Calculating the Right Offer
Do you know what purchase price you should offer based on your required cash on cash return? I’m going to discuss some really cool calculations here and you can set up a spreadsheet and just plug in your numbers. So, let’s say we're looking at an apartment complex or some other income producing asset, and it's got a gross income of $350,000. Next, let’s say the operating expenses are $166,250. We know that the seller is asking $2.8 million for the asset and our rate of return requirement for cash-on-cash is 10%. Now, remember a cash-on-cash return is your cash flow after all the operating expenses of the property and your principal and interest, debt payments divided by the actual money you have in it. Now let's talk about our loan terms. Our loan equation and our loan outputs are part of this whole equation. Now you want to figure out what kind of loan you can actually get on this property. And for this example, we're using a 75% loan to value ratio at a 4.25 rate with a 25-year amortization. Now we need to figure out what the current net income is. Obviously, you’d subtract the operating expenses from your gross income and you’d get a net income of $183,750. To calculate a cap rate from that, take the net income and divide it by the seller's asking price. That puts us at a 6.56% cap rate. Now we need to figure out some loan information. We want to figure out what our loan constant is. To do that simply take your full annual debt service, which you get from the loan terms, and divide that by your actual loan amount, which remember is 75 % of the $2.8 million purchase price. That gives you a loan amount of $2.1 million and a loan constant of 0.06051. Next, we need to figure out what the current in place cash on cash return is, which remember is after all the expenses and debt services have been paid. So, the net income minus our annual debt service comes out to $47,232, which is our cash flow. We would divide that by the down payment, which was 25%, or $700,000, and that equals a 6.75% cash on cash return. Now we want 10% so we're a good bid apart. We can tell right now that a $2.8 million purchase price is not going to work. But here's a couple of calculations you may not know about. We need to figure out what our debt costs are and what our return on equity is. In order to do that we take the 75% loan to value ratio and multiply it by the loan constant and that gives us a 4.88 debt cost. Next, we take the 25% down payment divide that by the 10% required return and that leaves a 2.5% product. When you add those two together you get a required capitalization rate of 7.38%. Now you take the actual property's net income of $183,750 and divide that by our required cap rate of 7.38%, which is the number for us to earn 10% cash on cash, and you get a purchase price of $2,491,308. Watch the full video in the link below to see the numbers in real life.
- Created on .