Concessions. You can’t live with them and you can’t live with out them, but what does it really mean to the rental property? Their affect on cash flow and value isn’t always clear. Over the last few years, concessions have become one of the biggest problems facing the real estate market.
Why are concessions so bad for the real estate market? In most cases, concessions lower the net operating income of the rental property, which in turn lowers the value. To the average Joe, this looks to be a double hit (lower income and lower value). Actually, in real estate it is a triple hit. First, income goes down, second, the real estate's value is lowered and third, the capitalization rate is raised and this further reduces the value of the property.
The following is a text book example that shows the actual risks involved when an owner or management company uses concessions that reduce the income by 10%.
Value (any real estate) @ 9% Capitalization Rate $100,000
Without Concessions (Assumptions)
Property Income $18,000
Property Expenses $9,000
Net Operating Income $9,000
With A 10% Concession (Assumptions)
Income Declines 10% $16,200
Property Expenses (remain the same) $9,000
Net Operating Income $7,200
Results From A 10% Concession
Capitalization Rate Increases (example 10%)
New Market Value @ 10% Cap Rate $72,000
Annual Cash Return On Investment $7,200
The preceding figures illustrate the affect on real estate of a 10% concession. The conclusion to be drawn from this example is that a 10% concession could increase the capitalization rate from 9% to 10% resulting in a loss of market value of 28% and a loss in cash flow of 10%. This means that if the real estate were purchased with a down payment of 30%, the buyer would lose the entire investment. (Allen Cymrot)
The moral, make sure you understand the financial impact of concessions before you give three months of free rent. If you have any questions about concessions please contact our office.