First, recognizing the problem . . .
All professional appraisers and most income property brokers use a technique called cap rate to arrive at a price for income properties. The concept of cap rate is that the first yearís cash flow represents some pre-conceived percent of the "proper" purchase price. The cash flow is simply what is left over from the first year's rental income after paying the first year's operating expenses, but does NOT include loan payments. Its use completely ignores the enormous influence from a loan or its interest rate.
For example, if it is determined, based on similar sales, that an "appropriate" cap rate should be, say, 10% (called a 10 cap) for a property that has $1 million cash flow, then the price should be $10 million. In other words, that $1 million cash flow is supposed to represent 10% of the purchase price, in this case $10 million. It is a quick stab at a price using a simplistic rule-of-thumb based on statistical similarities of other cap rates, but devoid of any connection whatsoever with the enormous influence from the interest rate on the loan. It is quick, easy and extremely popular. Unfortunately, it lacks any ability to assure an acceptable financial performance, over time, from the price it determines. In fact, the math of Performance Indexing clearly shows over and over again that it would be sheer luck if a price determined by cap rate generated an IRR that even approached an acceptable one. It is truly flying blind!
A sad statistic discovered by Mr. Neinchel was that a majority of investors who bought apartment buildings at prices determined by "comparable cap rates" were forced to raise rents within the first six months in order to support a price they should not have paid in the first place!!
There are some very valuable lessons that the math of Performance Indexing teaches. The single most important, and surprising, lesson is that as little as a 10% overpriced purchase will almost always reduce the resulting IRR to an annual yield about equal to what the investor would earn if he simply left his money in the bank (and with a lot less risk!) Believe it or not, that is the equivalent of changing a 10 cap price to merely a 9.2 cap price! (The lower the cap rate, the higher the price). Most investors and brokers are not aware of the extremely high sensitivity of price to cap rate. It is truly like the tail wagging the dog. At 15% overpriced, the IRR will be either zero or slightly negative, which means that the investment will actually lose money, even if rents are raised substantially several years later! The Performance Indexing process is approximately one-sixth as sensitive as price is to cap rate!!
The math of IRR generates results that are not widely understood by most people in the income property industry, but eventually must be accepted. For example, it shows that cash flows generated early in the investment (by paying no more than the proper price) can offset losses (or lower cash flows) later, and still obtain an acceptable IRR. But the reverse is not true. Lower cash flows early (caused by paying too much for the property) can almost never be made up by higher cash flows (rents) later. It means that the process is extremely sensitive to both the timing and the amount of cash flows. Early cash flows compound longer and become far more influential in generating an acceptable IRR. It simply means that the surest way to profitable ownership is to actively avoid paying even slightly too much for the property.
The most distressing result that Mr. Neinchel observed over and over was that every single failed property was purchased at a price derived from a single digit cap rate (under 10%) . . . every single one of them (This was a time when interest rates were between 8% and 11%). And almost every one of the successful properties was purchased with a cap rate that was at least 1% to 2% higher than the interest rate. Many properties that were purchased at cap rates between 9% and 11% often "treaded water" for a long time, and neither made nor lost money . . . and they were in the vast majority of those that were considered failures. All properties have a cap rate just as all people have a brain. But all cap rates and all brains don't always generate success! The lesson should be clear that cap rate is a very unreliable indicator of success, unless it is equal to, or higher than the available interest rate.
The vast majority of the failures were purchased at prices that were too high, on typical terms of 25% cash down payment, with the balance financed by a new loan. From the interviews that Mr. Neinchel had with many of those investors, a disturbing pattern emerged of a lack of knowledge and misunderstanding. Virtually all those investors admitted that they experienced near zero, or even negative, cash flow for a year or two. But by the fifth or sixth year when they sold the property, they had raised the rents sufficiently to ". . . make pretty good cash flow."
Many eventually sold or exchanged their properties for a higher price than they had originally paid for them. But when they were confronted with the facts of the IRR math, indicating that while they owned it, they actually earned an average annual yield, at most, the same as if they had left their money in a simple bank Certificate of Deposit, virtually every single one of them refused to believe it . . . and nothing could change their minds!!
There are two exceptions to all this. The first exception involves income properties that are considered "trophy" properties . . . extremely desirable and unique buildings in extremely desirable locations, such as downtown Beverly Hills or downtown Palo Alto, or overlooking Newport Beach yacht harbor in California. In most cases the seller demands, and usually receives, a price so high that it will require 40% to 50% cash down merely to achieve zero cash flow the first year. The math of IRR clearly shows that the seemingly unfavorable terms for the purchase of trophy properties (large down payments on high prices) require that they be held for unusually long periods of time in order to generate a favorable IRR. The few trophy properties that Mr. Neinchel tracked proved their worth only after being owned for between 10 to 20 years. Unlike typical properties, the benefit was not their initial cash flows but their sure-fire growth in value fueled by the combination of much higher-than-average rent raises and the continuous demand by other wealthy trophy hunters. The remarkable results were IRRs that were often nearly double that from a typical property! Typical properties, including Class A properties, usually require early cash flows in order to generate acceptable IRRs and are typically held for much less than 10 years. That is usually achieved by simply not paying too much for them.
The second exception involves income properties, apartment buildings in particular, where a sudden shortage of supply accompanied by a high demand has forced rents to rise much more rapidly than the costs of operation. That was the situation in the Silicon Valley section of the San Francisco Bay area between early 1999 and the middle of the year 2001. Apartment rents had nearly doubled, but the operating expenses hardly increased.
But the second half of 2001 saw the rapid collapse of many "dot-com" companies and triggered the recession. That forced people to leave the area, raising the vacancy rate, and forced rents to decline rapidly by about 25%. In addition, the interest rates were lowered dramatically by the Federal Reserve in order to stimulate the sagging economy.
The math of Performance Indexing clearly shows that this rare combination of high rents, relatively low expenses, and low interest rates generates values that just happen to also exhibit cap rates in single digits that are near the interest rate!! This rapid rise in income over expenses explains why an apartment building whose fixed operating expenses had been about 45% of the income suddenly became appropriately 33% of the income. So a 7-cap with an interest rate between 6% and 7% may actually be appropriate for properties in these locations. It is safe to say that the rents will probably remain stable for quite some time during which the expenses will slowly catch up.
An interesting result occurs when income properties are owned too long. If rents can be raised faster than inflation increases the cost of operation, then the value of the property increases along with the owner's equity, provided that interest rates remain fairly stable. Typical properties enjoy a growing yield on a growing equity until it reaches a point between 5 and 10 years after purchase when the yield on the equity actually begins to decrease. That is because, mathematically, the equity begins to increase faster in dollars than the components that make up the yield. That makes a strong argument for "trading up" to a larger property when the initial equity has about doubled, which historically has taken about 5 years or slightly longer.
Although trophy properties also enjoy an increase of yield on equity, that yield starts much lower but lasts much longer, and accelerates in the later years before beginning to decrease.
Now, the remedy . . .
The most comforting fact revealed by the Performance Indexing math is that between 90% and 95% of the purchase price it computes is determined solely from the raw property data and the loan interest rate. The remaining 5% to 10% is merely a refinement to that price depending on where, within the narrow success range of yields (1.50 - 3.0 times the interest rate), the risk-assessed IRR is established.
It is important to understand that the process does not tell WHAT to pay -- it tells the MOST that should be paid to obtain that minimum acceptable, risk-assessed IRR. After all, yield for risk is what usually creates wealth! In effect, the process lets the property's own data determine its own maximum value and (thankfully) removes the seller's subjective "opinion of value" from the loop. It is the first time ever that the purchase price has been mathematically linked directly to the risk-assessed yield it must earn. And because of that, it is also the first time that the value of an income property is directly linked to interest rates, the way the whole economy is so linked.
The process implements the logic that no prudent investor should accept the lower yield of a lender while suffering the higher risks of being an owner. But if he is willing to accept the lower yield, then he should be a lender of his money, not an owner!
The process appears certain to eliminate the confusing dual definitions of value --- market value and investment value --- so foolishly coveted by the appraisal industry. Market Value includes statistical similarities and subjective (and often emotional) data. However, Investment Value is supposed to be based strictly on the numbers because it is the only one that directly accounts for paying all the bills! Yet, incredibly, the appraisal industry continues to employ statistical similarities and comparable cap rates to arrive at an investment value!!! They obviously don't have the math to do the job right, and yet Mr. Neinchel's extensive contacts with the leaders of the appraisal industry clearly reveal that they really don't care and consider their present process sufficient!!
Some economists at the Federal Reserve and the House and Senate Banking Committees have indicated that the Performance IndexingTM process appears to be so enormously effective, that it is only a matter of time before they prompt lenders to adopt it as a "supplementary standard" for determining value for the purposes of making safer federally insured loans on income properties. Some also suggest that the increased reliability from its use may allow lower loan loss reserves for lenders, and may finally induce the creation of a large secondary mortgage market in income property loans similar to the current successful ones for single family home loans.
An important hindsight of Mr. Neinchel:
"Maybe my hindsight is 20/20 about all this but it has always seemed logical to me that any investor should always earn more than the lender, simply because he is always at greater risk than the lender. So it wasnít too surprising that the data confirmed my thoughts. The only part I didnít know was just how much more should the investor earn over the lender. And the answer to that question is simply an amount between 1.5 and 3.0 times the lenderís interest rate, depending on the risks of owning the property. Now we all know."
"But even in the unlikely event that an investor feels that the gap for success is too narrow, the math in the software will permit him to do what has never been done before -- select his choice for IRR based on the risks he faces and then compute, with absolute mathematical certainty, the maximum purchase price that will generate that IRR. That capability alone will dramatically improve the reliability of investing in income properties."
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