Peter Nikic - Pleasantville, NY

You are looking to buy an apartment building or other commercial property and as you look through the paper work, you see CAP Rate. But what does it mean and how is it calculated? You have at least heard of the term, but it was never clear to you as to what meant.

The CAP Rate is simply dividing the Net Income with the purchase price of the property.

If you were to purchase a multi-family property for $1,000,000 (assume that you are buying all cash) and that property has a rent roll of $100,000. From the $100,000 rent roll, there are expenses (such as taxes, water, fuel oil, repairs, etc) that need to be subtracted. Let's assume that those expenses are $40,000 per year.

This makes your Net Income $60,000 ($100,000 - $40,000 = $60,000). Simple enough to calculate.

Now for the CAP Rate, you divide the purchase price by the Net Income ($60,000 divided by $1,000,000 = 6%). This would be your CAP Rate for this property, 6%.

Once the purchase price is agreed upon, that is a fixed number and easy to use in this calculation. Where it gets a little tricky, is what expenses are included in order to obtain Net Income?

Realistically, ALL expenses associated with operating costs of this property should be included as expenses and subtracted from the Total (or Gross) Income.

Here is a list of expenses which I use to quickly evaluate a property and its CAP Rate (there could be others).

•Ø Vacancy - there will always be a certain vacancy factor which can vary geographically among other factors. A standard for this is 5%, though I just read a report in the Wall Street Journal that US vacancy rates are at 7.8%, a 23 year high.

•Ø Advertising - you will incur advertising fees in order to fill vacancies. I use $25 per unit as a measure.

•Ø Auto & Travel - how far is the property? How often will you go there? Meeting tenants, renting apartments, picking up supplies, etc. I use $50 per unit as a measure.

•Ø Payroll - does the property employ a super or handyman? This should be a known figure.

•Ø Legal Fees - evictions and or other legal fees, chances are they will be an expense at some point. I use ½ of 1% as a standard measure (of course it can vary).

•Ø Management Fees - will you hire a management company or manage the property yourself? Either way, that is a function of operating and should be considered an expense. This expense can vary, but many times it's 6%.

•Ø Repairs - I generally use 5% of my Gross Income as a basis for repair expenses (of course this can vary from year to year).

•Ø Supplies - you will always need supplies, cleaning products, garbage bags, salt, etc. I use 1% as a standard measure (of course it can vary).

•Ø Taxes - property taxes are fixed, but we all know that they seem to be ever increasing.

•Ø Electric - hallway and property lighting, powering boiler or other equipment. This should be a known somewhat fixed figure.

•Ø Water & Sewer - this should be a known fixed number but also has a general tendency to increase year after year. If the property has well & septic, there are expenses there as well. Water testing, purifying, softening as well as septic clean-outs.

•Ø Fuel Oil - this is very important if property has one central boiler where the landlord supplies the heat. Oil prices over the past few years have sky-rocketed. I used to be able to calculate this number by multiplying the number of units with $1,000, but this is no longer accurate (these days, it's more like $1,200 - $1,500 per unit).

Some of these expenses do no apply to every property, depending on its location and design. For me they apply 99% of the time. There may be other operating expenses to consider that may be specific to a region or a particular property. You would be wise to make sure nothing major is left out of the equation.

I had been fixed on buying apartment buildings at 8% CAP rate. Come to find out, there are brokers listing properties for sale at 8% - 11% CAP Rate. Needless to say, that got me all excited since it was at or above what I expected. But when I did my calculations, the CAP rates changed drastically. Many times they would drop down to 5% or 6%.

How did these proposed CAP Rates vary so much from my own estimations? This is the part where the buyer has to be clear on ALL operating expenses. If the seller leaves out the vacancy and management expenses, this alone would greatly change the CAP rate.

Recently I had negotiations with sellers/brokers who would swear that their property has high CAP Rates. They are either unclear as to how to calculate CAP Rates or they are intentionally leaving things out in hopes that the buyer will not pick up on it.

The area that is of most interest to me these days is the Bronx. As it turns out, an 8% CAP Rate is fairly equivalent to 6 times the rent roll. So in the case of our example above, where the property had an annual rent roll of $100,000, the purchase price should be in the ballpark of $600,000. I also find this interesting because in the past, apartment buildings in the Bronx were always priced on the basis of Gross Rent Multiplier (usually around 5 to 6 times the rent roll). Now I understand why buildings were priced this way, it was much simpler yet very consistent to the CAP Rate.

Can you buy apartment buildings at 6% CAP Rate or 8 times the rent? Yes, of course, but your return on your risk, work and investment would not make it a good investment. And unless you held on to that property for a very long time, it just might even be a bad investment.

Of course there are many variations and factors, but this is the basis of CAP rates.

If you own or are looking to buy apartment buildings in the Bronx area, please feel free to email me with any questions or comments.

Peter Nikic, Licensed Real Estate Broker (NY) (914) 804-0037

Broad & Bailey, Inc www.broadnbailey.com peter.nikic@broadnbailey.com

How many times have you been in situations where you saw a house that was priced much lower than the same house in another neighborhood or state? I feel that I run into these situations all the time.

So what is it that creates these fluctuations in price? How does the "Free Market" do this?

It's really a lot simpler than most people might imagine.

A house can only be sold for the price that a buyer is willing (or able) to pay. Why do I say able? I say this because most people will pay approximately 1/3^rd of their income on housing. So a buyer is willing to pay approximately 1/3^rd of their income because they are able to.

Yes, there are conservative people out there who buy modest homes in comparison to their income. Needless to say, that these people either have financial security because they're wealthy or because they're just conservative. They most likely will never face foreclosure on their homes.

And yes, there are people who buy homes that they cannot afford. They expect to make more money in the future which may not always happen. They may lose their jobs or sustain other unforeseen losses. These days, we're seeing a lot more of this type of buyer, hence the foreclosures.

If we analyze this middle section of people who pay approximately 1/3^rd of their income on housing, this is actually the Market and what creates the Market Value (or price) of homes.

Let's look at this backwards. If you earn $36,000 per year; you will be able to afford approximately $12,000 per year for housing. This just happens to break down nicely to $1,000 per month. Whether you are renting or buying, your monthly housing costs cannot exceed $1,000 per month. Makes sense so far?

Now with your $1,000 per month you begin your real estate search, knowing your budget, you eventually find a house or apartment.

Let's say that everyone in your town also makes $36,000 per year (or at least let's say this is the average household income). What do you think the average cost for housing is going to be in your town? If you guessed $1,000 per month, you're right. Of course there are always some variations, but it cannot be any higher because the average household cannot afford to pay any more. Also, it will not be any lower because the seller will always hold out for the highest price which in this case is $1,000 per month.

Still doesn't make sense?

In this example, the average household can only afford $1,000 per month for housing. To simplify this, we won't factor in utilities, taxes, etc, but focus on basic housing costs. If the average household can pay $1,000 per month, then the average sale/rent cannot exceed this. This means that the average sale (or rent) cannot exceed a price which will cause the monthly payment to exceed $1,000.

An average house in this neighborhood will most likely be around $200,000. How did I come up with this? If you buy a $200,000 house with 20% down payment, you will qualify for a $160,000 mortgage. At 6% interest, a $160,000 mortgage payment is just under $1,000 per month.

This is the basis of how this works:

If the average household income is $1,000 per month, then the average home will cost no more than $1,000 per month.

One of the factors that can greatly change the price of a home is the interest rate. If the interest rate was 10% (instead of 6%), then average home would only be about $140,000. At an interest rate of 10% the same person would only qualify for a mortgage of $110,000 plus 20% down payment, making the average home $140,000.

What if the average home in this neighborhood is listed at $250,000. What do you think would happen? Don't think too deep, that is exactly what is happening right now. That is why we have more inventory then buyers and until the prices start coming down, sales will be slow.

Basically, the average home is currently greater than the average income, the result is fewer sales.

(The chart was taken from: http://seekingalpha.com/article/123154-housing-where-is-the-bottom it clearly illustrates my point).

Remember, it's not the home that sets the price, but the income of the household. Interest rates, taxes, utilities, travel expenses, etc are factors that also play a major role.

A few years ago, home prices began to rise at unsustainable rates. What caused these prices to rise so sharply? Did you notice what a drastically difference in price of our $200,000 home when the interest rates went from 6% to 10% (down to $140,000)? Without getting into too many details, people were getting mortgages at 3% with a low down payment. This allowed them to buy that same $200,000 home for as much as $250,000. Before anyone realized what was happening, those $200,000 homes were selling for $250,000. If the 3% interest rate was fixed for 30 years, there would be no problem. But the problem become clear when the interest rates adjusted back to 6%, thereby devaluating those homes back to $200,000.

Do you know someone who bought that $200,000 house for $250,000? They probably took out a mortgage of $225,000. What happened? It seems that the value of the house is actually lower than the mortgage. Where are these houses today? Foreclosure?

A town with an average annual household income of $36,000 will have homes that average $200,000 where a town with an average annual income of $72,000 will have homes that average $400,000. Those homes could be identical in every way except price.

The difference? Average household income.

Catching up with a friend, we got into the conversation of real estate. Not a foreign subject to either of us since I am a licensed real estate broker, he is a contractor as well as both of us being multi-property owners. The conversation began when I asked him if he knew of a particular large scale property owner. I mentioned that I was trying to reach him in efforts to buy one of his buildings which he purchased 2 years ago and is now in financial trouble.

He proceeded to tell me a couple of stories regarding people that he knew that ended up losing large multi-family properties only because they were too stubborn to sell them at the right time and at a reasonable price. I chimed in with a couple of my own stories, and then we discussed how a mutual friend is currently in this same position. Though we both feel bad for our friend, there's little we could do to help him.

After a while, my friend asked me "Do you know how to catch a Monkey?"

I responded "How?"

He said put a banana in a bottle. When the monkey sticks his hand in the bottle to pull the banana out, his grip around the banana in a horizontal position, will not allow him to pull it out. Of course the monkey won't give up so easily, he will continue to try and pull the banana out until he is caught.

He added, "That's the problem with a lot of people and real estate these days. They don't know how to let go of the banana."

I thought this was such a great analogy, that I kept using it the rest of the evening. It seems that many of the property owners that each of us had dealings with did not know how to let go of the banana. Their properties fell into disrepair and eventually were lost to foreclosure. After each subsequent story, I would chime in "they didn't know how to let go of the banana."

Then I mentioned the large scale property owner again. I said that's why I need to get in touch with him. If he's a large scale property owner, he should know how to let go of the banana. He agreed that these types of owners usually know.

Do you know a property owner who's acting like a Monkey? Will someone please tell them to let go of the banana!

Many of my friends own apartment buildings in the Bronx. I also owned a building there several years ago. If you're unfamiliar with the area, you're probably saying to yourself "Now why would anyone want to buy a building in the Bronx!"

Well, if you're a real estate investor and live in the NYC area, then buildings in the Bronx technically qualify as real estate. Like anywhere else, the Bronx has a wide variety of real estate including warehouses, office buildings, retail centers, private homes, coops, condos and my favorite, apartment buildings.

This was the building that I once owned. It's a 5 story walk-up building with 19 apartments, 2 stores and as you can see from the photo, 2 billboards. Though a little too small, it was a great building to own. I do regret selling it, but at that time, my circumstances were such that I needed to sell it.

So, what do you think so far? Still think I'm crazy? In all honesty, owning and managing apartment buildings in the Bronx is not easy. I guess you have to be a little nutty to want to do this. Yet from another perspective, it could be very rewarding both personally and financially.

When you own an apartment building, you are housing many families, how could this not be personally rewarding? I don't make it a habit to be best friends with my tenants, but I always maintained good relations with them. For the time that I owned the building, I renovated some of the apartments, installed a new intercom system, installed a new boiler, and replaced the roof. Yes, I spent a lot of money, but I had 19 families that needed to stay warm in the winter. They needed the security of an intercom system. Their lives were more fulfilled with a cleaner more well kept building.

But this is a business, not a charity!

Yes, I spent a lot of money and time upgrading and managing the building, but I had 22 paying tenants. The money I spent came from them (at least from those who did pay their rent). These improvements made them happy to pay their rent, which in turn allowed me to make a profit.

The tenants were happy, the building was upgraded and kept clean and I was making a profit. How else can I view this, other than personally and financially rewarding?

Over the past few years, my circumstances changed, once again allowing me to own and manage apartment buildings in the Bronx. I've been looking for some time now, but so far unsuccessful. It seems that over the past few years, the Bronx was infiltrated by large scale investors and REITS. This caused the apartment building market to falsely inflate. Sort of like the rest of the real estate market across the country.

On the surface, it might seem like a good thing, but the problem with this is that many owners are having a hard time selling their buildings at realistic prices. They either sold some properties or knew someone who sold properties at much higher prices a couple of years ago. They can't seem to accept that those prices were unrealistic. For the buyers who bought at those prices, they either have deep pockets or will inevitably have financial problems. For those with deep pockets, they will be able to survive and make it up in the long run.

What is disturbing to me, is those who don't have deep pockets. Their financial problems will become personal problems for the many families that they are housing in their buildings. There is no need for this. The frenzy that lead them to overpaying, is causing problems for everyone including for those of us who are ready to buy.

Properly managing a building in the Bronx takes a lot of work, but overpaying makes it virtually impossible.

Here are a few suggestions on what to look for:

•Ø Get a clear understanding of the income and expenses.

•Ø Know the condition and location of the building

•Ø Plan to spend more time than you think it will take

•Ø Plan to make less money than you think you will make

Over the past 15+ years, I've owned and managed apartment buildings which allowed me to gain a lot of invaluable experience. In addition, I've created spread sheets which allow me to evaluate an apartment building in just a few minutes. I also learned to forecast property values, income, expenses and long term growth with excellent precision. My intention is to use this for my benefit as well as the benefits of dozens maybe hundreds or thousands of families.