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Fishing for Hot Investments in A Cool Market
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Capital reserve: $3,600 (4 percent)
Taxes: $6,000
Using these more realistic expense figures, the property's net operating income would be $48,500 -- a big difference from the $69,000 you would have taken in under the more optimistic scenario.
With these changes, the projected financial performance has deteriorated significantly. The cap rate has dropped to 4.85 percent from the 6.9 percent suggested by the seller's math. Now, this property does not look as promising, but your analysis is still not complete.
Assess Your Risks
Next you must evaluate your financing options. How much leverage will the property bear, and what are the available terms of that debt?
Let's assume you are planning to put down 20 percent and finance the rest, and that you would like to break even on a cash-flow basis -- meaning you want the property to bring in enough profit to cover your financing costs. Given that you expect the property to generate $48,500, your only option is to try to secure an interest-only loan charging about 6 percent (6 percent times $800,000 is $48,000). In this mortgage market, that means that you would most likely be limited to a short-term adjustable-rate mortgage, thereby exposing yourself to interest rate risk later when the interest rate adjusts.
More troubling is that you have no margin for error. If your expenses are higher than projected, or your rental income drops, you will start bleeding cash.
Now, here's the scary part. Let's say your projections are off and your property's net operating income is only $40,000. That means you're paying $8,000 a year after debt service. You want to sell. However, based on a 4.85 percent cap rate, you would get about only $825,000 (i.e. net operating income divided by cap rate). After paying your closing costs, you are unlikely to be able to repay the full amount of your debt.
That's right: A few faulty assumptions about a property's operating performance could result in not only losing your entire investment but also having to bring additional cash to the table just to get out of the deal. Ouch!
Consider what would happen if five years from now, the going cap rate for these kinds of investment properties reverts toward its historical average and is at 8 percent. In other words, investors insist on paying a price that would result in an 8 percent return, rather than the lower return investors appear willing to accept today. Assuming no change in your net operating income over the intervening period, the property value would have plummeted to $500,000. Big Ouch!
Other Sources of Value
As scary as the above scenario is, this property still could be a good investment, but only if you can identify other sources of value. If you can, you should make assumptions about their impact on your investment and build that information into your financial model.
Generally, these sources of value fall into four groups: improvements, additional revenue opportunities, local catalysts and systemic shifts in the marketplace.
