Many investors make the mistake of doing financial analysis as if they were already owning and operating the property; crunching the numbers with income, expenses, rent increases and debt. Yet an investment property should hold its own weight in the relationship and be a good deal without these levers being pulled. Debt and rent increases can put you in a risky position, so let's see how we break down an investment without the gimmicks.
The first good metric for this is the Unlevered Yield on Cost (UYOC) which is a ratio between your initial investment and the property's return. The formula is:
Unlevered Yield on Cost = Net Operating Income (NOI) / Total cost
Many investors will think of their initial investment in the property (down payment) as the total cost; however this eliminates a lot of required capital, especially if you're adding value. Totals costs could include:
Down payment
Closing costs such as appraisal, environmental and other due dilligence items
Architecture/Planning fees
City/county fees
Construction costs
Leasing/marketing fees
Any other outflows...
These total costs are what you really need in order to understand your initial equity position. This gets lost on some beginning investors when they acquire the property or are raising funds for an acquisition. Taking this into account and looking at the UYOC, does the return still fit within your investment parameters? Said another way, is the risk still worth the reward?
Note: These total costs are also helpful later on when you do Return on Equity (ROE) calculations. Many investors will simply give us their down payment number, which hides a lot of equity and can make holding a property look better than it is.
Another form of leverage is looking at trended rents. Trended rents means that you are anticipating increases either annually or as leases roll over and using those increases in your calculation. Many investors use IRR (Internal Rate of Return) metrics with trended rents and some disposition price based on a made up cap rate. We've talked about these hazards in previous posts. What happens if the market turns and you don't get those anticipated increases? Are you still cashflow positive and is it worth it? Try underwriting your acquisition using 'untrended' rents and see how the return is. Compare trended to untrended and see how much rental increase leverage is being used in promoting the deal.
The basic idea is to be realistic about expectations and actual returns. If you have to pull levers to make a good commercial real estate investment, then chances are you don't really have a good commercial real estate investment. Don't get fooled into believing a deal is better than it is.