It doesn't matter if you have been in the real estate investing business for 2 months or 20 years. We all know that we make the money in real estate when we buy, especially a commercial income producing property. Though the buying process is one of the most important components of investing, many entrepreneurs don't have a clue how to determine the true value of an income producing property or it's potential. Here are some simple tips to help you build more confidence in taking action.
Leave your emotions at home:
Many investors find a beautiful property where the seller promises the world of returns. Because of this beautiful
property they "fall in love" with and end up paying more than the true property value. The real pain begins when the property does not perform the way it was promised in that pretty picture and the deficit begins to hurt the cash flow. Investing in commercial real estate is like investing in a business. You find the true value in the income it generates vs. the costs associated with running and growing it. Don't fall in love with the property; fall in love with the numbers.
Let the seller prove it to you:
How did you arrive at that price? Don't just take the seller's word for their opinion of the property value; ask
them to prove it to you. You need to evaluate the property numbers to determine the true value, so begin by asking the seller or representative to provide you with all of the supporting evidence that proves the value of the property (financial statements, tax returns, bank statements, rent rolls etc).
Once they provide you with their case, you must always verify that the information is accurate and up to date. If
you are unsure of some of the information they give you, be honest and ask for more clarification. What you are looking for is the actual operating expenses and the actual rental income this subject property is producing.
Here are some common expenses for commercial properties.
• Insurance: Liability
• Insurance: Workers Comp
• Insurance: Property
• Legal/ Accounting
• Maintenance Labor
• Rent Discounts
• Reserves (Capital Improvements)
• License and Permits
• Property Taxes
• Management: Onsite
• Management: Offsite
• Utilities: Gas, Electric, Water & Sewer and Trash
In most cases you will not find capital reserves in the seller's numbers. This really should be addressed in your initial evaluation during your due diligence period. You should create a budget of the essential property improvements that will have to be executed over time to increase the property value. Please note that the operating expenses do not include the debt service (mortgage).
Know what ROI you want to make:
You need to decide what kind of returns you want to make as an investor. These returns can come in several ways.(Monthly Income, Tax Savings, Appreciation, Rental Increase, Mortgage Pay Down and Equity Build Up etc.) After you come up with the actual income the property is currently generating and deducting from that the anticipated expenses including your reserve budget for property improvements, you will come up with what is called the Net Operating Income (NOI).
Here is a simple formula that you can use. If you take the NOI and divide it by your potential purchase price you
will get the Capitalization Rate (Cap Rate). This rate tells you the projected annual rate of return you would receive if you would pay cash for the property. As an example, if the NOI is $100,000 and your purchase price is $1,000,000 the Cap Rate would be 10%. You can also divide your NOI by the preferred Cap Rate to determine the purchase price you would be willing to pay.
So here is the big question... What is a good Cap Rate? The answer is really up to the buyer and the ROI they desire to make. Some buyers say they want a minimum Cap Rate of 10, others at 7 and some at 12 (Many times their Cap Rates are too unrealistic in my opinion). By knowing what you want to make and creating your own criteria you will have a clearer picture when evaluating properties.
Note: Because we don't always pay cash for commercial property, we have to dig deeper on the numbers. Whenever you are using any kind of financing (debt), you will want to find what your Cash on Cash return is.
Start by calculating your debt service, subtract it from your NOI and you will have your cash flow before taxes. You can then divide that annual cash flow by the amount of capital you have invested to get a quick snapshot of your possible pre-tax annual Cash on Cash return.
Can you add value?:
At times you will find some deals that appear to be just shy of your desired returns. When this happens you
will want to take a closer look to see if the property cash flow can be increased in a short period of time. Here are some examples. If you are looking at a property that has leases $35 to $50 under market and through your due diligence you know that you could increase the rents in a short time and increase your NOI, can that become a higher Cap Rate?
What if you came back to the seller and told them that you want to close but in order to move forward the financial institution or lending source requires that the seller notify tenants of a fair market rent increase in order to get the cash flow to their satisfaction before closing. What if through your research you find that the expenses can be lowered by 25% in just a few short months because the seller was not being prudent about his or her spending?
Another factor to take into account is how much your financing will cost. Depending on the seller's situation you
may even find that the seller is willing to owner finance 15-30% of the sales price at a reasonable rate. This leverage may offer you higher returns now and over time.
Though what I have given you in this article is a simple starting point, if you don't take action and start making offers, running numbers and putting properties under contract you, will never get to the next level. There is an old saying that says "Think long and strike fast." This is how you should approach real estate investing. Think on the opportunities that you have in front of you and when the numbers work, "strike fast." If you don't feel comfortable or don't have the time to seek out these investment opportunities look to invest with buying groups. Many of our clients love working with us because all the work is done for them. They just evaluate the final numbers and if it works they invest. Regardless of which direction you want to take, when you approach investing, you must leave your emotions at home.