I have many philosophies around real estate investing, some of which I’ve expressed in my articles and Podcast here on BiggerPockets as well as my own blog. But one of the biggest is this:
How to Analyze a Real Estate Deal
Deal analysis is one of the best ways to learn real estate investing and it comes down to fundamental comfort in estimating expenses, rents, and cash flow. This guide will give you the knowledge you need to begin analyzing properties with confidence.
Extraordinary Opportunity Defined…
Obviously, the essence of that which defines the extraordinary is relative to the investment strategy and specific technique being applied. For instance, for a sub 2-er it is extraordinary in this day and age to come across an assumable mortgage. For a flipper, it is extraordinary to find $150,000 or more spread. And so on…
I am not a flipper, wholesaler, subject 2-er, or a lease-optioneer, and while I obviously recognize the above examples as indeed extraordinary circumstances worthy of taking action, in my world there many other structural elements that combine to constitute an extraordinary opportunity, which is the topic for today.
Immediately below is a bullet point outline of a few of the attributes which make a deal extraordinary in my life, followed by a brief discussion of the items on the list. This should really be an eBook, and perhaps it’ll become one some day, but in the context of this article the best I can hope to do is to skim the surface. My intention is to encourage you to see past that which is the obvious and mundane in the world of Real Estate Investing, and to shine the light on the world of creative finance, which is all about PERSPECTIVE…
Attributes of an Extraordinary Opportunity – Outline
- Multiple Exits
- Cash Flow
- CAP Rate
- Income expandability
- Expense expandability
- Expandability Through Financing
i. 100% financing
ii. Time-frame vs. Price
iii. Interest rate vs. Price
1. Multiple Exits
Don’t Lose Money – this should be every investor’s number 1 objective, and while there are many items that can be discussed relative to this, the most pertinent for me is presence of Multiple Exit Strategies. An extraordinary deal should lend itself to multiple exist possibilities. Sadly, few opportunities and strategies afford this, which is what makes this element extraordinary.
2. Cash Flow
Cash Flow is the essence of why I, a fundamental investor, buy property. I am in search of Financial Freedom, which is a function of gaining the ability to pay my bills and maintain my family’s life-style without earned income – without a job.
Can you relate?
I buy property not because I am in love with it, think it’s sexy, or because it somehow satisfies my sensibilities – not at all. I buy property because it represents passive revenue streams, which result in passive cash flow, which over time accomplishes the stated objective.
With this in mind, an acquisition can satisfy the threshold of extraordinary if the minimum requirement for monthly cash flow of $100 per door is met. Note, simply having met this requirement does not necessarily constitute an extraordinary opportunity, which is why I say can instead of using the word does – but it is a good start…
The third attribute of an extraordinary deal is Time. I don’t know if you’ve had an opportunity to meet him yet, but I am very close friends with Mr. Murphy – yep, he is alive and well indeed!
I have learned to have utmost respect toward the fact that no matter how well I plan things, something always goes wrong, and it seems to do so at the most inopportune times. Time, more than anything else, is the structural element in any transaction that is going to save your butt when things go sideways. Time will allow you to restructure, to adapt, to “find a way”.
With respect to time, therefore, an extraordinary acquisition is one that addresses to objectives:
I. Provides for unlimited time-frame of ownership, i.e. does not require the sale of the asset as part of the over-all investment strategy.
II. Not only must you be able to own it forever should you choose to or should it become necessary for any reason, but the acquisition must make equal sense 20 years in the future as it does now. Translation – don’t buy crap you wouldn’t want to own in 20 years!
4. Capitalization Rate
A lot has been said about the validity of the CAP Rate as a metric by which to analyze an investment opportunity. Still, there seems to be disagreement as to how definitive this metric is. I feel that the reason for the disagreement is due to a certain misunderstanding relative to the application of this metric…
Cap Rate is a measurement of return on investment which juxtaposes the annual NOI (Net Operating Income = Gross Income – Operating Costs aside for the cost of money) against the total cost of investment. The formula is:
CAP = NOI / Purchase Cost (Value)
Purchase Price (Value) = NOI / CAP
Thus, if you are analyzing a building which shows an NOI of $10,000, then if you are willing to deploy capital so long as you receive a 8% return, then you would be willing to pay $125,000 for the building, since the 10k of NOI represents 8% against an $125,000 purchase price. However, if you are willing to pull the trigger only if you can generate a 10% rate of return relative to the Cap Rate, then the most you’d be willing to pay for $10,000 of NOI is $100,000.
Notice that in the above example nothing changed about either the building or the financials representing this building in order to cause a 25k discrepancy in the purchase price. What changed is your expectation of the rate of return, which brings me to my next point!
The Less Obvious
While most investors seem to focus on Cap Rate as a means of setting value to a specific asset, the more important function of this metric is that it represents the behavior of the marketplace.
Think about this – if you asked 100 investors what kind of CAP they would accept to pay for a particular type of building in a specific location, and you received answers ranging from 8% to 8.5%, this would define “The Norm” for you, wouldn’t it? This would also tell you that if the building you are considering is showing an 8% Cap, then you are within that which is the norm for the marketplace; anything lower would not be good enough, and anything higher would therefore be above average.
Thus, an extraordinary deal relative to the Cap Rate would seem to involve beating the “Going Cap Rate” by whatever margin you define as an acceptable threshold. Furthermore, CAP should be given consideration relative to the purchase price, and also relative to your capacity to grow the rate through strategic management. And with this we’ve arrived at the last characteristic, or rather a batch of characteristics which combined under one subheading help define the Extraordinary in my world…
Expandability is defined in the following way – any tool, technique, term, or approach which either increases the investment return, or facilitates a transaction which otherwise would not be possible.
Expandability can be something we do during our ownership, it can be a technique we apply in structuring the transaction or during the acquisition process, or it can be a structural component of a deal such as a item in the Purchase and Sale Contract, the Promissory Note, or the Mortgage / Deed of Trust.
In that we purchase long-term holds for the income that they generate, it should be rather obvious that the value of an investment opportunity is relative to the income it generates.
Having said this, most investors prefer to focus on what I call the Present Value – value which is justifiable on day one of ownership of the investment. While this is indeed important for me as well, even more important to me are the available options for improving upon those returns and therefore creating value. In fact, I am not interested in any deal whereby I can not clearly define opportunities to improve upon the present returns. Therefore, presence of significant opportunities to do so constitutes an Extraordinary opportunity in my life!
One of the very obvious ways to improve the transaction is by improving the income, which is done in one of three ways:
- By expanding the present revenue streams associated – in essence raising rents
- Changing the character of the revenue streams – rezoning property for highest and best use
- By creating additional revenue streams – installing coin-operated laundry, adding units in attic or basement, subdividing SFR into a duplex, charging for storage and parking, etc.
Expandability on the Expense Side
Whenever I use the phrase “improving income” what I really mean is improving the NOI, which of course is a function of Gross Income less Operating Costs. Simply understood, the NOI is the spread between what the building earns and what it cost to operate (not including the cost of money).
Therefore, the opposite but equal piece to improving the revenue is to lower expenses, which increases the spread and results in higher investment returns and in the commercial space also forces appreciation. As such, presence of significant opportunities to lower the operating costs is also part of what constitutes an extraordinary deal. Anyone can plump some dough on the table to buy a perfectly-run asset. But, the real money is made in seeing the opportunities and having the know how to improve upon that which is currently there.
Expandability through Terms
While improvements to the income and expense structures of the investment certainly require management know-how and are the prerogative of the professional and seasoned investors, the next batch of ideas that I’ll be sharing with you are truly some of the most sophisticated concepts in real estate investing.
It’s Not All About the Bricks and Dirt…
You see – most investors make the grave mistake of defining value in real estate strictly as it relates to physical property, completely ignoring, to their great detriment, the fact that an awful lot of value resides within the terms of financing and the structure of the transaction.
Let’s talk about a few general concepts, and then, if my fingers don’t bleed too hard, I’ll zero in on one or two specific tools. Here are 3 simple examples to illustrate the basic perspective:
Suppose you are considering two identical buildings – they are situated adjacent to one another, identically constructed, identically laid out, and their income and expense structures are the same. However, the building on the right must be purchased utilizing traditional bank financing, necessitating that you compliance with qualification standards and a 25% cash down-payment. However, the building on the left can be financed by the seller with only 5% down…
Question – Would you be willing to pay 10% more for the building on the Left?
Answer – YES! If you assume purchase price of $120,000, then in the first example you would need to provide a $30,000 down-payment. However, even having paid $132,000 (10% premium) for the owner-financed building, your down-payment would only need to be $6,600! Which is better and more accessible?
Naturally, you’ll likely need to give up a bit of cash flow due to financing a higher amount; however, many of you who have access to $6,600 simply are unable to do $30,000 down…small piece of the pie is better than no desert!
Needless to say, all of the metrics previously discussed in this article (Multiple Exists, CF, Time, and CAP,) as well as some other ones that I haven’t touched on have to work well at the higher purchase price. But, if they do, the value of the owner-financed package is quite apparent! But – you must give the owner a reason to play ball…
Suppose we take those same two buildings again, but this time the difference in the financing package is relative to the interest rate. Suppose that in one case, you would be able to finance the building at 6% for 30-years, but in the other case you would have the option of paying an additional 20k of purchase price but financing the building at 3% over 30 years.
Question –Which would you chose?
Answer – Let’s do the numbers. The monthly payment on a $90,000 at 6% amortized over 30 years is roughly $540/month. On the other hand, $110,000 (approximately 20k more) financed at 3% over 30 years come with a payment of $464/month!
Question – which is better $540/month or $464/month on a long-term hold? I think you know the answer to this one
This next question is HUGE!
Question – do you think that having the ability to pay 20k more than your competition gives you an edge? I mean, all of your competitors are out there trying to steel each and every thing they see – that’s because it’s all they know to do. Do you think there is value to the seller in your ability and willingness to pay 20k than anyone else – from here it’s just about knowing how to negotiate, which is an eBook in the making. J
As you know by now, when it comes to financing, time-frame is very important with respect to the safety of a transaction. As you grow your portfolio, you will eventually arrive at the reality that you can no longer utilize traditional, conforming Fannie Mae/Freddie Mac mortgages and are forced to play on the commercial side.
When this happens, you’ll find out that Balloons and ARMs are the flavor of the day, month, and year – you can not avoid it. So, here is another question:
Question – Would you be willing to pay an extra 10% for the property if it allowed you to avoid a 5-year balloon payment?
Answer – You probably should, if the other metrics are still intact. There is nothing worse than having a ticking time-bomb in the form of a looming balloon payment. On a long-term investment that
you are planning to hold for many years, and which possesses all of the items of expandability, there is huge value in avoiding a balloon whenever possible. You should be willing to pay for this value – you’ll thank me later J
Before I finish, I’ve got one final question for you:
Question – do you think that may be the time has come for you stop scouring the MLS for dirt and bricks, which is what everyone else is doing, and start looking for terms instead? Terms very often transform an OK deal into an extraordinary deal, and you will NOT find terms on the MLS. I’m just saying – take it or leave it…
There is much more where this came from, but I am considerably over 3,000 words – are you still awake? I hope this gives you a bit of perspective on what is creative finance.
Allow me to leave you with this thought by the great German philosopher Arthur Schopenhour:
“Talent hits a target no one else can hit; Genius hits a target no one else can see.”
I am not suggesting that genius is a requisite condition for success in real estate investing – not at all. In fact, what makes real estate great is that you can buy one silly building, and if you buy it right you can create a better retirement for yourself by far than the Social Security check that your neighbors rely on. However, people who find lasting success in this business are indeed able to make distinctions that others can not; they are able to see things that others can not.
And the difference is – you got it – EDUCATION!
Please feel free to hit me up with your thoughts and questions below! – Good Luck!
Photo: Lucas Fox Barcelona – Ibiza