Understanding the investment property market
Real estate investment is a fantastic way to build wealth. As an investor, and as a Realtor helping owners buy and sell properties, we’ve had a front row seat on how the process works, and how successful investors succeed.
We aren’t wanting this to be about spitting out investment principles out like they so often are. For one, there’s already 10,000 sites that state investment formulas with certainty. The problem is that ‘for sale’ properties usually don’t jump out as being outstanding performers upon analysis. After all, why would they? What investor is likely to take a property that his performing optimally, making lots of money, low expenses, no repairs needed and sell it so someone else can make all the profits on their work and costs?
Real estate is fluid, so developing an understanding of what we call the ‘ownership cycle’ of property as well as the regular market cycle (buyer’s market and seller’s market) is important for anyone looking to invest. This is a factor that seems to be left out when most real estate investment guru’s are teaching. Here are the key points to consider when buying any real estate investment:
1. Investors that are actively selling are usually burnt out!
The most commonly used analysis is the Capitalization Rate (known as Cap Rate=Net Operating ÷ Cost of Property). A great property has a cap rate of 10-15%, not so great would be less than 7%. Its rare for a property being sold to already be in the ideal range using this simple formula. Why? Burnout. Unlike owner occupied homes, the typical landlord doesn’t sell on a whim and isn’t usually as motivated to sell as homeowners. Landlords rarely invest a lot of money getting their properties ready like homeowners do. They’re pretty much done, but being done doesn’t mean they’re going to take a lousy offer. “We don’t have to sell,” we’re frequently told when offers come in that aren’t good enough. Landlords usually only sell if the deal makes financial sense to them. Having said that, they often times have lost interest in being landlords and have stopped improving the properties, or at least haven’t upgraded them to attract higher rents. Because the financial numbers still make sense for them, burnt out landlords aren’t as likely to risk loosing a tenant by raising rent. We’ve been told thousands of times by realtors selling properties, “rents could be a lot higher…” We’ve also seen lots of scenarios where tenants were frustrated about matters that could be easily rectified after the sale.
2. Cap Rates vary based upon value, which can be negotiated.
Many novice investors get ‘analysis paralysis’ because their investment metrics don’t usually line up perfectly. The thought they have is that better properties will come, but usually they don’t. Even if they do, there are trade offs. The property with great cap rates sometimes indicate a property that hasn’t kept up with a responsible building maintenance in recent years.
What is usually needed is a change of perspective, starting with an understanding of point 1 above. If the cap rate of a property of interest is 8%, but the buyer wants it to be 10%, drop the price, and you’re in!! Getting the seller to agree may not happen, but view the property as an opportunity (like a gold mine) and dig a little deeper. Have a CPA familiar with real estate investment analyze the pro forma numbers. Can depreciation be increased? Were capital improvements made that weigh down the expenses? Have any rental fees been left off the analysis like pet rents? Can a more affordable hazard insurance policy be implemented? Could a rents be bumped up? Often times there are plenty of things a new owner can do to improve profitability. One landlord shared with me that he asked the tenants of a building he was considering, what updates would they like to see? After the sale, he approached them and gave them news about the updates AND a slight rent increase. In their minds, the increase was warranted by the improvements they really wanted!
3. Rely on Experience – Up close and personal
When I began my career in real estate investing, I read books and took classes, but one of the best sources of information was my local real estate investor association (REIA) and landlords club. Meetings weren’t devoid of a any profit motive, as there were more classes, conventions and products presented, but being there with other, like minded investors and talking to them about their business was powerful. Meeting landlords with decades of experience was like visiting my grandparents and getting reassurance that my efforts would pay off. They weren’t the “experts” selling videos or online training packages for hundreds of dollars. They were sharing their wisdom simply to be helpful. Regarding the media gurus:, I often wonder if newbie investors included all the unneccessary books, dvd’s and training programs as a part of their investment balance sheets, would they justify themselves then?
4. Always Consider Potential
Well maintained properties always hold their value better than those that are in rough shape . Properties that are occupied tend to be in better shape than those that are vacant. For whatever reason though, when buying, investors seem to get excited by the lowest value properties. The cost / benefit may be worth it, but in order to be a good investor that has to be explored. Just assuming that the property is a good buy because it is cheap or the numbers fit a good formula is flawed logic. The simple formula [cost + upgrades]-holding costs > updated market value should be used. Updated market value is what the property will be worth after upgrades and is usually based on what comparable properties are selling for, or possibly what projected rents will be. Digging into how similar properties perform that have the important updates can be done by searching rents online, and getting a before and after CMA (market analysis) from your Realtor can help too. The main thing regarding investments is that any successful investor is going to THOUGHROULY ANALYZE each aspect of the opportunity before taking the plunge. This analysis should be expected in every purchase, because to point 1, 2, and 3 above, people usually aren’t selling properties when they’re on a winning streak. It will be up to the new owner to assess the property based upon its ability to generate equity and profit AFTER its problems are fixed.
5. Watch Out for projected or estimated financials
Lastly, we see it often in the real estate sales process, when a landlord gives the buyer a financial statement on the property and the numbers aren’t real. VERIFY! VERIFY! VERIFY! We frequently see landlords try to sneak in what the tenant previously paid on a unit that is now vacant is being used. This could lead to trouble if the unit is substantially older and less maintained, and therefore wouldn’t fetch the same rent. Another common situation is the opposite, if apartments are newly updated but still vacant. The seller projects what rents and expenses are without any hard facts. To me, this should be considered fraud, but it happens all the time.