the-abcs-of-real-estate-investing-ken LifeFeeling

This is a significant difference and would certainly have set up an unsuspecting buyer
for failure. I’ll say again, net operating income is a very important number, and in a few
minutes you’ll see why.
Step 4: Find the Capitalization Rate and Valuation
Capitalization rate? I know you’re thinking this is starting to sound complicated;
definitely third-year college accounting. Well before you close the book, allow me to
explain. First, it sounds way more complicated than it is. In numerical terms, the
capitalization rate is the net operating income divided by the purchase price.
Capitalization Rate = Net Operating Income à ÷ Purchase Price
So now you’re thinking, “Ken, how can I calculate the capitalization rate when I don’t
have a purchase price yet? That’s what I’m trying to figure out through this whole exercise
after all. Don’t tell me algebra is involved!”.No, algebra is not involved. This is actually
really easy. The purchase price here is actually the purchase price trends for a comparable
building in your market. So this very complicated sounding word is actually something you
can get very easily from brokers, real estate agents, or even the pro forma document for the
property. The people in the business your team members will either know the capitalization
rate for your market or help you calculate it, and that’s all there is to it.
To determine how much the property is actually worth in other words the property’s
valuation you just divide the net operating income by the capitalization rate. The number
you arrive at is the valuation. It was called purchase price in the previous formula. And the
valuation is your initial offer.
Property Value and Offer Price = NOI ÷ Capitalization Rate
So let’s continue with our real-world example. The capitalization rate used in the
Phoenix property pro forma was 8.74 percent, a Standard rate used by the broker. At this
stage, I’ll just use the capitalization rate provided. There’s no point going through a lot of
effort to do otherwise until much later, if at all. So we’ll divide our NOI by our
capitalization rate, and in doing so, we arrive at a property value and offer price of
$255,926.
$22,368 ÷ 0874 percent = $255,926
The offer should be no more than
$256,000.
We’ve arrived! We have an offer price! But there’s something missing. Oh, yes, you’re
probably wondering what the seller’s asking price was on this property. I won’t keep you in
suspense. The asking price was $338,000. Of course, you’re thinking that sounds really
high. Here’s an indication of just how high that price is. If you purchased the property with
a down payment of 10 percent this would have equated to a loan payment of $25,524 using
a 7.5 percent interest rate. Remember our projected net operating income? Let me refresh
your memory: it was $22,368. Can you see the problem with this? The income falls well
short of even covering your loan, let alone anything else. Had you bought this property at
the list price of $338,000 or even at $300,000 you would have been in a negative cash flow
situation immediately.
And just in case you’re thinking that I pulled our example pro forma from a small-time
brokerage company that was unsophisticated, guess again. It was quite the opposite. This
pro forma was prepared and distributed by one of the nation’s top brokers.