Whether you are searching for your first building or are a seasoned investor the systems and procedures you should follow are the same. From finding a building for sale to viewing the building to arranging all the components of inspection/due diligence and finally financing. A solid set of procedures will make your effort seamless and more efficient with a high probability of a satisfactory outcome.
While learning the ins and outs of analyzing a building it is important to have an experienced person to reflect your calculations off, as this will save you valuable time, shorten your learning curve and prevent any pitfalls.
When you analyze enough buildings, you can quickly recognize the buildings running efficiently or inefficiently. But don’t shy away from inefficient buildings too soon as they may represent your best opportunity for creating net worth quickly.
Income property valuation is simple and one of the first lessons you must learn is never to trust the numbers being supplied. The numbers can be considered estimated, outdated or simply wrong. You must dig much deeper than the proforma statement that is being supplied and one of the easiest ways to start looking at these numbers is on a per-suite basis.
Understanding the industry-standard expenses that must be included to determine the net operating income (NOI) is crucial when seeking financing from financial institutions and the Canada Mortgage and Housing Corporation (CMHC).
These expenses typically include:
- Property Taxes: The annual taxes paid to local government authorities.
- Insurance: The cost of insuring the property against risks such as fire, theft, and liability.
- Utilities: Expenses for water, electricity, gas, and other utilities that are the responsibility of the property owner.
- Maintenance and Repairs: Costs associated with routine maintenance and unexpected repairs to keep the property in good condition.
- Property Management Fees: Fees paid to a property management company for handling day-to-day operations, if applicable.
- Marketing and Advertising: Expenses for marketing and advertising to attract tenants.
- Administrative Expenses: General administrative costs, such as office supplies and software needed to manage the property.
- Capital Expenditures: Funds set aside for major improvements or replacements of large items, such as roofs or HVAC systems.
Including these standard expenses ensures that the NOI calculation is accurate and meets the requirements of financial institutions and CMHC, providing a clear picture of the property’s financial performance.
When a building is under evaluation for its value, it is vitally important to thoroughly understand the condition of the building and any capital items that may require repair or replacement. This comprehensive assessment ensures that the valuation accurately reflects the true state and potential costs associated with the property.
First, the building’s systems and utilities must be evaluated. This encompasses the plumbing, electrical, heating, ventilation, and air conditioning (HVAC) systems. Any deficiencies or outdated components can lead to costly repairs or replacements, impacting the overall value. For instance, an outdated electrical system may not only be inefficient but also pose safety risks, while a failing HVAC system can result in uncomfortable living or working conditions and high energy costs.
The condition of the building’s exterior and interior finishes also plays a significant role in its evaluation. This includes the quality and state of windows, doors, flooring, and fixtures. Deterioration in these areas can detract from the building’s aesthetic appeal and functionality, thereby reducing its market value. Furthermore, it is essential to inspect for any signs of water damage, mold, or pest infestations, as these issues can lead to extensive repairs and health hazards.
Another critical aspect is the assessment of capital items that may require repair or replacement. Capital items include major components such as elevators, boilers, or large-scale mechanical systems. Evaluating the remaining useful life of these items helps in forecasting future capital expenditures and provides a more accurate picture of the building’s long-term maintenance costs.
Additionally, compliance with current building codes and regulations must be verified. Any non-compliance can lead to legal issues, fines, or mandatory upgrades, all of which can influence the building’s value. This includes ensuring accessibility features are up to code and that fire safety systems are adequate and functional.
In summary, a thorough understanding of the building’s condition and any necessary repairs or replacements of capital items is crucial when evaluating its value. This detailed assessment allows for an accurate valuation, considering both immediate repair costs and long-term maintenance expenses, ensuring that potential buyers or investors have a clear understanding of the property’s true worth.
Understanding Micro and Macro markets is essential as the value of a building can change dramatically based on its location and tenant profile. In some markets, this can change as quickly as a 5-minute drive.
Another area to explore is the suite mix and the percentage of units that are bachelor, one-bedroom, two-bedroom, and three-bedroom. A property that has more two bedrooms than one bedroom will have higher rent or higher revenue per door and have higher expenses due to more people living in each unit. Plus, in any given market one or two of the above units will be easier to rent as there may be more demand for them. Simply put, this is demographics and areas like Chatham Ontario will have more retirees than most neighborhoods in Hamilton.
Speaking with enough Sellers/Owners of buildings in any market and asking them which units are the quickest to rent is an easy and sure way of getting a handle on the suite mix that is most desirable for a building and its location.
Once you have and feel comfortable with all the numbers the formula is as simple as dividing the net operating income by the purchase price for determining a cap rate; however, when looking at the analyses you must take into consideration the price per door, cash on cash return, return on investment and debt service ratio. These are all components CMHC has set standards for and for financing through CMHC you must meet or exceed their benchmark.
The capitalization rate is determined by the market, not the Seller, Buyer, or real estate representative individually. It is a collective number based on what Sellers & Buyers determine to be reasonable value in any given transaction that changes hands on the closing date.
The obvious ones are gross revenue minus a vacancy & bad debt giving you the effective revenue, current taxes, gas, electricity, water & sewer, insurance, superintendent, management, and maintenance.
For the taxes and utilities, you must have the current and accurate numbers representing the past twelve months (not last year) when you apply for financing the lending institutions and CMHC wants to see a snapshot of these expenses for the past twelve months current up to the month of the agreement of purchase and sale date and beyond if there is a long closing period.
Your goal is twofold, one is making sure the numbers for utilities and other expenses are accurate and you understand the effect of increased cost over time. Second, is finding areas where an industry number may represent the building better for achieving your highest amount of loan-to-value financing. This is where the rubber meets the road and a solid understanding of how the financial institutions look at the income & expenses of any income-producing real estate is vital. Understanding how investment properties are analyzed is not only paramount but easy once you understand the foundation.