Determining How Much to Pay

There are many investors that hope to make their profits in real estate through appreciation, and effectively realize their profits when they sell the building since the building has gone up in value over the years.  While this strategy may have worked for some people, it is not the preferred strategy by most sophisticated investors. 

Sophisticated investors do not like to count their profits on appreciation, because doing so is pure speculation.  Property values can go up just as well as down.  Most sophisticated investors base their investment decision on the cash flow of the building, and make their profits on the buy rather than the sale. 

To determine the value of a commercial building, you should examine the income and expenses of the property.  For the purposes of illustration, let’s use a multi-family property example. 

What are all the sources of income?  Rents are your number one source of income.  However, there may be other sources of income such as vending machines, parking, storage, laundry, utilities charge backs etc.  Next, list all the expenses associated with the building.  There may be taxes, insurance, advertising, maintenance and repairs, operating reserves, property management expense, and building vacancy etc.  The only expense you should not include is your mortgage payments. 

Now, take all your income and subtract from it all of your expenses (except the mortgage payments).  The result number is called your Net Operating Income, or NOI for short.  Your NOI is the amount of money you have to pay for the mortgage payments.  If your NOI is $8,000 per month, that means your mortgage payments should not exceed $8,000 per month, or you will have to take money out of your personal bank account every month to cover the mortgage payments.  Suppose your NOI is $8,000 per month and you have managed to get a mortgage with a monthly payment of $6,000.  That means you will bring home $2,000 a month as passive income. 

What kind of mortgage would give you a monthly payment of $6,000?  Well, there are many mortgage options.  Assuming the bank is willing to give you a 30-year amortized mortgage at 8% interest, a monthly payment of $6,000 means that you are borrowing $817,700.96.  If the building is selling for $910,000, it means you need to come up with $92,299.04 cash in order to make the purchase (since the $910,000 purchase price is made up of the $817,700.96 loan from the bank + the $92,299.04 cash from you).  This means if you invest $92,299.04, you will get $2,000 a month as income, which is $24,000 a year.  That is a 26% cash on cash return on your money, since $24,000/$92,299.04 = 26%.  Is 26% a good return on investment?  Yes, it is!  There are not too many investments that can generate you a solid 26% return year after year.