Analyzing Investment Properties

If you have had any exposure to the world of Real Estate, you will have heard of two very important indicators, the capitalization rate and the gross rent multiplier. In market reports, the two indicators are usually placed side by side. In this short article I will detail the importance and significance of both indicators.

A capitalization rate, also known as cap rate, is simply the net operating income divided by the investment you make on the property. It is a simple percentage that helps determine whether a purchase is a sound investment. In order to calculate the cap rate, you first have to add up all the separate incomes of a building, i.e. rent, retail income, tax reimbursements, etc. You also have to calculate the total expenses. Usually, when making a purchase, that information will be available through the listing agent. Expenses are incurred through taxes, operating expenses and miscellaneous fees such as a superintendant or a management fee.

A big difference between financing a property and buying it all-cash is when you finance a property, the mortgage payments go into calculating the monthly investments. Oddly enough, sometimes it makes more sense to take out a mortgage on a property. Assuming you get a good rate and do not have to pay a large down payment, it might be financially beneficial to take out a mortgage. Once you have the total monthly or yearly income and the total monthly or yearly expenses, simply subtract the expenses from the income and you will have the net operating income. When you divide the net yearly operating income by the money you put down on the property, you will get a percentage. That percentage is an indicator of how sound an investment is. If the percent is negative, you are losing money. If it is positive, you have to make sure that it is above a certain threshold.

Usually cap rates of 5% and higher are considered “good”.

A gross rent multiplier is a number that one can only use if they have market data from the surrounding neighborhood. Put simply, one can figure out a gross rent multiplier by dividing the sales price of a property by the monthly income. Once one has a number of such multipliers, one can average them to find an average rent multiplier. Using this number, it is easy to figure out whether a property is a viable investment. If, let’s say, the average GRM for an area is 12 and you are considering purchasing a property with a monthly income of $12,000. Multiplying the GRM by the monthly income yields $144,000. However, the property is being sold for $200,000. This shows a huge discrepancy between the estimated market value and the actual market value. If the actual market value is higher than the estimated market value, the property is not a sound investment. If the actual market value is lower than the estimated value, then it makes sense to invest into the property.

Using these two indicators will allow an investor to judge whether a certain property is worth purchasing. While both of them are powerful tools separately, used together they give a very good feel for the viability of an investment.

Lack of Rental Vacancies
If you have tried to rent at any point in the past year, you already know how difficult it is to find a vacant apartment. In the rare case an apartment does go on the market, it is ferociously attacked and is typically gone in a matter of days. This may seem odd, especially in the summer when there is usually a large influx of renters. In fact, if you follow rental trends for the past few years, the spring & summer is when most of the rental business heats up. However, this summer an odd number of wistful tenants are left empty handed. In fact, most tenants are choosing not to leave at the date of expiration of their lease – choosing instead to renew it, even if it means accepting a higher rent.

While this may not make sense at first, after some consideration there is concrete logical reasoning behind this odd new phenomenon. While the rental rates for this year remain low, mainly because of the lack of vacancies, rental rates for last year are extremely healthy. This is due to the fact that people who wanted to upgrade their apartment did so last year, when rental rates were low and there was a lot of diversity in the market.

Many New Yorkers simply wanted an upgrade when the rates were still low. After this wave of upgrades, people simply stopped moving out. They were content with their new homes and saw no reason to move when rental rates dropped a bit. As a result, there are a lot of content New Yorkers and very few vacancies.

There are, of course, numerous new developments springing up across the city, but for the most part they are all luxury buildings with $4,000+/mo rental rates. However, even if you can afford one does not mean you will get an apartment in one of these new developments. A savvy buyer will seize the opportunity to get an apartment as soon as one is available. Having a fastidious and competent broker who will not miss a potential rental opportunity is of course highly beneficial.

Temporary Walls

Temporary walls have been around for, well… as long as expensive Manhattan apartments have been. Naturally, people want to change the way their apartment looks and functions to fit their own needs. One can attain this by putting up temporary walls – of the pressurized or non-pressurized varieties. Nowhere is this practiced as much as it is in New York City. Countless tenants of rental buildings all across the city have put up walls, converting their 1 bedroom into 2 bedrooms or 2 into 3 and so on. In NYC, if it’s possible to divide a space and provide privacy and a separate bedroom then tenants or landlords alike have considered the alternatives.

Unfortunately, for those tenants who have opted for this solution, the days of the temporary wall are apparently coming to an end. More and more landlords are beginning to crack down on temporary walls, asking people to tear down the structures in the apartment. Some housing complexes are only asking tenants to take down temporary walls constructed without accordance to the New York City Building Code, while others are asking them to remove all temporary walls.
In fact, the term “temporary/pressurized wall” has become something of a misnomer. The walls constructed by tenants often become permanent fixtures of the apartment. Some Stuy Town apartments were even marketed in their altered states.

As we know the only thing in life that is common is change and now is the time for this change. In response to multiple lawsuits involving fires, landlords in every area of the city are making home inspections to determine if any temporary walls have been put up. This is causing a rather uncomfortable situation for some tenants. Imagine this: you moved into an apartment marketed as a 2bed/1bath. You live happily in your three room apartment, paying $3,450 a month. Two years later, some gruff men from the local construction company drop by with a legal-looking paper from your landlord. Before you have a change to open your mouth, your 2bed/1bath has become a 1bed/1bath with an L-shaped living room. Now, unless you really wanted that L-shaped living room, you aren’t going to be too happy.

Considering my automotive past, let’s use an auto analogy. Say you buy yourself a lightly used 335xi BMW. You drive around for years, happy with your 3.5 litre engine. Then, one day a guy from BMW comes by and informs you that the vehicle was branded as a 335xi but is actually a 323i. Yes, you have been driving a rear-wheel-drive 2.3 litre car. Not only that, but the man also says that he has to rebrand it immediately or he is going to get a fine from the New York State Building Agency.

Tenants who have moved into mis-marketed, already altered apartments aren’t the only ones at a loss.

Let’s return to our automotive analogy. You buy a 3-series BMW with a 2.3 litre engine. However, a few months after you buy it you get a really nice bonus. You decide to splurge on a new 3.5 litre engine and put it in the car. Before installing the engine you talk it over with the owner of the BMW dealership and everything gets approved. You pay for the engine and for installation and voila, you have a 335xi. Happily, you drive around in your souped-up car. Then the same guy that approved it all comes by and tells you that you must put the original engine in. Again, not too happy?

For decades, landlords have disregarded the regulations pertaining to temporary walls. Now, those landlords are beginning to feel the pressure from the city and are taking those walls down.