Location - The location of each investment property is of great importance although higher rates of return may tempt investors to go to less desirable locations, the volatility of occupants and surrounding communities may create management complications which outweigh the theoretical increases in potential net income.
Rates of Return - Capitalization of the income stream is a common means of comparing potential investments. In each example, a projected annual Net Operating Income is divided by the Purchase Price to calculate a capitalization rate, which is a measure of the return of and on one's initial investment.
Net Operating Income is defined as Potential Income minus a vacancy factor and projected Operating Expenses. NOI does not consider debt service (mortgage payments) because the performance of an asset, for comparison purposes, will be the same without regard to the presence or absence of debt.
Cash on cash is another tool for comparing potential investments. Cash on cash is calculated by finding the ratio between the net cash flow (before or after taxes) and the initial cash invested at acquisition.
Internal Rate of Return is another popular means of forecasting the performance of an asset. A series of cash flows is analyzed to measure the performance of each dollar invested over the course of a projected holding period. The initial cost is shown as a negative. With luck, the subsequent annual cash flows will be positive. In the year of projected disposition, a net sales proceeds figure is added to the final year’s cash flow. The periodic cash flows over the holding period are compounded, a forecast of annualized return can be made.
Gross Rent Multiplier has been a popular tool for comparison of multi-family housing investments. In this formula, the annual gross rent projection is divided into the purchase price to obtain a factor for comparison. The value of this tool is limited, since it fails to consider who bears the costs of utilities and operating expenses.
Rent Rolls - The value of a leased investment is a function of the quality of the leases and the reliability of the tenants. Length of leases, historical timeliness of payment, increases in rental rate, and responsibility for expenses are some of the factors to be considered when looking at a rent roll. There is an inverse relationship between the strength and reliability of any tenant, and the rate of return to be expected from a property. When acquiring a rental property with tenants in place, it is crucial to obtain Estoppel Certificates from all tenants. These certificates establish the status of the relationship between Landlord (Seller) and Tenant. Is the Lease in full effect? Have there been any side agreements, and so on.
Financing Commercial / Investment Property - The documentation required to obtain a commercial loan differs greatly from the requirements for a residential loan. Leases will be analyzed; an environmental inspection may be required; a more elaborate appraisal will be required. This process is more expensive than for a home loan. Although loans are advertised using loan-to-value ratios, the actual limits are imposed through calculation of a Debt Coverage Ratio. This is the ratio between the annual net operating income and the projected annual debt service. If the lender wants the net operating income to exceed the annual debt service by 20%, then Debt Coverage of 1.2 would be required. In these loans, a more typical amortization period is 25 years. A further complication is usually imposed by the fact that the lender will fix a date, usually 5, 7, or 10 years, when the entire unamortized balance becomes due, and refinancing or selling is necessary. This puts a premium on watching market cycles and timing one’s real estate moves to be ready for these requirements.
Drafting and Documentation - The process of representing a client in a commercial or investment transaction is very different from the process in buying or selling a home. The variables are divergent. Special training is required if an agent is to know what the issues are and how to deal with them.
Market Trends - The commercial/investment market moves differently from the housing market. At times the housing market may be soaring while the commercial market moves at a modest rate. At other times, such as in 2007, the housing market is considered a buyers’ market, while the chief problem for an investment broker is to find quality properties, in good locations, with decent returns for the buyers we all have.