This week I received a phone call from one of my subscribers in Texas who had a twelve unit apartment building for sale. Unfortunately, the only offer he had received asked him to carry the note. My subscriber wanted to know the market price of this note after a reasonable time for seasoning.

The seller thought he had made a great deal since he sold his apartment to an investor at an 8% cap rate, when apartments in the area were valued in the 11% cap rate range. Moreover, the buyer had mid 700 credit and had a good job. The buyer would put 15% down, then the seller would carry a note for the remainder at 5.61% for fifteen years. Everything looked great. But the deal was an illusion. When we "crunched the numbers", which took me less than a minute; we discovered his note was worthless because it was just a matter of time before his buyer would have to default because the property could not support the payments.

Terminology Revisited: REMEMBER, THESE ARE ANNUAL FIGURES, NOT MONTHLY

NOI = Cap Rate times the Sales Price

Cap Rate = NOI divided by Sales Price

Sales Price = NOI divided by Cap Rate

For numbers simplicity, I am going to use $100,000 as the sales price. At an 8% cap rate, the Net Operating Income (Cap Rate times Sales Price) will be $8,000. Since the market value of the area is an 11% cap rate, this apartment complex should be valued at $72,727. (This is what I call the Cap Rate Trap) Therefore the seller considered a price of $100,000 was a bonanza. The buyer assumed that because he is getting in with a relative small down payment, the buyer thought he was also getting a bonanza. Both are wrong. Let's examine the numbers to uncover why the sale of these apartments as written was can of worms for both the seller and the buyer, and is actually a train wreck in disguise.

Let's first calculate the debt service. $100,000 sales price minus $15,000 down left a balance of $85,000 to be financed over 15 years at 5.61% with payments of $699.49. This translates the annual debt service to be $8,393.91. This is where the deal starts to fall apart. The reason it took me less than a minute to analyze the deal is because it did not take rocket science to realize when the NOI is $8,000 and the debt service is $8,393.91, neither buyer nor seller are going to like the future.

In my opinion, when analyzing whether to buy or sell an apartment complex, or to value an apartment note, the most important formula to consider is the Debt Service Coverage Ratio or DSCR. The DSCR is calculated by dividing the debt service by the NOI. A DSCR of 1.00 is exact break even.

It is insane to purchase income property close to the breakeven point, or worst, below break even. Banks want AT A MINIMUM a 1.25 DSCR.

What the banks are telling you is they want the apartment to be able to pay all its expenses PLUS debt service, and still have money left over to take care of contingencies when, NOT IF, these unexpected expenses occur.

No matter if you are buying or selling an apartment, you should also want your DSCR to be well above the breakeven in order to afford any unforeseen expenses.

What was the DSCR of this deal? The annual debt service was $8,393.91 divided by the NOI of $8,000 gives us a DSCR of .95, which is below the breakeven point. The property cannot support the debt service. This is what I call a foreclosure in embryo.

Because the property would not support the expenses and debt service, this note is worthless, unless you want to purchase what I call a "Pre Non Performing Note" at a deep discount with the goal of actually foreclosing on the property. But this is a topic for a different issue.

My subscriber was speechless. He was astonished that unlike an owner occupied single family residence, the buyer's credit had little value. The property's negative cash flow will override the borrower's excellent credit.

My subscriber also indicated that selling this apartment unit was his primary goal, not selling the note. He was very curious to find a way to salvage the deal. Since he did not want the property back because of management headaches, my subscriber was a very motivated seller. "Building Equity Fast with Good Terms" in THE NOTE PROFESSOR NOTEBOOK, provides the perfect concept to solve this problem.

One solution would be to raise the price to $105,000. With 15% down, the seller would carry a note for $90,000. Except rather than charging interest, the note would be carried at 0% interest. This would make the payments $500 monthly, or $6,000 annually. Dividing $6,000 into the $8,000 NOI results in a DSCR of 1.30. This ratio is well over the breakeven point, and will add a little more assurance the property will be able to support expenses and debt service. The buyer will benefit because every payment will be applied to equity.

Of course there are many other issues I would address, but from a number crunching and a "I want out" point of view, this concept is an immediate solution. What was ironic, is my subscriber took my apartment buying workshop, and "sort of" remembered discussing DSCR. He said he would look at his notes again, and stated he might need a refresher course.

Conclusion: Whether you are buying or selling apartments, or buying an apartment note, evaluating the DSCR is one of the first calculations you should perform. It makes no difference the price, cap rate or area if the property will not support debt service and expenses. Likewise, selling a note with a DSCR below 1.20 is going to be difficult, if not impossible. If you are able to sell the note, it will be at a deep discount.

If you want to know more about Do's and Don'ts of selling and buying commercial properties, I suggest you read the November 2008 of The Note Professor Newsletter

Note: If you would like to attend an apartment workshop for small investors in your area, please CONTACT ME . HAPPY THANKSGIVING!

CONTACT ME if you have questions or comments. And remember, if you know of someone who has a note to sell, I DO PAY REFERRALS.

Copyright © H&P Capital Investments LLC
All rights reserved
Tom Henderson
a.k.a. THE NOTE PROFESSOR

If you have not attended a Note Professor "How To Get Rich with Notes" class, be sure and purchase the Note Professor Note Book manual to enhance your knowledge of creative real estate financing and note buying and selling.

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You will learn at least one new usable concept to increase your profit in buying or selling notes and real estate.
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By popular demand, THE NOTE PROFESSOR NOTEBOOK is now available in easy, downloadable E- book form for a the low, affordable price of $39.95.

Other products are also available, including HOW TO MAKE OBSCENE PROFITS with SMALL MONEY, and GUIDE FOR SECOND LIENS. There is also a FREE download of CHECK LIST FOR OWNER FINANCING.

Simply go to the NOTE BUYERS STORE. I can think of nowhere that you can find such information packed products at such incredibly low prices. We are still working out the bugs, so if you have any problems, be sure to contact me.

The Thanksgiving Holiday season is on us again. I think it is appropriate to remember the REAL First Thanksgiving and be reminded again how socialistic economic systems fail, while free markets produce abundance. Below is a reprint from the November, 2009 Issue of The Note Professor Newsletter. Happy Turkey Day.

A valuable lesson in economic systems can be learned from the First Thanksgiving. For the most part, we are taught the Pilgrims landed in America in 1620, and had a harsh winter. However, with the help of the Indians teaching the colonists how to plant corn, in 1621 the colonist had a plentiful harvest, where they invited the Indians for a feast.

Not quite true. While there was a feast in 1621, the feast was to celebrate only a successful hunting party, not a plentiful harvest. In fact for the next couple of years, the colonists almost starved to death. How could this be in a land so rich in natural resources? A look at the economic systems employed by the colonists will give us the answer.

Governor William Bradford, the leader of the colonists, describes in detail in his book "Of Plymouth Plantation", that because of religious reasons, the Mayflower Compact set up a system of socialism as a way to organize production and distribution of goods. It just seemed like the "Godly" thing to do was to take all the production from hunting, fishing and planting and, place it in a pool, and then "share and share alike". The results were not pleasant. Instead of harmony, harsh words, anger, resentment were the results when workers could not enjoy the fruits of their labor.

From "Of Plymouth Plantation":

" --the young men--did repine that they should spend their time and strength to work for other men's wives and children without any recompense. The strong --had not more in division--than he that was weak and not able to do a quarter the other could; this was thought injustice. The aged and graver men to be ranked and equalized in labors and victuals, clothes, etc-- thought it some indignity and disrespect unto them. And the men's wives to be commanded to do service for other men, as dressing their meat, washing their clothes, etc., they deemed it a kind of slavery, neither could many husbands well brook it."

More importantly, because no one wanted to be forced to work for the benefit of others, the colonists almost starved. William Bradford, reported that the colonists went hungry for years, because they refused to work in the fields. They preferred instead to steal food. He says the colony was riddled with "corruption," and with "confusion and discontent." The crops were small because "much was stolen both by night and day, before it became scarce eatable."

Governor Bradford saw the system of "from each according to his ability, to each according to his needs" was not working. In the spring of 1623, Bradford changed the system. A plot of land was given to each family. However, what was produced on the land was the family's to keep. Any excess could be traded as the families saw fit. The same went for hunting and fishing. What were the results?

From "Of Plymouth Plantation"

"instead of famine now God gave them plenty,"--"and the face of things was changed, to the rejoicing of the hearts of many, for which they blessed God."

Some will say the abundance was just by chance. Governor Bradford had a different recollection as evidenced by his remarks, "any general want or famine hath not been amongst them since to this day." What is not mentioned is in 1624, so much food was produced that the colonists started exporting corn.

So when you are with your family giving thanks for your loved ones and enjoying the beginning of the holiday season, take time to remember also the reason we are celebrating this holiday instead of remembering a tragedy. The reason was a change from a socialistic economic system to a free market system. Another example of free

markets working, while socialism fails. HAPPY THANKSGIVING

If you have questions or comments, CONTACT ME Tom Henderson /a.k.a. THE NOTE PROFESSOR Remember: If you know of someone who has a note to sell, I DO PAY REFERRAL FEES.

Copyright © H&P Capital Investments LLC
All rights reserved

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