another discussion.) Deriving a cap rate works like a weighted average, using the known required terms of debt and equity capital.
The bank's return: the loan constant
We need to know the terms of the financing available. From that we can develop the loan constant, also called a mortgage constant. The loan's constant, when multiplied by the loan amount, gives the payment needed to fully repay the debt over the specified amortization period.
IT IS NOT AN INTEREST RATE, but a derivative of a specific interest rate AND amortization period. When developing a derivative cap rate, one must use the constant since it encompasses amortization and rate, rather than just the rate.
Using just the interest rate would indicate an interest only payment and distort the overall capitalization process. The formula for developing a constant is:
Annual Debt Service/Loan Principal Amount = Loan Constant
You can use ANY principal amount for the calculation, then calculate the debt service and complete the formula. The constant will be the same for any loan amount. For example, say your bank says they will generally make an acquisition loan at a two points over prime, with twenty-year amortization, with a maximum loan amount of 75% of the lower of cost or value.
Say prime is at its current 4.5%. That means the loan will have a 6.5% interest rate. Using a payment calculator or loan chart, find the payment for those terms. On a loan for $10,000, the annual debt service required is $894.72. Divide that by $10,000 to find the constant.
894.72/10,000 = .08947
Using the terms given then, the loan constant for that loan would be .08947 rounded to five digits.
The answer will be the same if you use $100,000 or any other number as the principal amount. (One hint: do not use a principal number with less than five digits, because the rounding will affect the outcome.)
You might note here that the mortgage constant is basically the lender's cap rate on his piece of the investment. Both the mortgage constant and "cash-on-cash" rates for equity are "cap" rates in their basic forms. A cap rate is any rate that capitalizes a single year's income into value (as opposed to a yield rate).
Your return: cash-on-cash return
The next step is to provide for the return on the equity. Start with the return you want on your money: Say the cash-on-cash return you are seeking is 20%.
If an investor puts in $30,000 and requires a 20% pre-tax return, then his annual cash in the pocket after paying the mortgage (but before income taxes) would have to be $6,000. In this case, the equity constant is .20.
Put it all together: Weighted average
Each of these cap rates is then weighted based on the loan-to-value ratio of each of the debt and equity positions to build the "overall cap rate." The formula looks like this:
(LTV debt ratio x mortgage constant) + (LTV equity ratio x equity constant)
= derived cap rate
To finish the example, using the mortgage terms given above, and the desired 20% cash on cash return, the following would be the overall cap rate with a 75% loan-to-value on the debt component:
(.75 x 0.08947) + (.25 x 0.20) = .1171
or
.0671 + .05 = .1171
To convert to a percentage, move the decimal two places, and therefore, under the stated conditions, the required cap rate for the property (income stream) is 11.71%. Using the normalized NOI figure, then the indicated value is calculated with this formula:
NOI/Cap Rate = Maximum Purchase Price to achieve your investment goal.
For the original deal above, the value would be calculated thusly to attain the desired return:
$125,000/11.71% = $1, 067,464
The asking price of $1,125,000 is very close to my target of $1,067,464. This is a deal that would definitely be worth taking a look at.
The other factors
Many factors can influence the value of an income property both positively and negatively. Some of the more important include maintenance; security of the income stream (strength of the tenants and length of the leases); comparable sales in the area; general economic and market conditions; and local market conditions; future area development and or restrictions.
All these factors and more speak to the relative risk and effort involved in the continuance of the income stream, and must be investigated during the due diligence by yourself and your Realtor.
Increase the required return and the cap rate changes, and so does the price. At this point you are writing your own paycheck.
In Closing
I hope you found this information useful and if you’re thinking of buying or selling an income producing property here in the Central Toronto area and would like a team of professionals representing your best interests, you’ll give me a call.
Feel free to ask me any questions you might have about buying or selling residential or commercial real estate.
Thanks for visiting my website.
Frank Jones
by Frank Jones
How do you know what a commercial income property is worth? How do you know that you can get your desired return on your investment? Is there a way to calculate the maximum you can pay for an investment and still achieve your investment goals? This article will answer these questions and more about valuing income property.
Many real estate investors determine the value of an income property by using the capitalization rate, a.k.a the cap rate.
Example:
Say the property has an NOI "Net Operating Income" of $125,000, and the price is $1,500,000.
$125,000/ $1,500,000 = 8.33% cap rate “rounded”
This does not tell you what your return will be if you use financing. Also it doesn’t take into account the different finance terms available to different investors?
What the cap rate above represents is merely the projected return for one year as if the property were bought with all cash. Not many of us buy property for all cash, so we have to break the deal down, to find the cash on cash return on our actual investment using leverage.
Now calculate the debt service to finance the investment, subtract that from the NOI, and calculate the return.
In order to correctly find the cap rate and get equal comparison, you must know the correct income and expenses for the property, and that the calculations of each were done in the same way.
A wide range of cap rates for property types with different risk and management requirements, which may or may not apply to the property you are looking at, and certainly does not take into account your own return requirements compared to the Market Cap Rate . So what do you do when you've found a property that looks promising, and the Seller tells you the cap rate is 11.1% and you better act fast? How do you know if it is worth pursuing?
What's it worth to you?
The real question is not how much I (or another investor, or even an appraiser) value a property at. Nor is it the value from a cap rate estimated in the market. It's the value at which YOU can attain YOUR investment goals, that is reflective of YOUR borrowing power, and gives you an intelligent starting point for the analysis.
I promise you if you learn how to do this, it will give you a leg up on 90% of the investors out there. Critical to this calculation is that the NOI is figured consistently with industry norms. The generally accepted definition of NOI is:
Gross Income - Operating Expenses = NOI
Please note that the operating expenses do not include debt service or the interest component of debt service. Obviously, the income and expenses must be verified, or all calculations that flow from them will be flawed. Verifying the income is usually easier than the expenses. Rent roll analysis and a contract contingency for tenant estoppel letters at closing can settle the income stream conclusively.
Your Realtors normal due diligence includes verifying with third party suppliers as many of the expenses as possible. But take care evaluating the operating expenses to uncover any anomalies that exist under the present ownership.
Owners often take a management fee that may or may not be market based; maintenance expenses may or may not include labor charges; items such as "office expense," "professional fees," or "auto expense" may or may not be property specific.
In short, before accepting the NOI presented, understand what is behind the numbers. This is known as "normalizing" the numbers. You can also tweak the numbers to reflect the way you will own and manage the property.
No two investors will own and operate a property the same way. It is entirely possible for two investors to look at the same property and come up with two different NOI, and two widely divergent values, and both are right.
That's why appraisers use comparable sales, replacement value, and the income approach as part of a three-pronged method in estimating value. They make the appraisal representative of the market conditions and the typical requirements of investors and lenders active in the market.
The third method, the income approach, is usually given the most weight. That method is also known as the "band of investment" method of estimating the present value of future cash flows. It addresses the return required on both equity and debt, and leads to what can be called a derived capitalization rate.
Deriving your cap rate
After you are reasonably certain that the NOI is accurate, Find the derivative capitalization rate. It requires two more pieces of information: You have to know the terms of financing available to you and the return you want on your investment.
We then use these terms for both debt and equity to indicate the value at one precise point in time--the instance of when the operating numbers are calculated--to derive the cap rate that reflects those terms. (The value in future years is another discussion.) Deriving a cap rate works like a weighted average, using the known required terms of debt and equity capital.
The bank's return: the loan constant
We need to know the terms of the financing available. From that we can develop the loan constant, also called a mortgage constant. The loan's constant, when multiplied by the loan amount, gives the payment needed to fully repay the debt over the specified amortization period.
IT IS NOT AN INTEREST RATE, but a derivative of a specific interest rate AND amortization period. When developing a derivative cap rate, one must use the constant since it encompasses amortization and rate, rather than just the rate.
Using just the interest rate would indicate an interest only payment and distort the overall capitalization process. The formula for developing a constant is:
Annual Debt Service/Loan Principal Amount = Loan Constant
You can use ANY principal amount for the calculation, then calculate the debt service and complete the formula. The constant will be the same for any loan amount. For example, say your bank says they will generally make an acquisition loan at a two points over prime, with twenty-year amortization, with a maximum loan amount of 75% of the lower of cost or value.
Say prime is at its current 4.5%. That means the loan will have a 6.5% interest rate. Using a payment calculator or loan chart, find the payment for those terms. On a loan for $10,000, the annual debt service required is $894.72. Divide that by $10,000 to find the constant.
894.72/10,000 = .08947
Using the terms given then, the loan constant for that loan would be .08947 rounded to five digits.
The answer will be the same if you use $100,000 or any other number as the principal amount. (One hint: do not use a principal number with less than five digits, because the rounding will affect the outcome.)
You might note here that the mortgage constant is basically the lender's cap rate on his piece of the investment. Both the mortgage constant and "cash-on-cash" rates for equity are "cap" rates in their basic forms. A cap rate is any rate that capitalizes a single year's income into value (as opposed to a yield rate).
Your return: cash-on-cash return
The next step is to provide for the return on the equity. Start with the return you want on your money: Say the cash-on-cash return you are seeking is 20%.
If an investor puts in $30,000 and requires a 20% pre-tax return, then his annual cash in the pocket after paying the mortgage (but before income taxes) would have to be $6,000. In this case, the equity constant is .20.
Put it all together: Weighted average
Each of these cap rates is then weighted based on the loan-to-value ratio of each of the debt and equity positions to build the "overall cap rate." The formula looks like this:
(LTV debt ratio x mortgage constant) + (LTV equity ratio x equity constant)
= derived cap rate
To finish the example, using the mortgage terms given above, and the desired 20% cash on cash return, the following would be the overall cap rate with a 75% loan-to-value on the debt component:
(.75 x 0.08947) + (.25 x 0.20) = .1171
or
.0671 + .05 = .1171
To convert to a percentage, move the decimal two places, and therefore, under the stated conditions, the required cap rate for the property (income stream) is 11.71%. Using the normalized NOI figure, then the indicated value is calculated with this formula:
NOI/Cap Rate = Maximum Purchase Price to achieve your investment goal.
For the original deal above, the value would be calculated thusly to attain the desired return:
$125,000/11.71% = $1, 067,464
The asking price of $1,125,000 is very close to my target of $1,067,464. This is a deal that would definitely be worth taking a look at.
The other factors
Many factors can influence the value of an income property both positively and negatively. Some of the more important include maintenance; security of the income stream (strength of the tenants and length of the leases); comparable sales in the area; general economic and market conditions; and local market conditions; future area development and or restrictions.
All these factors and more speak to the relative risk and effort involved in the continuance of the income stream, and must be investigated during the due diligence by yourself and your Realtor.
Increase the required return and the cap rate changes, and so does the price. At this point you are writing your own paycheck.
In Closing
I hope you found this information useful and if you’re thinking of buying or selling an income producing property here in the Central Toronto area and would like a team of professionals representing your best interests, you’ll give me a call.
Feel free to ask me any questions you might have about buying or selling residential or commercial real estate.
Thanks for visiting my website.
Frank Jones
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