CAP Rate, Cash on Cash Returns, IRR – What would you use to accurately evaluate the return on your investment?

Having a set of principles, procedures and tools that assist in interpreting financial data is important in itself. More important though is the ability to truly understand and construct them. This is what turns them from numbers on a page into an accurate model of a potential investment.

Investors use different metrics to compare one real estate investment opportunity against another. What is the right metric to use? CAP rates are a very popular way to quickly analyze the return on an investment but this CAP rate only represents a moment in time, that is, it tells you what the return on the investment will be based on that year’s projected net operating income without taking into account the impacts of financing.

For example; say you are buying a 10 unit multi-family property for $1,200,000. The net operating income is $60,000 yielding a CAP rate of 5.00%.

$90,000 NOI / $1,200,000 Purchase Price = CAP RATE of 7.5%

The Cash on Cash Return gets you one step closer towards getting a truer picture of what the return of investment will be to you personally. That is, the Cash on Cash

Return looks at the annual before tax cash flow left over after deducting any debt service against the property and the total cash invested. So depending on your loan to value ratio and the interest rate, the Cash on Cash return will be different for each investor.

The formula for calculating the Cash on Cash return is:

Annual Before Tax Cash Flow

Total Cash Invested

The $30,000 Annual Before Tax Cash Flow / $300,000 Equity = 10% cash on cash return which looks even more favorable than the 7.5% return demonstrated by using the CAP rate to determine the real return on the investment

Using the Cash on Cash return does have its limitations because it doesn’t take into account the other 9 years of operating cash flows in the holding period. It also ignores the reversion cash flow at the end of year 10 that comes from the sale of the asset.

The most accurate way to determine the long term return of an asset is by looking at the Internal Rate of Return (IRR) which not only accounts for financing but uses discounted cash flows and the reversion cash flow at the end of year 10 that comes from the sale of the asset.  Most analysis models assume a ten year holding period and use a discounted cash flow rate. The IRR is as close as you can get to the real return on investment, this being said it is often the most useful in comparing to an expected or desired return and gauging attractiveness of different investment opportunities. A more thorough dialogue about the IRR metric will be coming in a future article.

Catherine Chapnick,

Broker Associate

Keegan & Coppin Co., Inc.

We are continually monitoring the Investment Climate and tracking the trends for commercial investment opportunities as they present themselves.

Californians are experiencing unprecedented returns on long held properties as cash remains cheap and cap rates making sense in the sub-five range for many investors. The appetite for 1031 Investments remains brisk and the robust demand for top retirement income generating returns is strong as baby-boomers opt for retirement and troll the Country for income as well as stability of principal.

I came across an article from the Business Insider (dated 8/4/15) and I thought it was really kind of interesting. It was a ranking of the top State economies from the absolute best to the worst.

In all fairness; there are a number of these tables, lists and surveys to explore. Forbes does a comprehensive list in the spring that I like to research to get their take on the investment climate.

What was interesting to me regarding the Business Insider was that North Dakota was ranked Number One as the Top State in the US Economy. Who Knew? The Oil Fracking Industry is going strong in that area, and the climate for investments in that area is worth noting.

Number Two on the list was Colorado. No surprise to me because I am bullish on that area; not only for the number of great businesses/companies headquartered there but also the robust amounts of revenue being generated by the Marijuana Industry .The Marijuana Industry is probing and thriving its way through antiquated mores and is developing from an underground business to a prolific business resource. It appears to be setting records in its ability to create a number of business opportunities from cosmetics to paper as well as adult recreational bars and places for entertainment.

Number Three was the District of Columbia, understandable as the seat of Government, but not a place I typically think of as a place to invest.

The rest of the top ten included (in this order) Texas, Washington State, Massachusetts, Utah, New Hampshire, New York, and Oregon.

Got you thinking?…I hope so. The World is rapidly changing, and opportunities abound for those willing to “step out of their box” and look to the future. Happy Investing!!!

Annette Cooper
Senior Real Estate Advisor

A Quick Guideline to the Art of the 1031 Exchange/2014

The New Year is a good time to re-visit the recent developments in the Capital Gains rates that were established in 2013. In essence; as predicted for years, the Federal Capital Gains Rate is “inching up” for high net worth investors from 15% to 20% and the State is adding another 3.8% from its current rate of 9.3%. These dubious factors (income levels, health care insurance costs, and mental health costs) that loom large in the background are positioned to accelerate capital gains ratios upwards to over 35%.  This is a big shift from the old standard “rule of thumb” that was approximately 25%, and there is more reason than ever to re-visit the 1031 Exchange Option that is alive and well.

The 1031 Exchange Option still requires an Investor to identify their potential replacement properties within 45 days of the Close of Escrow of their current property; and actually complete that purchase within 6 months of the Close of Escrow of that underlying property. So, you have approximately 4.5 months to actually purchase a replacement property after the 45 day identification period expires.

On the surface, these arbitrary time frames (as dictated by Congress) may appear to provide an investor adequate time to re-position real estate equity, but my experience tells me that these time frames are woefully inadequate.

The biggest looming pitfall to orchestrating a 1031 Exchange is that initial 45 Day Identification Period. These stringent, unyielding identification requirements require the investor to spend some introspective time evaluating what they want to buy before they decide to sell.

The most common error is waiting too long to begin/define a new property search. I have seen investors languish with a property search and wait until the 45^th day to identify 3 properties that just appear to be a reasonable investment.

This approach is just fraught with peril. Often, the Due Diligence Process has not even been initiated, and the property not vetted for acceptability.

How many times has an Investment Prospectus contained a significant error and/or a glaring omission that significantly changes the property’s desirability? It is such a common cliché, yet it still remains common for investors to identify a property in an Exchange that has not been significantly investigated.

In my humble opinion, the search for a new property really begins even before you market your existing Investment.

It is so important to acquaint yourself with the Investment arena you desire, research the market you want to explore, know the reasonable expectation for the new cap rate, safety of principle, any lending/loan requirements, tax implications from your accountant, and/or any prepayment penalties.

I have personally witnessed some of the following consequences of waiting too long to begin a replacement property search:

1. You nominate a property in your exchange that is no longer available.
2. The Due Diligence process reveals a Cancellation Clause in the primary lease “no one” knew about (I know this sounds ludicrous, but I have seen it happen).
3. You discover there is a significant environmental issue that was not initially disclosed.
4. The building has some latent defects that were not known when the Investment initially hit the market.
5. There is Mold Damage that was not discovered until deep into the inspection process.

I was once representing a client, and as we were finishing up the Due Diligence Process, we discovered that the nearly new 5 year old building never received an Occupancy Permit from the local Municipality. The building had had a tenant for over 5 years. Really!!!

I think I have made my point. I am not panning the Exchange Process. Quite the opposite. Capitalizing on long held equity through the Exchange Process is still one of the last remaining wealth building options in this country. It can protect your estate and your assets from the “Government Tax Shave”, and expedite building wealth through Real Estate Appreciation. You can take advantage of the depreciation available and interest deductions.

The key is understanding the process, allowing careful planning and preparation to save a lot of “heart-burn” and deliver the financial rewards you have worked for. It’s the “devil is in the details”, and that’s what you can avoid by planning ahead.

An Ounce of Prevention is Worth a Pound of Cure.

Annette Cooper
Senior Real Estate Advisor
Keegan Coppin/ONCOR International

The passage of the 2010 Patient Protection and Affordable Care Act (ACA) may result in some unique and interesting opportunities for the alert investor.

OVERVIEW

While the recession has been brutal to the commercial real estate industry forcing occupancy levels across most asset categories to painfully contract, the implementation of the ACA may afford savvy investors new opportunities to meet the needs of accelerated, “good old-fashioned” demand in health care sectors.

Expanded health insurance coverage will surely expand the need for medical office space, as well as the retail, manufacturing and industrial space for health-related businesses.

Remember that approximately 32 million of the 46 million uninsured Americans will receive insurance coverage under the new legislation in 2013.  Approximately 260 million people in the U.S. enjoy some kind of medical insurance coverage.

MEDICAL OFFICE BUILDING (MOB)

The need for new medical space for patient care appears not to be tied to any one asset type.

For instance, observe retail space morphing into medical use becoming a new part of the retail sector’s economic recovery.  The marriage of medical use and retail space is becoming an important and growing part of the U.S. primary care delivery system. This new strategy is providing increased visibility and easy accessibility to a potential patient.

“Owners of better-quality, performing medical office properties should enjoy stable returns over an extended period, as tenants tend to make significant investments in improvements and on-site equipment, discouraging relocations.”( Marcus and Millichap report)

Medical office building (MOB) investment opportunities should begin to outperform other real estate sectors as hospital and medical group executives move ahead with plans that have been on hold. Long-term stable leases, diversity of income sources (i.e. insurance companies, government reimbursements, and private sources) coupled with the matrix of expanding tenants (Assisted Living facilities, Pharmaceutical companies, Biotechnology companies, etc.) all contribute to these contemporary investment strategies evolving within the healthcare industry.

Consider the industry multiplier of 1.9 sq ft required per patient. This estimate should eventually increase the amount of requisite “patient space.” It can be estimated that 64 million additional square feet may be required to meet the increased demand.  The surge in demand for space is estimated to happen almost immediately.  Vacancy rates in retail and office make both sectors ideal candidates to absorb the increased medical demand.

TRENDS TO KNOW

16% of hospital executives indicate future projects for them are outpatient facilities in neighborhood settings. (ASHE2011 Construction Survey)

We will be watching this trend through in the upcoming year 2013.