How to Evaluate an Investment
An APOD is an Annual Property Operating Disclosure Statement.
It is a key tool for Las Cruces real estate investors.
It is the starting point for comparing investment options, and helps investors by providing a number of different investment indices. You can determine whether this investment meets your criteria, and it is a tool with which you can compare one investment against another.
The bottom line is that the APOD shows the property's annual income after vacancy and credit losses and expenses, debt service and property taxes.
The APOD form is used by the Commercial Investment Real Estate Institute because it provides almost everything an investor wants to know about a property.
The form on the left, has added to it rent a roll, and it shows the financial ratios that an investor needs. The end result is a wonderful document that shows you a variety of measurement ratios as well as the financial information supporting the numbers. I know that the image above is not easily readable or usable as a functioning tool.
Now that I have told you how wonderful an APOD is, and how to print out a copy that is readable, go through the form. To understand the APOD, let's start at the top. The top left corner describes the property, and breaks down the property into land, improvements (buildings), and personal property which you will ultimately need for tax / depreciation purposes. The top right corner shows the purchase price, costs of acquisition (costs involved in getting the loan like appraisal, survey etc.), any points and fees and the down payment. The sum of these is the amount of cash you have invested. This financing information has a significant impact on cash flow that the property generates, because the purchase price less the down payment is the loan principal balance. Based on the interest rate and term of the loan you will know the loan payment. The next line shows the first of the indexes that you and your bank will use to evaluate the investment - the Debt Coverage Ratio. The bottom line of the investment the annual NET OPERATING INCOME is divided by the ANNUAL DEBT SERVICE (total loan payments for the year). The Debt Coverage Ratio (DCR) best explained as follows: if you need to pay the bank $1 each month, the bank wants your net operating income to be $1.20 so they can feel comfortable that you can pay the loan each month. The higher the DCR the more secure your loan is and the more valuable your investment is. Note: Banks also look at the loan to value (LTV) ratio is the amount of the loan divided by the appraised value of the property. A 70% to 80% loan to value is a typical requirement.
If the seller has produced the APOD for you must be sure the numbers real. Can you get loan with 20% down payment, check how many points the seller is assuming, and the term of the loan? Many banks require up to 30% down, 1 or 2 points, and loan terms of 15 to 25 years depending on the property type and the borrower's credit. These differences change the entire value of the investment. Be sure.
Now jump to the bottom of the APOD, where we see CASH FLOW Before Taxes. In many cases investments will "cash flow" - have a positive cash flow before taxes, but the buyer must beware. Fewer investments in this market are truly showing positive cash flow and investment value is based on tax benefits and property value appreciation. Again, you must be sure all the numbers from the Gross Rental Income on Line 1. through all of the expense figures that the seller has listed are accurate. Be sure income is not inflated, and expenses under-estimated.
Once you have verified all of the assumptions you can calculate a whole group of indices that evaluate this investment. This allows you to do a number things: evaluate this investment, evaluate whether the numbers are similar to other investments of this type and not inflated, be sure that these same indices meet your investment criteria, and finally enable you to compare one investment against another. Remember an APOD can only be relied on for 1-year. Income, vacancy, expenses all can change drastically over time. You must repeat this exercise on a yearly basis for all of your investments.
What can we determine from this wonderful instrument - The APOD. The Gross Rent Multiplier (GRM - cost of the property divided by the annual gross rental income), the price per unit (total cost of property divided by the number of rental units) and the price per square foot (total cost of the investment divided by the total square feet of the property) -the best use of these indices is to compare their value against other similar investments. One must question the data if any of these vary significantly in either direction from similar investments.
The factors that investors use most to determine whether an investment meets their needs are the Cap Rate and the Cash- on- Cash Return. Cap Rate assumes a the investment was purchased for cash so the Annual Net Operating Income (before debt service) is divided by the Gross Purchase Price ( not including any loan or other acquisition costs). This is one of the most valuable investment measures. It is a measure of what the gross percentage return an investment provides. It lets you value one investment against any other investment irrespective of type (apartments versus single family residences, versus a strip mall).
The other major index is the Cash on Cash Return. Cash on Cash Return takes into account the financing costs and any leverage that provides for the investor. First, we determine the Actual Cash that it cost to obtain the investment (down payment and all acquisition costs). We then take the Annual Net Operating Income and deduct the Annual Loan Payments from the to obtain the Cash Flow Before Taxes. The Cash on Cash Return is obtained by Dividing the Actual Cash Invested by the Cash Flow After Debt Service, but Before Taxes. This percentage shows the rate of return, in year one, of the actual cash the investor spent to obtain the subject property as a percentage of the net cash flow that the investment produces. This can be a positive or negative number. Investors have different requirements about cash flow versus other benefits of a given investment.
Of course there are many ways to cheat on the APOD - vacancies can be understated, as can expenses. When evaluating an APOD, be sure to ask if the income reported is actual or potential. Also ask to see prior year information, since the APOD only shows a Snapshot for one year. But the APOD is a great foundation upon which further, more sophisticated, analysis is built on. |
