The second method that we can use to estimate the sale price for this property, is called the capitalization rate, or cap rate. It's extremely important as a real estate finance professional in construction management, or otherwise to know what a cap rate is, because it's very common. It's used all the time, okay? The general concept is, we want to consider the property from the buyer's perspective, the entity or the person who's going to buy this and manage it while the the grad students are living in it. Enjoy the cash flows from the graduate students living in it, paying their rent. So, that from their perspective, we ask, what's my annual operating return on equity, okay? And that's what cap rate is, okay? That's required to make this purchase viable for me. All right, so what do we mean, first of all, by operating return on equity? Okay, in general, in finance if you had a first course in finance, you probably learned that operating return on equity looks something like this. Our annual earnings before interest and tax minus our maintenance capital expenditures on the property. Maintenance capx means fix the leaks in the roof, re-point the bricks every now and then, replace windows, as they need replacing. That sort of thing. So, our earnings before interest and tax, minus our maintenance capital expenditures, divided by the market value of the equity of the entity, or the project, or the property at the beginning of the year. So this is annualized EBIT in our first year, divided by the market value of the equity at the beginning of the period. In real estate finance, we just morphed this a little bit into something very similar. So this is going to be our net operating Income from the property from APEX In its first year of operations. [COUGH] Divided by what we're going to pay for it, okay? And that's called the cap rate. And cap rates are always measured in percent, okay? We have dollars over dollars, so we measure this in percent, okay? So now, we have another term to define. What do we mean by net operating Income? So, net operating income is a very important term also in real estate finance, and it's defined to be our cash revenue during the year, minus the set of cash operating expenses plus maintenance capx, okay? All measured for one year. All right, so let's see how this is going to work. So to estimate our sale price, now that we've learned those terms you might want to go back getting review those terms that we just learned a couple of times before moving ahead. But I'm going to blast on forward. because, I know you can do that watching this recording. So to estimate our sale price using cap rate, first of all we're going to have to guess estimate our buyer minimum viable cap rate, okay? That's called a buyer's going in cap rate, okay? And it's equal to what they think their net operating income is going to be in the first year divided by their purchase price, okay? So, they're going to have an idea, buyers are going to be saying rather than, I don't want to pay more than $5 million for this property. Where they typically start, and this is why cap rates are so important, is they'll say, in this environment, in this area, I think I need a cap rate of 8% or 5% or something like that. So from point of view, we need to guessestimate with those perspective buyers are thinking. So we do that, and then we go ahead and estimate their annual operating revenues, expenses and maintenance capx for their first year. [COUGH] Okay, and that's going to allow us to compute estimated net operating income for the first year, okay? And then, our sale price estimate Is equal to the purchase price, of course, which is going to be pretty close, hopefully, to the NOI estimate. Our estimate. Cap Rate of buyer divided by the cap rate of the buyer. All right, so, where can we get a good feel for cap rates for buyers? Okay, as usual, Internet search. Also, local Rrealtors, they're very happy to share with you cap rates these days for multi-family rental properties. Near Lewiston, about 6%, 7%. That's what I'm seeing. Local realtors, great source of that type of information. Some lenders will know that. And of course, if you have a lot of experience in a certain area, you will know now about that area, and you'll have a good idea yourself. This, actually, I've gotta come back to Internet searches because there is an incredible amount of cap rate information on the Internet. If you look for cap rates of Class A office space in Manhattan, for example as a Google search, you'll probably find four or five pretty good sources for that. So, don't discount, again, the ability to get this information from an Internet search, okay? So bad news about cap rate, it's only considering one year's worth of operations, it doesn't include forward inflation or anything like that. So we will, a bit later, learn to maybe to better by considering more years. And to do that, we're going to need discounted cash flow methods. But for right now, let's just stick with cap rate. All right, so here we go. So we've gotta get the net operating income. CAG needs to estimate this All right, so here we go. They've got the monthly rent they think is going to be based on what rents are in Lewiston, what they think they're going to be when more engineering students come in. About 1,200, 1200 a month. So, if everything in the building was occupied all of the time, the fully occupied rent would be about 490,000. They're assuming, again, this is quick and dirty, that all the time throughout the year, there's a 5% vacancy rate. So we'll subtract 5%. They're also assuming that they're going to get fee income from that. A little bit of room in this building for washers and dryers, and things like that. So, they that's going to be 6%, so they add this. So, this is Laundry, rooms, etc. And I would just note here that I think this is way too high. Again, in your office working for your managing director or when you're consulting for someone, never ever be afraid to question numbers that you see. Okay, so the operating expenses in the first year. Gotta pay their property tax, very separate from income tax, completely different things. Property tax comes from local authorities, typically counties. And CAG has estimated that the property tax on this building will be a little less than 40,000. They need insurance. They're going to estimate that at about 5,000. going to have to pay utilities, about 10,000 a year. They're going to have a super who is part time. And most managers of cash flow producing properties, either on several, so they'll have a super that moves from building to building to building, and is part time in each one. Or, if they just own one building, they take on the super job themselves. But it's about $30,000 worth of work a year, okay? And then there is going to be maintenance on the building, which CAG estimates as every year 1/40th of the project cost per year. And, again, this is for thing is like repairing leaks in the roof, cracks in the sidewalk, repainting and cleaning the parking areas, etc, etc. And so, we get their total operating expenses for the year of about 179,000. And that's about 36.2% of this effective gross income number, okay? So now, they can compute their net operating income. The net operating income is simply, their x, sorry, effective gross income minus their operating expense, or about 315,000. All right, so we're getting close. So you have to do a lot of work here to get his cap rate based estimated price. So, what they've found Here is the cap rate of buyers Is something like what we see here, okay? They've talked to local realtors in the area. They've done an Internet search, which didn't work too well in Lewiston because it's such a rural area in Pennsylvania. And they look at their own experience doing this type of thing for Penn State and other schools nearby. And they think right now that cap rates for this type of property, from a buyer's perspective, that's 7.5%, okay? So, using this formula here, the purchase price is equal to NOI over cap rate. They find that if there is a really good set of circumstances, a market upturn, that they may get 4.5 million. They're expected, with a cap rate of 7.5%. They're going to get about 4.2 million. And in a market downturn scenario, 3.9 million. And let me just put what this is equal to here. The, okay. Okay, so that's where we got the 4.2 million number from. So that's good. So now we have the sale price. We still have the cost, how much it cost CAG to develop this project, from before. So we do the same exercise now that we did before with the comp spaced pricing, okay? So we're going to have our three scenarios, market upturn expected, market downturn. First of all, we get our gain, which is our sales price minus all of our expenditures for this project. The tax is 35%, again. Okay, we subtract that. And that gives us our post tax gain. And knowing our post tax gain, we can get our return, which is just our post tax gain divided by all our expenditures for the project. So, in a good condition, we've got about a 12% return over a year, about a 7% expected return, and about a 2 and change percent return if things are bad. So, this is kind of interesting. This is giving me more warm and fuzzy feelings. Because we found using two different pricing methods, that this project looks like it's going to make money for CAG, even under circumstances that are maybe not so great. Maybe not a lot of money, 2.3%, and we had a small number for comps under similar circumstances. But at least it looks like it's making money, even with no debt financing. And it'll look better with debt financing.
