There is an old saying about real estate investing, which is, "Buy in bad times on good economics and sell in good times on bad economics." I don't know who originally came up with the phrase, but it's a great rule to follow.

Real estate, like other parts of the economy, goes through good times and bad. We're in some very challenging times right now, but they'll help bring real estate investment pricing back to good economics.

So the question is, what are good economics for real estate investing? For this discussion, let's focus on existing commercial and multifamily income-producing properties priced between $150,000 and $3 million. Most of the investors our company deals with on a daily basis shop in this price range.

In Spokane there is a lot of competition for properties at the lower end of this range. Spokane is a conservative community, and many small-business owners want to own the real estate they occupy. Owning real estate might not be the best option in all cases, but for businesses that are established and have predictable growth, it makes great sense.

The business owners here who want to own real estate sometimes will pay more for these lower price-range properties than an investor can justify, so competing with them for properties can make it tough to find a good buy.

When evaluating properties, there are a number of methods to determine value. One of the most commonly used methods is the income approach, in which the annual income and expenses of a property are evaluated to determine net operating income (NOI). That's what's left after accounting for vacancy and deducting all anticipated operating expenses from the potential income the property is capable of generating. Successful real estate investors have developed enough market knowledge and experience to assess a property's NOI accurately.

The next step is to evaluate the unique features of the property and select a capitalization rate, or cap rate, that reflects those features. In a nutshell, the cap rate is an evaluation tool that is used to establish the market value of the property. An investor evaluates a property and determines what rate of return he would require if he paid cash for the property and there was no debt. As an example, if the property produced a NOI of $100,000 a year and the investor believed that his return should be 8 percent, then the investor would be willing to pay $1.25 million for the property.

Many factors will influence what cap rate an investor will require to make a property an attractive investment. Keep in mind that as the cap rate required by the investor goes up, the price he is willing to pay for the property goes down. Conversely, the lower the cap rate the investor will consider, the more he will pay for the property. The constant in the equation is the net operating income.

To determine an appropriate cap rate, an investor will consider factors such as the property's age, location, parking availability, vacancy history, and its long-term flexibility; tenants' credit and occupancy history; length of current leases; deferred maintenance; and future capital investment needed.

Cap rates also will vary from city to city, based on a property's unique characteristics. Newer multifamily and single-tenant properties with long-term leases to quality tenants tend to have low cap rates that today would be around 6.5 percent to 7.5 percent. Older buildings with high expenses and lower-credit tenants will have higher cap rates that could range from 9 percent on up.

So, with that background, what are good economics for real estate investors? First of all, an investor should be able to borrow money at an interest rate that is less than the cap rate. This is called positive leverage. During the past seven years, we saw such demand for quality properties that investors were willing to pay prices that reflected negative leverage, meaning they were willing to buy at cap rates less than the rate of interest at which they could borrow money. You may have heard of properties selling in California for cap rates as low as 4 percent when the interest rates on financing were around 6 percent. That is negative leverage.

A study of the national investment real estate market done about three years ago concluded there were 20 potential buyers for every property that came on the market—low supply and high demand, the perfect environment for bad economics!

In a survey we did recently, interest rates for income-property loans being offered by financial institutions in Spokane were in the range of 6.25 percent to 7.25 percent. These quotes were made to good-credit borrowers seeking low-leverage loans. By low leverage, I mean they wanted to borrow 50 percent to 60 percent of the properties' appraised value. With interest rates in those ranges, cap rates should be at least 1 percentage point to 2 percentage points higher, so corresponding cap rates will be 7.25 percent to 8.25 percent or more.

Secondly, with good economics, an investor must get a market "cash-on-cash" return on their investment. If you buy an investment property and pay $100,000 as the down payment, when you collect the income, pay the expenses, and pay the mortgage, there must be cash flow left over to provide a return on that $100,000 initial investment.

That market return, again, will vary depending on the property type and other factors. For a quality property with quality tenants on long-term leases, the return may be smaller. For older properties with lower-credit tenants, the return needs to be larger.

Over the last seven years, with a low supply of investment properties and high demand for good properties, some investors have bought properties with high leverage and no cash flow projected in the first few years of ownership. That is not good economics!

The craziness in the financial markets today makes it hard to peg what cash-on-cash rates of return an investor should expect. What I hear from most investors, though, is that their return expectations are going up. One investor I recently talked to said he was going to be happy with a 6 percent cash-on-cash return on a quality property, which is up from 4 percent to 5 percent a few years ago. Other investors I have talked to who were considering higher risk properties now want a 10 percent to 12 percent cash-on-cash return, which substantially higher than the 6 percent to 8 percent return that would have satisfied them in past years.

We now have a new factor affecting real estate investing: the changes in our banking industry. Banks have taken a new approach to income-property lending. They will no longer make income-property loans without larger down payments and more stringent oversight.

The new lending guidelines and the market swing toward good economics make it a great time to be a real estate investor. It still takes hard work to find good properties, and it will take some sellers a while to adjust to the changes in the market, but now is the time to be looking for good investment opportunities.