Updated: Mar 7
Despite the fact that the country is in the middle of a devastating pandemic, many investors are still looking at purchasing properties. Considering what the stock market has done over the past month, it’s no surprise that a lot of people are looking for other places to put their money. If you’re still looking at real estate investments and you’ve found what you consider to be the perfect multifamily property, it would be wise to reassess the sale price before you commit to the seller. That’s because if you don’t get it right, you stand to lose thousands, if not millions, of dollars on that one deal! You should also ask yourself if you have the ability and contacts to raise the money needed to finance the property, or you could lose the deal.
This is the time to double and triple-check your calculations because even a single mistake can be financially devastating. I’ve seen many people jump into a deal without the proper knowledge or experience and end up losing a substantial amount of money. Many of the mistakes made were avoidable if only the investor had followed some basic solutions prior to committing to the purchase. I would like to share those with you in order to help you avoid making some costly mistakes.
Solution #1: Be Conservative
When looking at investments, it pays to be conservative. One of the key metrics to look at is the cap rate. It’s one of the best predictors of profitability and a property’s return potential. A cap rate measure’s a property’s yield over a one-year period, making it easy to compare the cash flow of one property with another - excluding debt. The higher the cap rate, the lower the price of the property. The cap rate is calculated by dividing the net operating income (NOI) by the current market value of the property. As an example, if you have an NOI of $50,000, and the current market value of the property is $1,000,000, then the cap rate would be 5%.
One of the keys when evaluating a property is to have an exit cap greater than an in-place cap rate. An exit cap is the cap rate of property on the date you sell the property. It’s calculated by dividing the expected net operating income (NOI) by the expected sale price and is expressed as a percentage. Ultimately the type of property, the demand at the time of sale, and the market’s inventory will all affect the final price. Cap rates can change from 4% for Class A buildings in secondary markets, to 7% class C in the mid-west, with 5.5% being the average cap rate in the U.S. prior to the COVID-19 pandemic. When doing your pro forma on a property, it’s best to plan on the conservative side. If you’re planning on buying a property with value-add improvements in mind, plug in lower premiums than the numbers you’re actually targeting. Premiums are the increase in rent, so if a current apartment rents for $1,000 and you plan on raising the rent to $1,200 after the value-add is completed, the premium would be $200. In plugging in the numbers, however, it makes sense to plug in a premium of $150. That way, if you can’t ultimately rent all the units for the projected premium, you won’t be finding yourself with a lower income than you projected. In a post-pandemic world, I’d highly suggest keeping rents flat for 12-24 months, since we assume it will be challenging to raise rents for a while.
The same approach goes for your expenses. Plug in higher expenses than what you anticipate, so if for your expenses come in below your expectations, your net operating income won’t be impacted. For example, if you project utility expenses at $3,000 per month, but the actual utility costs are $2,500, your projections will appear better than if you had plugged in the $3,000 amount. Using a conservative approach when projecting vacancy rates on your pro forma is also a smart way to go. If you want to prepare yourself for the variables that happen with properties, assume a vacancy rate of at least 7% to 10%, even if the actual is much lower, and especially when you underwrite a deal during a recession. Having an overstated vacancy rate on a pro form could be a red flag about the property.
Solution #2: Hire a Mentor
If you’re new to real estate investing, you probably don't yet have enough knowledge or experience needed to analyze a deal and ensure you’re paying a fair price for the property. Hiring a mentor can solve your problem, as the mentor will have the experience and knowledge to look at a deal and determine whether the price is equitable or not.
The operative word here is “hire” - you’re not looking to barter your time in exchange for your mentor’s knowledge. The reason is simple: you want to work