What Do You Do When an Investment seems Tricky?
by Pat Delaney, CCIM
In a recent social media post, we posted this “WeekLee Challenge“:
A buyer wants to make an offer on an off-market deal. He needs a 5.5% cap rate. The gross annual income is $1,000,000. The expenses (excluding property tax) are $30,000 annually, and the property tax rate is 1.25%. What amount does the buyer offer to achieve this return?
In this post, we will break down the answer on a step-by-step basis. So before you read any further, we challenge you to please spend a few minutes solving the above and review the following terms: NOI & CAP rate. Go ahead…we’ll wait!
The Challenge, Accepted
The basic formula to solve this tricky investment is called the Income Capitalization Approach, which is:
(Net Operating Income (NOI))/(Capitalization Rate (CAP RATE) = Value
However, as we are evaluating this “off-market” deal from the buyer’s perspective, we are looking to find the “Purchase Price” (P). (Let P represent Purchase Price for the remaining of this blog.) This can be denoted as the following:
Purchase Price (P)= NOI/CAP
With the information provided, let’s begin to set up the equation by plugging in what we already know: the CAP rate:
P= NOI/.055
Likewise, since the NOI is not provided, the buyer would need to find the NOI, as well. To solve for NOI, use the following equation:
Gross Annual Income-Expenses (not including property tax)-Property Tax=NOI
So let’s plug in the buyer’s gross annual income and his expenses, less property tax, into the equation:
$1,000,00-$30,000- (Property Tax) = NOI
Which brings us to another problem: what do we know about this building’s Property Tax? Well, we know that this building’s property tax is 1.25% of P. Now given this new information, we can now fill in the rest of the equation and solve for NOI:
$1,000,000-$30,000-.0125 x P = NOI
When we subtract the known expenses ($30,000) from the gross income (1,000,000), we get:
NOI=$970,000-.0125P
We are now able to put it all together:
P= ($970,000-.0125P)/.055
From here on out, we can use old fashion algebra to solve for P.
Multiply both sides of the equation by .055:
.055P = $970, 000 – (.0125P)
To get P on one side, Add .0125 to both sides:
.0675P = $970,000
Now divide both sides by.0675 to isolate P:
P= $970,000/.0675
P = $14,370,370
Therefore, the buyer would offer $14,370,370, for this deal, to achieve a 5.5% cap rate.
Moving forward: A Shortcut
Use this shortcut to find the correct amount to offer:
Take your gross income, subtract all expenses (except for the Property Tax), and then divide by the CAP rate plus the Property Tax Rate.
Final Thoughts
Looking to make your next commercial real estate investment, or if you are interested in finding more about our services, we would love to talk to you! Connect with us today, hang out with us on Facebook, LinkedIn, Google+, Instagram, and Twitter.
About the Author:
Pat Delaney, CCIM is a principal with Lee & Associates Orange. Pat specializes in tenant representation and investment sales of warehouse buildings. Pat is also a member of the State Bar, even though he does not practice law. Instead, he uses this credential as a shield, rather than a sword.
