Bluestone and Hockley Real Estate Services
Last night I was reviewing income and expense analysis reports for three different properties, and once again I realized how hard it is for the average investor to make heads or tails of the information.
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.
What disturbed me most as I was reviewing the cash flow information on these properties, was that the tax assessor had significantly overvalued the properties. In one case a listing broker wanted to sell his client's building for $1,600,000. The building was half-empty (no real revenue there), the projected income at about 10% over the market, and yet also had expense estimates (yes, estimates, not real numbers) that were 10% to 15% below market for similar buildings. In addition, the broker did not include any estimates for tenant improvements for new tenants, or leasing commissions for brokers that would be procuring new tenants.
The location of the property was good — close to freeways and major arterials — but that did not justify his price. After I completed my adjustments to bring the pro-forma into some sort of reality, I arrived at a potential purchase price of $1,250,000. Even with adjustments, the cash return was only 5% on the down payment.
I will grant you that every marketplace is different , and market conditions may force you into overpaying for a property you really want, but if return on investment is what you want, you cannot afford to overpay for real estate investments 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 the cash flow is what counts.
So how does an investor assure himself that s/he is making the right decision and assembling an income and expense statement that is accurate?
- Examine many similar properties at the same time:
It is helpful to examine similar proformas at the same time. You will see what one owner or broker may include, and what another may leave out. Look at the market to see how long it is taking to find a new tenant. Talk to other real estate brokers, lenders and property managers in the market to establish a baseline.
- Review 3 years past operating numbers
Most financial analysis reports will exclude capital expenses. Bear in mind that you must reserve for capital expenses. The roof will leak, the HVAC will fail, and the main water line will break. I guarantee you things will happen that you do not expect. Prepare financially for potential problems. Remember that real estate is an asset that wears out: doors need to be painted, carpets replaced, new faucets installed, etc. By reviewing 3 years of income and expenses, you will have a much better idea of vacancy rates as well as real expenses.
- Obtain comparable rent income numbers
Drive the neighborhoods in which your potential property is located. Call the brokers and the managers to find out what the rents are. Are there any concessions being given to rental units or lease space? Use this information to double check the information you are getting regarding the property you want to buy.
- Examine the vacancy rate in the market place
Each market and type of real estate investment has a vacancy rate. Some locations are better than others, and will perpetually have a lower vacancy 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 a re 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.
- Talk to an appraiser regarding common incomes and expenses in the marketplace
This seems like common sense, but no one seems to do this. The agent representing you is motivated to close a transaction. They may not be experienced, or may not provide information you need. You need accurate information to make an informed decision.
- Review the BOMA and IREM expense analysis books for the marketplace
These books are updated every year and can give you an in depth look at how properties are operating.
- Ask for schedule “E” tax return information for the property
Many Sellers will refuse to supply the schedule, but in my mind the proof is in the pudding.
In my conservative opinion, cash flow is what the investor seeks. If your property has a 8%-10% positive cash flow after all of the adjustments discussed above, it should make sense. Many buyers also use CAP Rates as an indicator of value; I find that it to be a lagging indicator if you compare your property to others in the marketplace. Just because other investors are buying a 4% CAP property, does not mean you should. Maybe the market is overheated, perhaps there is more demand than supply, maybe you should look in a market with 8% to 11% CAP rates, or perhaps low interest rates give you the opportunity to buy something with a low CAP rate and still make money.
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 inline or understated). Don't forget to look at the financing and due diligence costs as part of your transaction.
All this analysis will mean that you may make lower offers than another investor. It may mean that you will not be willing to pay as much as a Seller wants. On the other hand, do you want to buy a property that will not appraise, or worse yet not have a positive cash flow? I do not think so.