A common question…
How did you or the seller come up with the price?
Take a look at a sample calculation below based on a price of $1,500,000, with 20% down at 7.5% interest, amortized over 25 years.
There are three key metrics we look at when backing into a price that is financeable: 1) the Debt Service Coverage Ratio (or DCR below); 2) the Cap Rate, and 3) Gross Revenue Multiplier (GRM).
Let’s look at 2021 – this shows a debt coverage ratio of 1.39. This means that the NOI covers the debt 100% plus leaves 33% as cash flow. So that exceeds the bank’s average minimum of about 1.2 to 1.25. Therefore, this is considered financeable. Each year after that shows a higher DCR, so increasingly better. When we look at the cap rate for 2021, that falls inline with (or exceeds) the 7-9% we often see of small independently owned and operated inns. The cap rate is a reflection of controlling expenses where possible (without it resulting in deferred maintenance, of course). The higher the cap rate, the better return for a buyer. The lower the cap rate, the higher the expenses, therefore lower NOI and a lower or slower return on investment. But as long as now the DCR and the cap rate fall in line with what we see for comp sales in the industry, then the price can be supported by the numbers. Then if we look at the GRM, if that falls in line with the 4.5-5.5 times gross sales we often see, then that’s the third measurement of value that supports this price. If all three fall within what sales show, and the seller is fine with that list price, that’s what we take to market. I could go more into cap rates, but that is for another post on its own!
You can see that NOI is key to understand if the purchase can be financed and then you will understand what your potential return or compensation will be based on the year’s performance.
Does this mean that a property won’t be listed at a higher price, requiring the buyer to put more money down than 20%? Not at all! There could be a variety of reasons why a property is priced higher than the metrics can support without additional money down. Is the property fully renovated, the seller did all the heavy lifting of infrastructure updates and all a buyer has to do is walk in, operate, enhance the marketing, etc? Is it a trophy property? Is it a unique property with a very unique USP (unique selling proposition)? Is it a one of a kind, visually or architecturally speaking? These are things to consider when trying to determine if paying a premium for an inn makes sense.
Another common question…
Why don’t I see a seller’s mortgage in the P&L?
This is a very common question prospective buyers ask, hence the explanation here. The answer is simple. Are you (buyer) going to pay their mortgage? No! So you want to see the operating expenses. The gross income less operating expenses before any debt service (mortgage) or owner compensation equals NOI (net operating income). And from the NOI you pay YOUR debt service and YOUR owner compensation. Buyers often ask why they don’t see a seller salary on the P&Ls. Well, for the same reason, we remove that because YOU the buyer won’t have to pay the seller salary. So the NOI is the key number when looking at whether a property will cash flow once you subtract your debt service. Then you can pay yourselves from what remains.