ANCHORAGE COMMERCIAL REAL ESTATE INVESTMENTS
OPERATING COSTS AND METHODS OF ANALYSIS
From Ray Metcalfe
Jan. 18, 2004
Because most Real Estate Brokers present the information about the properties they represent in a variety of differing formats with varying degrees of accuracy. Consequently using the numbers they provide in the promotion of their listings usually leads to an apples to oranges” comparison.
The following formulas enable investors to more accurately compare “compare apples to apples.
In the examples we use to compare apartment buildings totaling four units or less, we assume that the owner is an owner-occupant, managing the property without a management fee.
Although before concluding any purchase, the actual expenses should be verified. Unless a building has a serious deficiency or an extraordinary energy quality, most buildings are very similar in operating costs.
Buildings that don’t meet or beat the following operating costs formulas are very likely deficient in some significant way.
Expenses: The average apartment building in Anchorage has one electric meter for the common areas, washers, dryers and building lights etceteras, and an additional meter for each unit. The average building also has a single gas meter supplying gas to a single gas fired boiler that heats the entire building. In the case of a four-plex, it will have five electric meters and one gas meter. Tenants usually pay their own electric and the landlord pays every thing else.
The average four-plex owner will pay very close to an annual average of $400 per month for sewer, water, gas, electric, garbage utilities, snow removal and yard maintenance.
For four-plexes, if the building has no electric meter for common areas, subtract $20 per month from the $400. If the building has separate furnaces and separate gas meters for each unit and does not have a common area to heat, and the tenant pays the gas, subtract an additional $175 per month from the $400 in expenses. Apartment buildings with electric heat are few and far between so I don’t address them here. Also, if you want to keep a four unit property in good shape, anticipate setting aside around $300 per month, to cover future maintenance, remodeling and replacement needs.
Income: The monthly rents figure supplied by the Seller or Broker is the one seller provided figure you can use. If the building has a common area, coin operated washer and dryer, add $15 per unit per month to the income if the washers and dryers are owned by the landlord or $7.50 per unit per month if they are supplied by a company who supplies them in exchange for half of the washer/dryers income. Don’t use the Sellers or Brokers figures for any thing but monthly rents.
When comparing larger buildings, it is wise to view them from the point of view that it is strictly an investment that you intend to turn over to professional management, with instructions to keep the building in good condition, while you do nothing but receive the benefits of ownership.
By using $275 per unit for five-plexes and up, you will usually be making a more accurate comparison than you will if you use the numbers supplied by the Seller or Broker. For true value comparisons, use this formula whether you intend to manage it or not.
The following formulas are calculations you can make to compare one building to another.
"Cap Rate", or rate of capitalization, is determined by dividing the “net operating income” for one year by the purchase price. The higher the cap rate, the better the deal. (Net operating income is the cash left over to pay principal and interest, or go in your pocket; after all other expenses have been paid)
"Gross Rent Multiplier", or (GRM), is determined by dividing the Purchase Price by the “Gross Annual Income” for one year. The lower the number, the better the deal.
"Cash on Cash", or Cash Flow Before Taxes is determined by calculating the income left over to put in your pocket, after all expenses of ownership are paid for one year, and dividing that amount by down payment and closing costs. This formula gives you the actual cash return on the actual cash paid out at closing. The higher the number, the better the deal. If you’re going to live there, add the value of the rent you don’t pay to the amount of income left over.
Another comparison you should make is cost per square foot of living area. To do so, simply divide the price by the square foot. Building square foot includes living area only, not garages. In making comparisons, compare buildings with garages to buildings with garages and buildings without garages to buildings without garages.
IRS 1031 Tax deferred exchanges (IRC 1031) can be done either forward or backwards. In other words, if you have the down payment, you can acquire a property before or after you sell your exchange property or properties, for so long as you close all transactions within 180 days of each other and comply with all the other rules.
When considering a tax deferred exchanges, figure out how you are doing on your own building. Do a cap rate calculation, using your estimated value of your building in place of a purchase price. Do a cash on cash calculation using your estimated equity in place of down payment and closing costs. Do a gross rent multiplier to see how your estimated value of your building compares to the buildings you are considering.
There is an enormous difference between purchasing a four-plex and five-plex. Any building with five or more units is considered commercial real estate and typically requires 20% down. Buildings with four units or less are considered residential real estate and, if you’re an owner occupant, can be purchased with the same comparatively small down payments typically required for single family home buyers. For owner occupants, the cash return on their small down payment is comparatively enormous. When non owner occupants buy four-plexes, they are considered investors and have to put 20% down just like they would if they were purchasing a building with five or more units. Because of the high return on the small down payment, owner occupants drive up the price of buildings four units and under. If you do the math, (The GRM) you will see that an average four-plex sells for around 7.8 times its annual rents while a typical building over five units, usually sells for closer to 6.6 times its annual rents. Consequently if you’re not going to owner occupy, your highest return on your 20% down is going to be found in buildings of five or more units.
Written by Ray Metcalfe, who has owned and operated Metcalfe Commercial Real Estate since 1977.