This post originally appeared on tBL member Allen C. Buchanan's blog Location Advice and is republished with permission. Find out how to syndicate your content with theBrokerList.
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I received a call from an attorney last week. We recently completed a lease for his law firm and we swap referrals.
This time the conversation centered around an opportunity with which he had been presented.
In short, a friend of his is eyeing a building and approached my friend on becoming a partner.
The counsel I gave the counselor was post worthy – so here goes.
First, compute the potential revenue. In this case, my friend was not going to occupy the building with his business. So, the opportunity will strictly be an investment. Also, the real estate is currently vacant. Considered should be the rent a tenant(s) will pay – not a puffed-up version – but a real true number. Next – how long will it take to lease the space. Finally – what concessions will have to be given to attract a paying customer? Oh yeah, if 100% is every tenant paying every month on time – you might want to figure in a shrink factor of 5-10% in case someone slow pays or stiffs you.
Next, add up the expenses. Biggest in this line of figures is property taxes. Insurance, maintenance, and utilities tag along as well. Don’t forget – the property taxes will rise in accordance with your purchase price. Make sure you take this into consideration.
Now, subtract the expenses from the potential revenue. The difference is a return – also known as a Net Operating Income. However, from this amount you’ll need to make sure you allocate some dollars for a new roof or a blown AC unit – lest you are swiping your Visa Card when your tenant is broiling on a July day.
OK. Now we have realistically modeled our income, subtracted real expenses, and created a reserve for major repairs.
Most would now do some math – return divided by the purchase price. This simple formula allows you to see what your percentage return is for an all-cash purchase – with no loan. In today’s market – this percentage should be 5.5% at a minimum. Frankly, I like 6%+ much better. Because, likely the purchase will be financed and with creeping interest rates – you don’t want the advantage of leverage to be a disadvantage. Said simply, if your borrowing costs exceed the all-cash return – YOUR spendable amount – after you pay the bank – will be much less.
Now, take a reality check. Remember, you have made some assumptions on the market rent and time it will take you to fill the vacancy. Will the deal still make sense if the lease up time is double? What if you can only get 75% of the rent you anticipate? Remember 2008? Yeah. Me too.
It’s the numbers, stupid! Investing in real estate is all about the cold analysis of the deal. Please don’t fall victim to the “but I love it” syndrome.