This is the second part of a three-part series on how I personally size up real estate investment opportunities. Over the past year I’ve had several people ask me this question. So I thought what the heck, sure I’ll explain how I determine whether a property is worth investing in.
In Part 1 of this series I explained that the first step in the process. For a rental property to be considered it must meet four criteria. If you want to read what these four criteria are, click on this link: Part 1. If the real estate opportunity doesn’t meet all four criteria, it doesn’t make the cut. It’s a simple as that. If a property has survived the first cut and is worth further consideration, then these are the next steps in the process.
2. I want to hear the property’s story
I want to hear why I should buy this property and it needs to be a convincing story. For me to invest in a property, it needs to be a value-add play in order to get an acceptable return on my investment. Gone are the days that you can buy a turnkey property whose rents are at market that will yield an acceptable ROI. Those properties do not exist today in the Pacific Northwest.
What do I mean by “value-add?” I mean there is some reason why the property is under performing the market. And if the problem were corrected it would result in an excellent return on your original investment. For example it could be that the property has been poorly managed, or possibly the property needs to be renovated.
A couple of years ago I invested in a fractured condo project. Fractured condos typically consist of a small minority of units that are individually owned, but the bulk of the units are owned and operated as apartments. As an investor I was purchasing those units that were operated as apartments. Fractured condos are a pariah in the real estate market. They are avoided like the plague and rightly so. But if you have experience with fractured condos and can solve the problems associated with this property type, you are handsomely rewarded for your efforts.
Bottom line: For me to invest in a rental property, its story needs to be compelling. It needs to be believable too. How many times have I heard a supposedly value-add play when in fact it’s just an overpriced property with no real upside.
3. I run the numbers
Notice that I don’t even look at the property’s numbers until I get this far along in the process. I begin by spreading out the historical operating statements. I specifically want the current year-to-date operating statement and the previous two years. I also want the current rent roll. There are times when the seller is reluctant to provide me more than a Trailing 12 Month statement. Sorry, but if I’m going to invest in a property, I insist on getting the documents I’ve requested, or I refuse to go any further in the buying process.
One more thought: Don’t ever use the pro forma income and expenses found in the seller’s marketing package, sometimes called an Offering Memorandum. To paraphrase Mark Twain, “There are liars, damned liars and then there are people who prepare Offering Memorandums.” The income and expenses on an OM rarely reflect reality.
I review the historical operating statements. I look specifically for trends in the numbers. I also look for large swings in the numbers from one year to the next and if I find something that looks odd, I ask the seller for an explanation. Based on the historical operating statements, I then generate my own pro forma. Since any purchase I make is a value-add play, I estimate the market rents after the completion of the capital improvements.
4. I size the loan
One of the more common mistakes of investing in commercial real estate is not fully understanding the importance the lender has on a property’s return on investment. Now I know what you’re thinking. “Doug, of course the lender is important to a property’s ROI. The lower the interest rate the higher the ROI. Duh.” Yes, that’s true but that’s not what I’m referring to.
Maybe even more critical to a property’s return on investment is the size of the loan. It’s the lender that ultimately determines the loan size. Not the pro forma found in the marketing flyer, nor the buyer’s proposed budget. It’s the lender. And without having an accurate estimate of the loan amount, the buyer doesn’t know how much cash is required at closing. And how much equity that’s required to purchase the property is a key factor in determining the property’s cash-on-cash return.
This is not an academic exercise. As an investor the sizing of the loan is a critical component for calculating the property’s return on investment. That’s why it’s important to understand that lenders have rules of thumb that they use in their underwriting guidelines. It has the potential of significantly affecting the property’s cash-on-cash return. Not all lenders have the same rules of thumb. That would be too easy. Generally there are seven rules of thumb that most lenders will use to determine the loan amount. So the next step in the process is to apply these rules of thumb to the property I’m analyzing to get a good estimate of the loan amount.
If you would like a copy of the Excel spreadsheet that I use to size a loan based on these seven rules of thumb, click this link: Property Investing Analysis Spreadsheet.
The Final Decision – The Property’s Investment Return
Now that I have an understanding of the property’s story and I’ve run the numbers including an estimate of the loan amount, the last piece of the puzzle is to evaluate a property’s return on my initial investment. Is it worth buying? Is the return sufficient to make an offer?
In the third and final part of the series l discuss why I favor using a more simplistic Cash-on-Cash Return instead of the more sophisticated Internal Rate of Return. I’m going to let you in on a poorly kept secret: I’m not a fan of using IRR for the buy/no buy decision which I will discuss in my next blog post.
Those are my thoughts. I welcome yours. What criteria do you use to decide if you should purchase a rental property?