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:
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:
We are now able to put it all together:
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 = $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.
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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.