14 May 2013

Assessing a suitable price for real estate income properties

Having once worked for several companies that were involved in real estate acquisition and management, it has always amazed me how many deals are arrived at without a proper financial assessment of cash flows and risks. Fortunately, there are some tools available to help make the analysis more rigorous and dispassionate.

The capitalization rate ("cap rate" for short) is very useful in that regard. In order to calculate it, you must first assess what the net operating income is for the property you are investigating, which is simply the operating profit before amortization and interest expense. You then determine what the NOI will be over the timeline you are assessing.

Assuming that a = NOI and i = cap rate, therefore the price of a property should be equal to

$ \large \sum\limits_{n=1}^\infty  \frac{a}{(1+i)^n}  $

which is the infinite series:

$ \large \frac{a}{(1+i)} \,+\, \frac{a}{(1+i)^2} \,+\, \frac{a}{(1+i)^3} \,+\, \frac{a}{(1+i)^4} \,+\, \cdots $

This is a geometric series with common ratio $ \frac{a}{(1+i)} $. The sum is the first term divided by (one minus the common ratio):

$ \large \frac{a/(1+i)}{1 - 1/(1+i)} \;=\; \frac{a}{i} $

You will then be in a position to compare the cap rate with the financing rates that is being proposed for the debt and equity components of the acquisition, in order to assess the viability of the deal.

What does this mean in practice? According to a recent article in The Globe and Mail, cap rates for Canadian commercial properties are currently in the range of 5.75% - 7.50%. Therefore, the purchase price for such a property should be its NOI divided by its cap rate. Conversely, the NOI of a property divided by its purchase price should equal the cap rate. Of course, if NOI varies by year, you will need to set this out in a spreadsheet to compute the present value of NOI over multiple periods, but that is relatively simple to produce these days.

If, on the other hand, the above calculations show that the cap rate for a property falls outside the acceptable range, it should lead to negotiations for a more appropriate price, or choosing to walk away from the deal.

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