When you are thinking about making a commercial real estate investment, you need to figure out how to make the right offer.
Okay… you have the “cap rate” and the asking price and you know what kind of annual return you want on your money but what offer do you need to make?
The problem with “cap rate” is it’s the rate that you would earn on your money if you bought the investment for cash. But, most of us are going to finance around 70% of the purchase price. So… if we wanted to earn 12% on our cash investment, how do we work out what our offer should be?
The way to work it out is to take into account the financing rate, the amortization term & ratio to value as well as the required “cash-on-cash” return required on the cash investment you’re making and it’s ratio to the purchase price.
Let’s look at an example:
A commercial investment is advertised for $1,250,000 with a NOI of $112,500. That equates to a “cap rate” of 9% – $112,500 / $1,250,000 => 9%.
But, you want a return of 12% so what should you pay? Easy enough, take the NOI / required return i.e. $112,500 / 12% => $937,500.00
So, if you had enough cash to pay for this deal in full we’d be done now.
BUT…. most investors don’t want to put down all cash. Most want to put down around 30% and finance the rest. And depending on your financial situation and the property in question, the financing you’ll be offered will have differing terms – some people or some properties (or a combination!) will qualify for 8%, some for 5% and some for 10%. Many factors are in play. So…. with the same 12% return required on your funds, what offer price should you make?!!
Don’t worry, there’s a very easy 4-step solution.
Firstly, let’s get some details on the financing:
– let’s assume we can get a 6.5% interest rate
– amortized over 20 years
1. Find the “Mortgage Constant”
To calculate a “mortgage constant” we divide the annual payment by the amount financed.
So, let’s say we are looking at $10,000 and, using the 6.5% interest rate & the 20-year amortization we calculate a monthly payment of $74.156. So, the annual payment would be $889.87.
So, the mortgage constant is:
=> annual payment / amount financed
=> $889.87 / $10,000
2. Identify the “Equity Constant”
This is the return you require on your investment funds.
So, in this case we want to earn at least 12% on our investment.
So, the “Equity Constant” is 0.12
3. Calculate a “Derived Cap Rate”
Now we need to work out a derived “cap rate” using our two constants and the ratio of each component in the whole investment:
=> (LTV x mortgage constant) + (ETV x equity constant) [LTV = Loan to Value; ETV = Equity to Value]
=> (70% x 0.08899) + (30% x 0.12) [The loan is for 70% and the cash deposit is 30%]
=> 0.06229 + 0.03600
This percentage, 9.83%, is now the “derived cap rate” that you can use to quickly calculate what your offer price needs to be to obtain the required return on the amount of money you’re investing! So, just one thing left to do….
4. Calculate Purchase Price!
To work out exactly what we should be paying, do the following:
=> NOI / derived cap rate
=> $112,500 / 9.83%
At that purchase price, based on what we’ve been given as to the NOI of the investment and your cost and amount of financing, your “cash-on-cash” return will be 12%.
– is fairly quick and easy to calculate if you’re in a rush
– is a good starting point for further investigation
– does NOT take into account a final sale price (see “IRR“)
– does NOT take into account subsequent changes in NOI (see “IRR“)
Thanks for your time!
Commercial Real Estate Investment Specialist
Cell: 832-483 8655