How I Analyze a Real Estate Deal, Step by Step

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All of our investments to date are single family residential – but that’s about to change.  Single family is great to get your feet wet, but the amount of time and effort involved to take it to the next level is extortionate.  So, we’re testing the waters in other arenas.  The options on the table are either buying apartment complexes (100+ units) or going commercial.  We’re running both down, but at the moment we’re excited by a package of outlots which will be auctioned by a bankruptcy trustee next week.  Since at least one or two you seem to care about what we do, I thought I would walk you through the process of how I analyze a real estate deal.

Determine Timeline

There’s no shortage of investment opportunities.  You’ve heard it before but “the deal of a lifetime comes along once a week-”  assuming you’re looking!  So we prioritize our time, and when a property is presented to us, we first determine how fast we need to act.  If it’s been on LoopNet for 4 months, we’ll stick it on the back burner no matter how appealing the numbers.

For today’s lesson in how to analyze a real estate deal, I’m going to pick just one of the properties on the block next week.

Crunch the Numbers

When I see a property in person I sometimes become…attached.  I’ve caught myself saying “Ooh I love those windows!”  and “check out the well manicured lawns, it must be a nice area!”

The trouble is our investors don’t give a flying F about any of those things.  Most of them will never even see the property – they just want a check every quarter.

Why waste my time?  I don’t visit at a deal until I get actual numbers (not just what the claimed NOI is on LoopNet).  One day, when we’ve accumulated a large cash flow base, I might consider more speculative deals, but that is not this day.

The trustee for this property provided us with very thorough numbers:

analyze a real estate deal baseline

Now when we invest, our first criteria is a 10% cash on cash return.  Since we are too short on time to line up financing, we’ll be buying this property in cash.  Thus a 10% return gives us a purchase price of $1,028,710.70 (102,871.07/.10).

That should be our maximum bid, correct?

Not just yet.

Calculate Income/Expense Discrepancy

For triple net leases (which these are) our non base rent income should offset the operational expenses (excluding management fees).  Let’s see if they do in this case.

The relevant income items are reconciliation, CAM, administrative fees, real estate taxes, and insurance.  These all add up to $8,782.05.

The corresponding expense items (CAM, real estate taxes, and insurance) add up to $12,817.36.

Something is off.  These items should have the same sum, but the expenses are mucho mas grande.  In theory, the owner should be collecting an additional $4,035.31.   I can see three potential reasons for this:

  1. The lease years don’t line up with the fiscal years, and the difference is thanks to “drift.”
  2. The leases state CAM cannot be increased more than 5% per year.  A quick jump in expenses might max this out.
  3. It’s an absentee landlord who has been doing a poor job managing the properties and didn’t collect as much as he should.  Based on other information, which I’ll come to, I think this is the most likely explanation.

If the reason is option 1 or 3 we should be able to fully recoup this discrepancy.  If it’s option 2, we’re SOL.  To keep things simple and conservative, I’m going to say we will recoup half, thus our NOI increases by $4,035.31/2 = $2,017.66.

Get On the Ground Information

Those calculations are a great starting point, but we now we need details about the property itself.  Unfortunately, I don’t live anywhere near it and time is of the essence so I can’t visit.

Side note, we did visit a number of the properties in our area last week (drove well over 10 hours).  In fact we wound up in Lima, Ohio and Ben Leybovich was good enough to meet up with us for a half hour or so.  The same crew built all of these properties and the two we saw were exact replicas of one another.  From everything I can tell, the property in question is the same.  Normally I wouldn’t dream of bidding on a property sight unseen, but I’m confident I know what to expect.

Rather than trekking there myself, I did the next best thing: I called all of the tenants in the buildings.  Yep, I plugged in the addresses, pulled the business names from the leases, and googled their numbers.  I spent about three hours on the phone today with tenants all over the country (my favorite accent was Minnesotan, or, as I like to call it, Canadian).

For this property, I got a hold of a business owner that has been a tenant for 10 years.  Here are the highlights of the conversation:

  • When he first moved into the building there was a management company in place, but the property owner fired them after a month or two.
  • In the last 10 years he has never seen the property owner.
  • The one vacant unit has a small “for lease” sign, but the phone number it shows is out of service.
  • The roof leaked and the trustee repaired it in preparation for the auction, however, there is still water damage in the walls and the back door.  The tenant is pissed off that they didn’t fix it for over a year and won’t sign another lease until they fix the damage (he’s on a month to month lease since they couldn’t come to terms).
  • The property owner didn’t properly divide the units.  The ducting and electricity are crossed/shared and need fixed.
  • There are two other strip centers very nearby which are full occupied.

Calculate Offsets

Now we’ve a bunch of information, and get to figure out how to adjust our numbers.

Mismanagement

I’m not going to do anything with the fact that this property has been mismanaged.  If I start down the path of “I could do it so much better” I become a speculator.  On this property, I think it’s true, but I don’t want to bake that into my numbers.

Fixing the property

To fix the poor division, repair the water damage, and give myself a little cushion in case the roof repair didn’t take, I’m setting aside $60,000.

Vacancy and Turnover

There is one empty unit, but let’s plan for more.  Considering the high occupancy in the area I’m chucking on a measly 5%.  That brings our estimated vacancy to 15%, which is super conservative.

Our Company’s Fee

Everyone has to make money, and we’re no exception.  Technically, we can take up to a 20% deal oversight fee, but we will cut into that at the time of auction.  I ran two scenarios, one at 10% and one at 20%.

Wrap It Up: The Final Tally as We Analyze a Real Estate Deal

What do we get when we add all that together?

analyze a real estate deal with adjustments

 

So, if we take a 10% payout, we are willing to bid ~$840k.

Keep in mind this is one of many units being auctioned.  Our true maximum will be determined by the auction order and how much capital we have already invested.  If this is the first property on the block or we’re low on funds, we’ll want closer to that 20% number.  If it’s the last one of the day and we’ve not bought anything, we’ll start bumping up on the 10% payout.

I’ll let you know how it goes!

If you folks like this type of article, give me a heads up.  There is no shortage of “analyze a real estate deal” material.

As you probably figured out, I spend a lot of time exploring numerous aspects of real estate (check out my personal blog or other posts on BiggerPockets if you don’t believe me).  If you have a burning desire to have me analyze some real estate related topic, throw me a comment or a tweet!

Photo: Peter Jensen

About Author

Kenneth Estes

During Kenny's decade in finance he bought many single family rentals in rural areas, as a hobby. Along the way, he talked some brave souls into joining him as investors and recently retired from finance to take his hobby to the next level. Find more by and about Kenny on his personal blog and his recently created twitter account!

22 Comments

  1. Kenny, another great article, thank you! I found it interesting how your efforts to track down the tenants gave you valuable information you wouldn’t have otherwise known allowing you to determine a more accurate / comfortable bid range.

    • Kenneth Estes

      Technically it’s cash.

      In reality we invest it all back into the company (same as any other investor). Any money above and beyond what my wife and I need to survive get’s invested at an 80/20 ratio, 80% into the fund, 20% into other (stocks at the moment).

      Cheers,

      Kenny

  2. Deal analysis is by far my favorite topic on BP – please do, do more!

    On the Final Tally, I’m a little confused on the vacancy offset – it doesn’t seem to have been applied correctly, or am I misunderstanding how that works? Thanks!

  3. Kenny
    Great job.
    We use Rules of thumb. 50 units 45-60% depending on how they handle utilities. ON larger properties 15%+ vacancy the property is considered unstable funding is bridge financing which cost more until its stable.
    Best practice go to IREM.org search for ARM certified for <50 units CPM certified ask them what they see expenses per category per unit for a property that size and what they see them selling for per unit. In addition what sections of the city they like and dislike and why.

    There are 2 rules in Real Estate Investing rule #1 is you never fall in love with the property you fall in love with the numbers. Rule #2 NEVER forget rule #1.

    IMHO Owners or brokers over-report income and under-report expenses. Numbers don't lie, people do!

    Paul
    Paul

  4. Good article.
    I like the analysis and explanations.

    One thing that I liked a lot was when you talked about your investors and how they don’t really care what the lawn and windows look like.
    It highlights what I think is most investors unhealthy obsession of actually seeing a property before they offer on it. Personally there are few things in this world that I hate more than wasting my time looking at a property that I don’t buy.
    Now I have never CLOSED on a property before seeing it, and generally will see it before I have a contract on it (The few times I get an acceptance rather than a reasonable counter, that is a drop everything kind of day…) but rarely waste time looking at it in person just to put in an offer.
    I do realize that due diligence for an auction needs to be a little different.

  5. Great article!
    A lot of new terms for me to look up and ponder. I too would like to see more articles about how and why of analyzing property (investment). If at all possible a sfh, so I can compare to how I do it. Thanks again for helping me out with the knowledge and wisdom you deliver.

    Steve

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