Updated: Jan 9
As a passive investor, you join the party after the deal terms have been set between the seller and the Lead Investor. When analyzing a real estate deal, there are many factors that determine the optimal purchase price. Determining the max price is part art and part science; there are market and property-level factors that contribute to that decision, but there’s also some intuition – which comes from experience – that makes up some of the decision. Here are the main price drivers that Lead Investors take into consideration:
Simply put, cap rate is the ratio of the property’s NOI or Net Operating Income (income minus expenses) and the Price. Basically: NOI/Price. The Lead Investor uses the cap rate when evaluating the price, mainly by comparing the deal’s cap rate to similar multifamily properties that have been recently sold in the area. This way, the Lead Investor can make sure they are not overpaying for the property. Even though cap rates do play an important role in any investment, many investors tend to focus on cap rates when assessing a deal, and not rightly so (assuming the deal cap rate is the area cap rate). A property can be sold for a 5.25% cap rate, but if the Lead Investor can increase the NOI, the cap rate will be higher within a few years, and the in-place cap rate (the cap rate at purchase) will be a little less relevant. Hence, the deal’s cap rate is important, but only to an extent.
The Deal’s Upside
Another important component in determining price is the deal’s upside. When it comes to real estate investing, an upside is any opportunity to increase the property’s profitability. The most common ways to find the upside are:
- Reducing expenses by bringing an experienced property management team to manage the property.
- Taking legal actions to appeal against your property tax assessment.
- Raising rents (with or without renovating the property).
Many Lead Investors take into consideration the higher NOI and the time it will take them to increase it when evaluating the purchase price. A conservative investor will run a sensitivity analysis to understand how different NOIs affect the deal once they buy it at a certain price.
Investor’s Target Returns
Every investor has different returns they are aiming to get. Two of the most common ones are CoC, or cash on cash (This is the cash income earned on the investment) and IRR, or Internal Rate of Returns (Generally, this refers to the investment’s returns while taking time into consideration, but more specifically, it is the discount rate that makes the NPV, or net-present value, of the investment’s cash flow equal to zero).
When I am trying to establish the proper purchase price, I am always making sure that I still meet the returns I aim at. Normally in the market, you will find 6-8% CoC and 15-18% IRR. Hence, even if a certain price works well with the area cap rate, or with any other price drivers for that matter, but paying that amount will bring the deal’s returns to, say, 11% IRR – for me, it’s not a good deal. Sometimes I will submit an offer that is lower than the official purchase price, and I do so as long as the price makes sense with my returns in mind.
Appreciation and Exit Price
One if the most critical factors that affect returns (CoC or IRR) is the Exit Price (the price by which you believe you can sell the property for after you hold period is over). A good Lead Investor will make an educated assumption regarding the exit price, and a great Lead Investor will be conservative and run their analysis based on the worse-case scenario (assuming that in 3-5 years, when they want to sell the property, cap rates will go up, meaning that buyers will be willing to pay LESS for similar properties with similar net inc