So, how do you evaluate real estate?
No matter where you live, you’ll find that there are plenty of properties for sale. There may be commercial or residential developments or vacant land available for purchase. You need to be careful not to fall into the trap that some new real estate investors fall into, being overanxious to get in the game. I know I said that some people have analysis paralysis. That refers to overanalyzing an opportunity to the point that it’s too late to do anything. You need to analyze each property carefully to be sure it will be profitable, but don’t go overboard. You will never have all the information until the deal is done; you’ll need to make the decision based on the information you do have. There’s a formula for finding a property that I refer to as 100:10:3:1. It works like this: You look at one hundred properties, out of which ten will be good opportunities. Out of those ten, you may place a contract on three of the properties. Finally, out of those three, you will probably close on and purchase one property. This is not an empirical formula, but I’ve found through experience that it’s quite accurate. How do you get from one hundred properties to the one that you actually buy? I’ve looked at hundreds of properties, from looking at pictures in advertisements to going to the property and walking through it.
Don’t expect to find the perfect property the first time you go look. But don’t rule it out for that reason alone, either; you might have beginners’ luck. It takes time to do all this looking at properties, so you should always be looking, no matter where you are, even on vacation. You may also be concerned that only one out of three contracts will close. There are several reasons why a contract on a property you like won’t close, so don’t be discouraged. One problem could be that your financing doesn’t materialize to your liking. For example, it could be that you want ninety percent financing, but you are unable to find better than eighty percent financing within the time allowed by the contract. Likewise, the seller’s problems could cause the sale not to close. The seller may have a lien that he didn’t realize was on his property, or there may be a problem in the chain of title, which cannot be cured economically enough to make finishing the deal worthwhile. Other times, the property itself will be the problem. A survey may show there’s an encroachment on the property, such as a neighbor’s wall extending into the property, leaving part of the property on the neighbor’s side of the fence. Or you may discover the property doesn’t have the appropriate zoning for your intended use.
Suppose you want to buy a lot to build apartments on, but it’s zoned single-family residential. You would need to get the zoning change approved or obtain a variance from the municipality that regulates zoning where the property is located. Changing a property’s zoning can sometimes increase its value, but it usually takes a considerable amount of time and money to accomplish it. And sometimes the municipality won’t grant the zoning change. There are no guarantees. Your contract may be contingent upon the seller changing the zoning, which isn’t always possible. It’s better to lose your earnest money (or a portion of it) than to buy a piece of property you can’t use as planned. A real estate inspector may discover some problems in the building that aren’t in your budget to repair, making the property worth less than what you have contracted for. In this case, not closing is a good thing. You should provide for an inspection period in your contract, so you can better know what you are buying. A licensed inspection may also help you negotiate down the price, because of unexpected repairs.
My ex-wife and I once looked at a duplex that needed some cosmetic work, but we saw we would be able to put four more units on the same property. Based on these assumptions, we agreed on a price with the sellers, subject to an inspection. The inspection showed that it would cost more to repair the old duplex (turned out the damage was more than cosmetic) than it would to knock it down and build two new units. Even though we explained these points to the seller and we were willing to pay more than the raw land was worth, the seller wouldn’t lower the price. We walked away. After you ascertain that the property will physically and logistically suit your purposes, you can go to the next step in the evaluation process. I recommend buying income-producing properties because they will pay for themselves. At this point in your evaluation you have to determine the purpose of your investment. Is its long-term cash flow, or short- or long-term capital gains?
Your purpose will determine how you evaluate the property, but either way, you make money when you buy, not when you sell. By this I mean that, if you buy low enough, you will be able to at least break even if there’s an economic downturn. If you buy high, you’re at risk of an economic downturn putting you upside down on the property, meaning that you owe more than it’s worth. The lower you buy, the more money you will make on the property. In an income property, your debt service will be less, leaving more cash flow. In a property you buy for appreciation, you will make more money on the sale. To analyze any income property, you need to determine the acquisition costs and the expenses first. Some of the typical costs are obvious — the purchase price and closing costs. Let’s take a closer look at these issues on a typical purchase:
Purchase price / Bank fees / Prorated taxes Appraisal fees / Inspection fees / Other closing costs / Attorney fees
TOTAL ACQUISITION COSTS
Loan proceeds / Prorated rents / Tenant deposits / Prorated taxes / Credits/allowances
At the closing, you will have to add up the acquisition costs and deduct the credits. The result will be the cash portion that you will need to bring to the closing. As you can see, there are many different costs involved in the purchase side of the formula. And as you can see, there are credits that can help reduce your total cash outlay. We’ll discuss that in more detail, later. Whether you’re buying a property for appreciation or income, the above analysis is the first you will need to make. Remember that your purchase price will strongly affect your profit and income. The lower your purchase price, the more room for appreciation and the greater the potential for profit. Like they say, “buy low, sell high.” This is also true for income property. The lower the purchase price, the lower the debt and carrying costs. For an appreciation property, you need to determine what your exit strategy is. That is, how long do you intend to hold the property and how much do you expect it to appreciate before you sell? The longer you hold the property, the more interest you have paid if you financed the property over the length of the hold. On the other hand, if you pay cash for the property, your appreciation will need to be at least enough to cover any interest you would have received on the cash, which could be about the same amount. For income property, you will need to make a bit more of an analysis of the cash flow. What you need to determine is the income potential and expenses of the property over a monthly or yearly basis. The following is an example of factors for a typical income property, such as an apartment complex:
Rental income / Other income (laundry/vending machines) /
Expenses / Debt service / Property taxes / Insurance / Management / Vacancy projection / Maintenance
Once you arrive at these numbers, you take the total income and deduct the total expenses. If the result is a positive number, then the property will generate a positive cash flow and make money. The annual cash flow divided by the amount of cash you put as a down payment and multiplied by one hundred will give you your cash on cash return percentage:
Annual Cash Flow/Cash Investment x 100 = “Cash on Cash” Return
“Cash on Cash” return is what the return on your actual cash investment is called. Another way of looking at this is to ask, “How fast will I get my money back?” If you get your cash investment back in one year, your cash on cash return is one hundred percent. This can really be seen in leveraged transactions when you’re using the bank’s money to finance your projects. If you buy a property worth $100,000 and put down $10,000 cash out of your pocket, your cash investment is $10,000. If the property has cash flow and appreciation of $10,000 at the end of the first year, you have a one hundred percent cash on cash return. A good investment will provide a good cash on cash return. I like to compare a property investment return with the return you would make on a stock after you’d held it a year. The difference in these two types of investments is that the income property is paying for itself and can be more highly leveraged, so there is a larger base that will appreciate in value. The value of stock is what a share is worth at any given moment. Let’s say you bought an income-producing property worth $100,000 and put ten percent down. You would own the property by paying just $10,000. If, instead, you took that $10,000 and bought stock, you would have stock worth $10,000. Now, let’s move forward a year. We’ll assume the stock value rises by ten percent. Now you have an asset worth $11,000. On the other hand, let’s assume the real estate value rises by five percent. You have an asset worth $105,000. You owe $90,000, so you have equity of $15,000, which means a fifty percent return on investment from appreciation. This does not include the cash flow from your investment. Now you can see why I like real property, especially income property. Remember that you need to evaluate the property up front and before you fall in love with it.
This article is an excerpt from my book, The Road Map to Rich: a Lawyer’s Perspective on Getting and Staying Rich. If you would like your own hard copy for free, contact us and we will deliver to your preferred mail box.