In a Comparative Market Analysis, adjustments to comparable property oftentimes are made to reflect the motivations of a delineated market area’s typical buyer and seller.  Adjustments for conditions of sale reflect the motivations of buyers and sellers when they are not typically motivated and purchases do not reflect arm’s-length transactions.

ADJUST FOR SALES BETWEEN RELATIVES/FRIENDS

Family members often sell houses to relatives at prices other than market value depending on the relative financial strength of the buyer and the seller.  It is often difficult to ascertain motivations without interviews.  For example, parents may sell property at lower prices to help children purchase property, or children may attach greater importance (sentimental value) on property and pay higher than market value for them.  Oftentimes, property will be sold to relatives for tax considerations and estate planning.

ADJUST FOR DIFFERENT FINANCIAL GOALS

Developers who believe that value can be increased through plottage resulting from greater utility of a larger site may pay more than market value for lots needed in a site assemblage.  A seller might be under financial duress and require capital immediately, which will result in a quick sale at lower than market value.

ADJUST FOR TAX CONSIDERATIONS

There are instances where a sale occurs that is at arm’s-length but still requires adjustments for conditions of sale due to lack of exposure on the open market, unusual tax considerations, and eminent domain.  With a new administration in the White House, tax policies will likely shift.  Changes in capital gains tax, income tax level, and even positions in the security market will often influence investors to reallocate assets when assessing their financial situation from an overall portfolio context.  Investigation as to whether adjustments can be made, supported by market evidence need to be made.  Sometimes, comparables have to be thrown out or used only as secondary support data.

Photo Credit: woodleywonderworks

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Tags: CMA, Comparative Market Analysis, property analysis, property valuation

Due diligence is a term used for a number of concepts involving either the performance of an investigation of a business or person, or the performance of an act with a certain standard of care. It can be a legal obligation, but the term will more commonly apply to voluntary investigations. A common example of due diligence in various industries is, the process through which a potential acquirer evaluates a target company or its assets for acquisition. – From Wikipedia

It is important to not only know what due diligence is, but how everyday investors make it work in their favor when buying a home. Proper homework can not only eliminate some of the risk when buying, but it can also lead to a better return on your real estate investment. An article is not enough to outline the various forms of due diligence one could perform on a real estate transaction. However, here are five simple but important steps to take when buying a rental or investment property:

1. Neighborhood - Once you have identified a property, go find a map of the area and draw a 5 mile radius circle around the home. Look closely at the circle for parks, schools, freeways, and amenities. Also drive the streets of the neighborhoods looking for indications on whether this area is on the way up or down in terms of condition and crime. Your rental is an asset that you want to appreciate, so having a good idea of the surrounding area can help make a good decision.
2. Crime - Most metropolitan police departments either have web sites or information they can give on a particular area. High crime areas are not only difficult to rent to your ideal tenant, but are nearly impossible to sell at a premium.
3. Internet - Utilizing the websites like Zillow, Google Maps, and state and local websites can give you insight into the property from a number of perspectives. Zillow can show estimated values, recent properties sold and an area map. Google maps can give you a satellite view which allows for a close look of the neighborhood. Identifying freeway access, parks, golf courses and schools are all future marketing elements used to sell your investment.
4. Appraisal & Inspection – The value and condition of your potential property is critical to future appreciation. Investors should structure their purchase contracts to allow proper valuation and inspection of the property. Once the reports are done carefully, walk through each report with someone that understands them better than you. Even seasoned investors should have someone they trust to thoroughly walk through each report. Remember different regions and neighborhoods require local expertise.
5. Market Analysis of Rental Market – Even if cash flow is not your reason for investing, investors should analyze whether they are going to be able to cash flow the property. I have seen a number of fix and flip projects fail because of market changes and the investors could not carry the negative cash flow long term. Remember, positive cash flow can survive all market cycles. Most lenders require both Single Family Comparable Rent Schedule (Fannie Mae Form 1007) and Operating Income Statement (Fannie Mae Form 216) when funding a property with conventional financing. Your Realtor should be able to complete an analysis of the rental market using the regional MLS. Also look at Craigslist and local newspaper classifieds.

There is no way to sugarcoat due diligence; it is hard work. But it is also a way to increase your knowledge and become an expert on the property you are about to purchase.

Tags: appraisal, crime, inspection, investment property, property analysis, real estate, real estate investing

Determining the value of an apartment building investment is one of the greatest difficulties that many new commercial real estate investors face.

Most people who invest in apartments have some experience investing in other types of real estate, typically residential homes or duplexes and triplexes. The issue that new investors face is the fact that apartment buildings are valued by different methods than residential real estate. In fact, it is usually quite easy to find the fair value of residential estate using a comparative sales approach. The comparative sales approach simply uses the existing sales prices of similar residential properties in that particular area and determines value based on an average sales price of comparable properties. This should be very straight forward.

However, commercial real estate investors and appraisers use a variety of appraisal methods to determine the fair market value of an apartment building. These new methods should not deter the new investor because once they are understood they actually will help tremendously to locate the best apartment building for acquisition.

The first unfamiliar term that a new apartment building buyer will encounter is the capitalization rate or CAP rate for short.
As the new investor is searching for an apartment building his Realtor will supply him the CAP rate of the property. The CAP rate is a measure of the income produced by an apartment building divided by the cost of the building. For example: if an apartment building is purchased for the price of $1,000,000.00 and the property produced an annual net operating income of $100,000.00 the CAP rate of the property is 10%. (Net operating income is gross rents minus expenses.)

Net Operating Income:  $100,000.00
Purchase Price:        $1,000,000.00

CAP rate =                    10%

An investor can also use the CAP rate to determine the maximum price he can pay for a property when he knows what the net operating income is.

For example, if the investor is looking at an apartment building that is seeing a net operating income of $150,000.00 and he wants to see a CAP rate of 11% he can determine the maximum purchase price as follows:

Net Operating Income:  $150,000.00
CAP Rate:               11%

Maximum purchase price:  $1,363.636.00

This simple formula to devise the capitalization rate (CAP rate) of an apartment building is limited however. The simple CAP rate assumes that the investor will be purchasing the property for cash and does not take into account the financing terms that will affect the investor’s rate of return on the building. In other words the simple CAP rate is good number to use when comparing apartment buildings as potential investments but a little bit more analysis is necessary to determine exactly what the true rate of return will be on a particular building when using financing to purchase the property.

The goal for the individual investor is to determine what the property is worth to him or her. In other words, the investor should only be concerned with paying a price for the property that allows him to realize his sought after rate of return. The best way that I have found to determine the investment value of an apartment building is to use the “Band of Equity Investment Method”. The “Band of Equity Investment Method” of determining value will tell you the maximum price that you can pay for your apartment building and still realize the rate of return that you are looking for. The greatest advantage of this valuation formula is that it takes into consideration the terms of financing that the investor is using to purchase the property. Thankfully, this method is not that complicated and it merely requires that you know some financial information about the property and the terms of the financing that you will using.

Here is how the “Band of Equity Investment Method” is figured:

Mortgage: 	Loan To Value of Mortgage  X  Mortgage Constant =  ______

Property: 	Down Payment on Property (as a percentage)
                                 X  Desired Rate of Return   =_______

Mortgage:        80% (.80)  X  7.99% (.0799) = 0.06
    +
Equity:          20% (.20)  X  11% (.11) = 0.02

Cap Rate:        0.08 = 8.0%

With this new “derived” CAP rate you can now determine your maximum purchase price for any apartment building and ensure that you will be realizing at least an 11% rate of return on your investment. For example, you are out looking at 14 unit apartment building with your realtor and he tells you that the net operating is $150,000.00. You know that your bank will give you a 30 year loan at an interest rate of 7.99%. You know that you need to see at least an 11% return on your investment. You simply divide $150,000.00 by your derived CAP rate of 8% and you get the price of $1,875,000.00. You know that you can purchase the building with a 20% down payment and a 30 year loan at 7.99% and still realize a net return of 11% on your investment.

Tags: apartment builting, apartment investing, cap rate, Commercial Real Estate, derived CAP rate, landlord, property analysis

I was having a conversation with someone that had absolutely nothing to do with investing. The conversation was about a different business but he was talking about how difficult it was to work with people who were always trying to cut corners. People often think that they know better than the experts do, or that they can build a better mousetrap by doing things their way. Instead of using methods that were tried and true they were always trying to “trick the deal”. In the end it never worked but only served to make things more difficult.

I thought about what he said and how it applied to real estate. Real estate investing is very much a numbers game. We deal with situations and people and associated problems but, in the end, it comes down to the numbers. A property either has equity or it doesn’t, it either has positive cash flow or it doesn’t. No matter how you manipulate the numbers, at the end of the day your bank account will tell you the truth. As they say, a deal either “pencils out” or it doesn’t.

Numbers Don’t Lie

While even veteran investors can sometimes fall prey to it, it is usually the novice investor who will fool himself into thinking that he has a deal by using the numbers improperly. He may see a property that he likes and play games to convince himself that he has a winner. He may do this by underestimating the cost involved to acquire the investment or by underestimating the amount of work that the house needs. It can also happen by being overly optimistic about the price that can be achieved when flipping, or how long it will take to complete a sale.

Perhaps the biggest cases of self-deception come with rental properties. Sellers and agents alike are quick to claim that a property provides a positive cash flow and the novice buyers are all too eager to believe it.

It is so easy to fudge the numbers on rental properties that it is imperative to dig as deep as possible to verify their accuracy. A vacancy factor of 5% is typically used, but is that appropriate? A factor of 5% means that a unit will be vacant for 30 days once every 20 months, do the tenants stay that long? How easy is it to get the unit cleaned and rented in only 30 days? Perhaps a 10% vacancy factor or even higher would be a better bet. Another number that is often overlooked is maintenance, can you really expect that no maintenance will be needed? Property management is often ignored because the investor intends to manage the property as well. Does that mean that the expense should be ignored? What if a manager is needed down the road? Should an investor really work for free by managing his own properties without getting paid? That’s what it amounts to if you ignore the fee. What about accounting, legal and other administrative expenses? These costs are real even if you choose to ignore them.

Novice investors tend to accept the numbers presented to them at face value. They will also look to real estate agents for advice. If the agent is a real estate investor as well and truly has the best interest of the investor at heart that may be fine. However most real estate agents have never owned an investment property and only know what they have been taught. Remember that an agent only gets paid if he makes a sale. For a property to have positive cash flow it must cover all of the expenses not just the mortgage.

What it comes down to is honesty. Not the honesty of the seller or the agent or the appraiser or home inspector or anyone else involved in the deal. It is all about the investor being honest with himself. Do not try to make the numbers work because you are eager to do a deal or because you’re frustrated with not being able to find something that works. If you do convince yourself to do a bad deal you will pay the price in the end. Although you “can’t trick the deal”, you can trick yourself.

“Trust, but verify.” – Ronald Reagan

Tags: cash-flow, property analysis, real estate investing, real-estate-deals