Solving the “What’s the Cap Rate” Dilemma – Part 3 of 3

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Let’s have a little fun with mortgages.

Spreads between Market Mortgage Amounts and Existing Mortgage Balances

This type of analysis becomes really fun when the mortgage amount that you can get is much less than what the current mortgage balance really is.  If you redid the calculations above but with a $2 million mortgage balance, you’d have a higher debt service, so let’s say it was $20,000 more per year.  The before tax cash flow would be $30,000 ($200,000 NOI – $170,000 debt service) divided by an asking equity of $1.1 million, so now we drop down to 2.73 percent!

What does this say?  Simply, the higher the existing debt service, the lower the purchaser’s return.  That’s with the same net operating income, the same asking cap rate and the same asking sale price.  It’s called negative leverage.  There’s nothing up my sleeve here.

Here’s another worthy observation:  if the existing mortgage is $2 million and the buyer could only get $1.5 million, that’s an additional $500,000 equity that has to be made up somewhere.  So using a $30,000 before cash tax flow based on the higher existing $2 million mortgage and an 8 percent equity return requirement, that’s an equity value of $375,000.  So…. the buyer has to put up $500,000 to get $375,000 in equity!  Game Over!

Advice for Marina Buyers

Before you spend hours going through a marina’s books or on the telephone, get a copy of the mortgage.  Using the financials provided by the seller and the mortgage, do the math.  Then get a really good idea of how much of a mortgage you’ll be able to get and the terms.  Plug them in like I did above.  If it works, then close the deal.  If not, move on to the next one.

John's Signature

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