This is the third and final part of a 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.
Part 1 – Does it meet my 4 criteria?
In the first part of this series I explained that the initial 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 as simple as that.
Part 2 – Is the property’s story & analytics compelling?
If a property has survived the first cut and is worth further consideration, then I:
- Want to hear the property’s story (it better be a compelling story)
- Run the numbers
- Size the loan based on how the lender will size the loan, not on how the seller’s agent sizes the loan in the offering memorandum
If you would like a further explanation of these three steps on how I size up a real estate opportunity, then I would encourage you to click this link: Part 2
Part 3 – Should I buy this property?
The fifth and final step in the process is to evaluate the property’s return on investment. My method will be viewed by some as being too simplistic. I, on the other hand, believe their approach is off the charts inaccurate. Who’s right? You decide.
5. Evaluate the property’s return on investment
My property valuation method is based on knowable assumptions or at least reasonably educated guesses, such as:
- What will I offer for the property in an as-is condition?
- What is needed to renovate the property, and how much will it cost?
- When the improvements are completed, what will be the new market rents?
- How long will it take me to achieve stabilized occupancy?
- What type of financing should I get? A permanent loan with a holdback for repairs? Or a full-blown bridge loan followed by a competitive non-recourse loan?
All of these questions require and can receive at the very least educated guesses. Once these questions are answered objectively as possible with the most likely outcomes, they can be inputted into a CRE investing spreadsheet. I focus in on a before-tax return-on-equity in the first year of stabilized operation. If it’s in the 5 percent or better range, then I know the property will do well over time.
The problem with using an IRR calculation
Now you may be thinking, “This guy is just intimidated by the sophistication of the Internal Rate of Return method.” Not so. I actually enjoy doing an IRR calculation. It’s so analytical, and I love that. I just don’t believe it provides the best approach to making a buy/no-buy decision. Here are two examples of what I mean:
Problem #1 – Garbage In/Garbage Out
Depending on your assumptions, you can get whatever IRR you want to get. If your IRR is not high enough to justify purchasing the property, then increase your annual rent growth by 1 percent or lower your sales cap rate in year ten by fifty basis points.
Thirty years ago, as a financial analyst for a syndicator, that was my job. I played with the numbers until I got the desired return my boss wanted for our investor presentations.
Problem #2 – Cash flow vs Property Appreciation
In my opinion, cash flow is king. But you can use an IRR calculation to justify purchasing a property having little or no annual cash flow. You can do this by inflating the sales price in year ten over a property that has generous cash flows over the holding period.
I would rather choose the property with the good cash flow and slightly lower IRR than the property with little cash flow and higher IRR. Wouldn’t you?
Am I an IRR Neanderthal?
Now that the IRR aficionados have labeled me an IRR Neanderthal, I must confess that I do use a before-tax IRR calculation after I’ve sold a property. At that point, all the variables are known. I know:
- How much equity was required when I purchased the property;
- My annual owner distributions;
- The number of years I owned the property; and
- The amount of cash or 1031 equity I received at closing when I sold the property.
Knowing those four things, I can then run an accurate IRR calculation. The properties I’ve sold have had an IRR as low as 7 percent and as high as 28 percent. But I calculate an IRR calculation after the property is sold, not before.
Doing so after the property is sold yields an informed and accurate return on my investment. In contrast, using the IRR method to value a potential purchase is a fool’s approach to valuing commercial real estate because there are too many unknown variables.
Want to know more?
If you would like to learn the specifics of how I analyze a property purchase, I would encourage you to listen to a short two-minute video presentation on my website. Click this link Spreadsheet to listen to the video. If you like what you hear then download my Property Investing Analysis Spreadsheet for FREE.
And of course if you want the full meal deal, buy my book Mastering the Art of Commercial Real Estate Investing by clicking on the Amazon link below.
Those are my thoughts, I welcome yours. How do you evaluate a property purchase?