3 Shortcuts to Save Time
Have you ever been overwhelmed with looking through a stack of deals from a dozen different brokers, all of whom swear he can get you the best deal?
Or maybe you’ve trolled through the Loopnet listings and wondered why the listing that shouts, “Great deal. Priced below replacement cost!!!” has been on the market for eight or nine months?
Welcome to the world of commercial real estate, where every broker is doing you a favor, every seller thinks his property is the best, and neither is true. The reality is that there are a lot more properties for sale than true deals, and if you don’t understand the difference you’ll spend a lot of time chasing rainbows.
Over the years I have probably spent more time looking at properties for sale than any other activity connected with real estate. This is a numbers game, and the math is simple. I have a closing average of one-in-ten deals investigated—defined as having examined the listing information, made a site visit and collected some preliminary market data, and decided the property fits my general criteria. So if I want to close five deals a year, I have to investigate fifty.
The first task is to find the fifty deals worth investigating. If the one-in-ten ratio applies here (I don’t know this for certain, but it feels about right), then I have to scan at least five hundred deals to spot the right ones to chase. That’s a lot of looking.
Making the First Cut
The first challenge in finding true deals is to cull through as many as possible, quickly, and then shorten the learning curve on those that make the cut.
I use a combination of tools in a series of “quick cuts”—preliminary judgments that pare the field—but without censoring the results too heavily.
The key is to use a wide net to capture as many deals as possible that are the type and size we’re looking for, and then use mental filters to decide between the non-starters and the ones with potential.
I use five criteria to make that decision:
2. Property Type
3. Deal Size
4. Terms and Timing
5. Asking/Offer Price Differential
Market, Property Type, and Deal Size
The first three are result of my having set my investment criteria in advance. I’ve already defined the market area and the property type, and my capital resources define the maximum deal size.
If the offering meets those criteria, the next step is to evaluate the deal requirements.
Terms of SaleThe next cut is not a rule of thumb, but has the effect of quickly culling properties that do not fit your financial capability.
The terms of a deal will have a direct bearing on whether the deal is one you can do. Specifically, if you are working with a small amount of capital, you may only be able to look at deals with mortgages that can be assumed or some amount of seller financing.
If the seller will only consider an all-cash deal that may eliminate your offer right away. But if the seller is willing to discount the price or accept outside collateral to secure seller financing, then you’re still in the running. (A note of caution: some deals may require the buyer to assume securitized financing. Be aware that the lender’s criteria for assumption usually require the buyer’s net worth to be equal or greater than the loan amount.)
The timing of the sale may be accelerated, as with auctions and foreclosures. In these cases one must be willing to comply with whatever the process demands, but a consequence may be that the financing available on short notice will be more expensive than if the buyer had time to shop around.
The end decision of whether we can realistically get the deal to the closing table will hinge on the ability to act quickly. Due diligence in these situations can be difficult, but not impossible. If the deal requires a short time frame then it should rate a high degree of potential return to justify the effort and expense of bringing the resources and expertise together quickly to get it closed.
A broker once told me that everything is for sale—price is really the only question. The comment was made in the context of his contacting me to ask about a property we owned but were not trying to sell. I laughed at the statement, and had to agree that there was a price for which we would sell the property.
However, paying high prices relative to returns is not a recipe for successful investing. The old adage, “make your money on the buy” is one of those enigmatic truisms that investors ignore at their peril.
The cardinal sin in real estate is paying too much on terms that do not allow a reasonable return. Therefore, the most important factor in differentiating between a deal and just another property for sale is price, tempered by available terms.
Determining the true value of a property is a subjective exercise that depends foremost on verification of the income stream. That’s later though. On the first look at a deal you have to take the stated income at face value and decide whether or not to inquire further.
To do that, there are four commonly used rules-of-thumb which vary in effectiveness from useless to helpful.
1. Gross Rent Multiplier (GRM)
2. Per-Unit Cost and Average Rent Ratio
3. Operating Expense Ratio
4. Capitalization Rate
Let’s take a look at each method and evaluate each. We will use an example deal through the methods of evaluation.
Property Type: Multi-family
Size: 20 Units
Gross Income: $120,000
Net Operating Income: $72,000
Gross Rent Multiplier
Many realtors and investors rely on the Gross Rent Multiplier (GRM). The GRM is simply the price of a property divided by its gross income. Generally, the lower the number in relation to others of the same type, the better for the buyer. The gross income for our example is $120,000, and the price is $900,000. That yields a GRM of 7.5.
900,000/120,000 = 7.5
But does that really tell us anything?
The limitations of the GRM are severe. It can vary widely from one market to the next and unless you know the details of comparable transactions the number is useless. It doesn’t take expenses into account, and it relies on the assumption that you know the exact gross income of both the subject property and the competitive sales in the market. The figures used in may reflect full occupancy or potential rent amounts. Anything but the gross revenue from the actual rent roll renders the GRM meaningless.
In my opinion a GRM is too rough a number to make a judgment.
Per-Unit Cost and Per-Unit Rent Ratio
Another common rule of thumb used in judging a deal is the cost per unit and the per-unit rent ratio. This is a simple calculation of the sales price divided by whatever per-unit measure is appropriate for the property type. Staying with our example, the asking price reflects a cost per unit of $45,000.
$900,000/20 = $45,000
The advantage to this shortcut is again a quick read on where the property stands in relation to other sales in the market as the cost per unit of comparable sales can be determined from recorded public information.
The rough correlation between the average per-unit rent and the cost per unit is the 1% rule of thumb, which states that the average rent per unit per month should be at least 1% of the cost per unit. We can test for the 1% rule using the gross income of $120,000 (assuming this number is correct) from 20 units.
First divide the annual gross income by twelve to get the average monthly gross income.
$120,000/12 = $10,000 gross income per month
Then divide the monthly gross by the number of units:
$10,000/20 = $500 average gross rent per unit
Then divide the average gross rent per unit by the cost per unit:
$500/$45,000 = .011 or 1.1%
The price is roughly in line with the 1% rule, so the deal is still alive. However, the 1% average rent ratio to the cost per unit can often indicate the property is priced in balance with the income, but little else. The limitations of the calculation are similar to GRM.
Operating Expense Ratio
All property types have an average operating expense ratio, and comparing the subject property with the averages can give a quick read on whether the numbers presented in the listing are in the ballpark of industry norms. Using our example, we calculate the operating expense ratio like this:
120,000 – 72,000 = 48,000
48,000/120,000 = 0.4 or 40%
Apartments average 40%-45% in operating expenses, so the numbers would seem to be in line, for now. I see many, many deals where the stated expenses are far below norms. If so, we know that some digging will have to be done to verify that the stated NOI is accurate.
Here we use the cap rate formula to give us an indication of the seller’s motivation, and determine if we would be interested in the property based on our return requirements.
Remember that the capitalization rate as generally used in the industry is the potential rate of return on the investment for one year as if it were purchased for all cash. The basic formula for calculating the asking cap rate is:
NOI / Price = Capitalization Rate
Continuing with our example, the property is priced at $900,000, and the stated Net Operating Income (NOI) is $72,000. That yields an asking cap rate of 8%.
72,000/900,000 = .08, or 8%
Is it a deal worth consideration?
In light of current market realities, it may be priced competitively. The last few years have seen buyer demand for investment real estate at an all time high, and interest rates for long-term financing at historic lows. This has combined to significantly raise prices, and lower cap rates.
Remember that as prices rise, the cap rate declines. Current average cap rates for well-maintained apartments are in the range of 7%-8%.
Given the current market realities, a deal priced below an 8% cap is likely an indication that the seller has very high expectations for the property. Prices above a 9% cap may indicate a property with some problems, but are recognized by the seller in the initial pricing. Those in between could go either way. In this sense the asking cap rate is an indication of the seller’s motivation and the state of the market.
But the real question is whether we want to pursue the deal based on our own return requirements. If my current investment criteria calls for a going-in cap rate of 9.5% and the deal is priced at an 8% cap rate, I have to decide whether the deal can be discounted or terms structured to serve my requirements. .
Most real estate does not sell for the asking price, but most brokers will tell you that it takes an offer within about 10% of the asking price to be seriously considered. My target cap rate of 9.5% would yield a price of $758,000, a difference of $142,000, or almost 16% below the asking price. That’s on the cusp of being un-doable. I may proceed in hopes of finding some way to structure the deal or the financing to make it work, but not spend a lot of time on the deal unless the seller becomes more motivated.
We can’t go any further in developing an opinion of value at this stage without verified numbers. Many properties are represented with potential income. This may or may not reflect the actual rent roll, concessionary units or all of the expenses, and hence may be wildly inaccurate.
Finally, the return indicated by the asking cap rate also has limitations. It has no allowance for property condition (i.e. deferred maintenance), or the use of leverage (debt), and deal structure. At this point we accept the stated income at face value and as we progress with due diligence the stated numbers will either be verified, or not. If we’ve decided to go look, then we pick up the phone and make the appointment.
After working with a number of deals you’ll likely find yourself doing the above calculations in your head. If the deal has gotten this far, then you’re ready to crunch some numbers to establish whether to really start looking at the deal.