“Price Check on Property 6 Please” …. Taking 10 to 20 minutes to complete an easy pricing validation test can save an investor hours of time and effort.
I’m continuously surprised at how many buyers of commercial properties, even those considered experienced investors, get so deep into the purchase of a new property without having taken the 20 minutes needed to see if the price being asked fits the building.
For anyone looking to acquire a commercial property, the rule is the property must pay for itself. This is true whether it is a multifamily rental, a mixed-use property, a light industrial building or even a land purchase they will later develop. This means that the revenues and net operating income, or NOI, must be sufficient to cover the financing payments by a factor of 1.2 to 1.4 times. I’m referring here to the debt servicing calculation.
For someone in the early stages of looking at a property, it’s a pretty straightforward exercise to reverse the debt servicing calculation to determine what an expected price for the property should be.
Once calculated, if that price check is materially lower than the seller’s asking price, the potential buyer has to ask themselves if this is really the strong investment they’re looking for.
Let me give you a quick example of how this works.
Start with a simple calculation of the net operating income from the property. If its an existing building, use the existing revenues, not what they can be built into later on. The extra comes from your work and shouldn’t be paid to the current owner.
The only time you should use projected revenues and net operating results is for land or construction projects.
If you don’t have the actual operating expenses, use a factor of 20% to 40% of the gross rental revenues, depending on the type of building. Ultimately you need to obtain those true costs, but for this early exercise, the 20% to 40% estimate can give you the indicator you need.
Now divide the NOI results by the 1.2 to 1.4 debt servicing factor to arrive at the mortgage payment amount.
Then do a present value calculation using that calculated mortgage payment amount to determine what a lender will advance against your project. When making this calculation, use a reasonable LTV factor of 65% to 75% depending on the building.
Once you know the potential mortgage you can expect to secure for the building subtract that from the proposed asking price to see how much equity or sub-debt is needed.
Is that amount reasonable and is it an amount you are prepared to come up with for this property?
If it is, the price check tells you this acquisition project is likely worth the time and effort you need to go through to win the deal.
If it’s not perhaps your time is better spent looking for another investment property.
Acquiring a new property takes time and money. You can save yourself aggravation and avoid larger out of pocket expenses by undertaking certain simple, less costly due diligence steps up front.
Don’t be hesitant to put up a small amount for fees to cover early-stage tests like this one, if it means identifying do-able deals with real long term profits sooner.
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