Re: Advice about deal/financing 2 - Posted by ray@lcorn

Posted by ray@lcorn on April 18, 2006 at 20:26:37:

InNJ,

(note: I reposted this to correct a number of typos in the previous post)

To determine your reasonable offer, you need to determine your minimum acceptable rate of return, the loan terms, and the NOI.

You’ve got the loan terms (which sound about average, and the fees are in line with the norms), you know how much cash you will put in the deal, and you have a starting point for the NOI (subject to verification).

So the only missing factor is your minimum acceptable return. That’s up to you, but I would point out that you can get 5% with a 10-year T-bond, with no risk and no effort. You can buy investment grade corporate bonds with 7%-8% yields, with very little risk and no effort. So think about that before accepting returns below that level for real estate that carries more risk and requires more effort than a bond.

Once you set your minimum return, use the derivative cap rate formula to give you the minimum cap rate to apply to the NOI.

(LTV debt ratio x mortgage constant) + (LTV equity ratio x equity constant) = Derived Cap Rate

*note: the equity constant = ROI

For example, if your minimum acceptable return on investment is say 15% and the loan terms are as you’ve quoted (6.5%, 25 yr)), then the minimum derived cap rate would be 9.83%.

The numbers would be:

(.75 x .08102) + (.25 x .15) = .0983 = 9.83%

Change the ROI to 10% and the minimum cap rate would be 8.58%.

Then you can calculate the maximum price that can be paid and meet that criteria. (NOI / Cap Rate = Price)

In this case, if you want the 15% ROI, the maximum price would be ~$580,000 (assuming no deferred maintenance). With a 10% ROI, the maximum price would be ~$664,000.

See http://www.real-estate-online.com/articles/art-216.html for a full explanation.

ray

p.s. the state of retail property types is still hot. From what you describe, the property is a local small-shop strip with 33% of the tenants on short-term leases with uncertain futures. In my opinion, that puts it in the upper ranges of the risk curve, and I would be looking for at least a 15% going-in return. However, because it’s a hot market that offer will likely not be accepted, especially if it is a new listing. As the price increases, the return decreases. So you have to decide (a) how much you want to make and, (b) how much risk and effort you will undertake to get it.