Derivative contracts, in particular credit-linked notes on corporate bond indices, have a variety of uses: to gain synthetic exposure, as an arbitrage tool, to effect overlay strategies and to invest cash balances efficiently. The growing popularity of JECI and Trac-X as well as the exchange traded funds on the iBoxx Euro Liquid Corporate Index and the Goldman Sachs USD InvesTop Corporate Bond Index demonstrate the rising sophistication of market participants in the credit markets. They have realized that using a benchmark index that also has a liquid derivative contract can be of great benefit to investors.
The index market is becoming increasingly competitive and commercial. With little differentiation in construction methodology, competition between index providers is focusing on brand. Nevertheless, investors have to keep in mind their intended usage, be that fund management, trading, advice or research.
Capitalization rate? I know you’re thinking this is starting to sound complicated; definitely third-year college accounting. Well before you close the book, allow me to explain. First, it sounds way more complicated than it is. In numerical terms, the capitalization rate is the net operating income divided bv the purchase price:
Capitalization Rate = Net Operating Income -T- Purchase Price
So now you’re thinking, “Ken, how can I calculate the capitalization rate when I don’t have a purchase price yet? That’s what I’m trying to figure out through this whole exercise after all. Don’t tell me algebra is involved!” No, algebra is not involved. This is actually really easy. The purchase price here is actually the purchase price trends for a comparable building in your market. So this very complicated sounding word is actually something you can get very easily from brokers, real estate agents, or even the pro forma document for the property. The people in the business—your team members—will either know the capitalization rate for your market or help you calculate it, and that’s all there is to it.
Keep in mind, at this point in the process your goal is to get an idea of the ongoing services and repairs as well as upgrades the building may need. Later in the process, you’ll go into lots more detail. This is the time to put rough numbers on paper and analyze if the cost of the needed repairs will still allow you to be profitable. There is a real balancing act between spending enough to get the place in shape and overspending. Again, your property management representative can help you determine many of these costs.
The goal throughout this whole exercise is to get a picture of where your expenses are and try to find ways to do things better, smarter, and for less money. Those increase your net income and increase your profitability. So what are the expenses? To answer that question, we’ll turn to the pro forma expense table. It shows the seller’s anticipated expenses for the coming year (the pro forma column) and the actual expenses for the prior year.
Common sense will tell you that if an apartment is not rented, it is not producing income, and that reduces your cash flow. Even if the vacancy rate is listed on the pro forma, verify it with the property manager on your team. He or she will be able to tell you if the va¬cancy rate listed is at, above, or below the average of the market and will know this because vacancies are mostly a function of supply and demand within the market. You can also find this information by looking at the monthly rent rolls and move-in dates on the leases.
The income section on the pro forma is where the seller lists the property’s income and the vacancy rate. It shows the income from rent, minus the average vacancy for the property, and adds to it the other income the property generates. The typical pro forma income table looks like the one below, which contains numbers taken directly from the property in Phoenix. In this real-world example, the seller or broker is reporting a total income for the property to be $45,120 per year, using a 7 percent vacancy rate and $480 in other income. That seems pretty good.
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