Investing in real estate is a tricky business, and, like the stock market, every investment will not be a great one. As a matter of fact, what makes a great real estate investment is keyed as much to timing and interest rates as it is to the true operating costs of a property.
Sometimes the tax assessor will significantly overvalue a property. Take the example of a building listed for sale at $1,600,000. The building was half-empty (no real revenue there), the projected income was about 10% over the market, yet its expense estimates were 10% to 15% below the market average for similar buildings. In addition, the broker did not include any estimates for tenant improvements for new tenants, or leasing commissions for brokers who would be procuring new tenants.
The location of the property was good (close to freeways and major arterials), but that alone could not justify the asking price. After completing some adjustments to bring the pro forma into some sort of reality, the potential purchase price turned out to be closer to $1,250,000. Even with adjustments, the cash return would only have been 5% on the down payment.
Granted, every marketplace is different, and market conditions may force you into overpaying for a property you really want. However, if return on investment is what you want, you cannot afford to overpay for real estate investments, certainly not if you expect to retire on the income. Sure, there is a lot to be said for leverage and appreciation, but at the end of the day cash flow is what counts.
So how do investors ensure that they are making the right decisions and are compiling accurate income and expense statements?
1. Examine many similar properties at the same time.
It is helpful to examine similar pro formas at the same time. You will see what one owner or broker will include and another will leave out. Look at the market to see how long it takes to find a new tenants. To establish a baseline, talk to other real estate brokers, lenders, and property managers.
2. Review operating figures for the past three years.
Most financial analyses exclude capital expenses. Bear in mind that you must always create a reserve for capital expenses. The roof will leak, the HVAC will fail, and the main water line will break. Always expect the unexpected: prepare financially for potential problems. Remember that real estate is an asset that wears out: doors need to be painted, carpets replaced, and new faucets installed. By reviewing three years of income and expenses, you will have a much better idea of vacancy rates as well as real expenses.
3. Obtain comparable rent income figures.
Drive around the neighbourhood in which your potential property is located. Call the brokers and the managers to ascertain what prevailing rental rates. Are there any concessions being given to rental units or lease space? Use this information to verify the figures you received for the property you wish to buy.
4. Examine the vacancy rate in the market place.
Each market and specific type of real estate investment has a known vacancy rate. Some locations are better than others, and will perpetually have a higher occupancy rate. Look for concessions that have been offered. How will they affect your cash flow when you own the property? Why is your property full? Did the seller hastily rent to tenants from emergency aid shelters (yes, this has happened in weak markets)? Banks will not loan on buildings with more than a 5% vacancy rate. They will, however, offer construction loans if you are renovating the building. This may give you some time to find tenants to fill a building; otherwise you will be forced to guarantee the rents, which means your hard-earned cash will not be at work making more money for you.
5. Talk to an appraiser regarding typical incomes and expenditures.
This seems like common sense, but no one seems to do it. The agent representing you is motivated to close a transaction; consequently, s/he is probably not the best person to rely on for accurate information. S/he may even be too inexperienced to provide all the information you need. You need accurate, comprehensive data to make informed decisions.
6. Obtain tax return information for the property.
Many sellers will refuse to supply recent returns, but it pays to be persistent. Cash flow is what most investors are seeking. If your property has an 8-10% positive cash flow after all tax adjustments have been made, it should be a sound proposition.
You should look at comparison indicators as you pursue your investment strategy:
- cap rate
- cash-on-cash return
- debt coverage ratios
- price per unit (or price per square foot for comparable properties in the same marketplace)
- percentage of expenses (are they realistic or understated?)
Don’t forget to look at the financing and due-diligence costs as part of your transaction.
All this analysis may mean that you will make lower offers than other investors, simply because, on the basis of your accurate data, you are simply not willing to pay as much as sellers want. On the other hand, do you really want to buy a property that will not appraise, or worse yet, not have a positive cash flow?
Adapted from an original article by Clifford A. Hockley