# Category: articles

## 5 Mistakes Every Real Estate Investor Should Avoid

In my nearly 30 years of providing analysis software to real estate investors, and almost a decade of writing books and teaching real estate finance at Columbia University, I’ve had the opportunity to talk with thousands of people who were analyzing potential real estate investments. Some of these people were seasoned professionals, many were beginners or students, but just about all were highly motivated to analyze their deals to gain the maximum advantage.

I’ve seen some tremendous creativity in their analyses, but I’ve also seen some huge missteps. Here are some of the pitfalls you will want to be sure to avoid.

1. The Formula That Doesn’t Compute

If you are attempting any kind of financial analysis, then a full-featured spreadsheet program like Excel is almost certainly your tool of choice. You might opt for professionally built models, like my company’s RealData software, or you could attempt to construct your own.

• One of the most common problems I see in do-it-yourself models is the basic formula error. A robust financial analysis involves the interaction of many elements, and it is really easy to make any of several errors that are hard to detect. The simplest of these is an incorrect reference.  You entered your purchase price in cell C12 and meant to refer to it in a formula, but you typed C11 in that formula by mistake. You may (or perhaps may not) notice that your evaluation of the property doesn’t look right, but it can be difficult for you to find the source of the problem.
• You used to have a formula in a particular cell, but you accidentally overwrote that formula by typing a number in its place. The calculation is gone from the current analysis, and if you re-use the model, you’ll always be using that number you typed in, not the calculated value you expect.
• Cutting and pasting numbers seems innocent enough, but it can scramble your model’s logic by displacing references. Simple rule: Never cut and paste in a spreadsheet.
• Perhaps the most insidious is the formula that doesn’t do what you thought it did. Let’s say you have three values that you enter in cells A1, B1, and C1. You want to write a formula that adds the first two numbers and divides the result by the third. It’s easy to say this in plain English: “I want A1 plus B1, divided by C1.” So you write the formula as =A1+B1/C1. Wrong. Division and multiplication take precedence, so the division happens first and that result gets added to A1. Not what you expected. The formula that does what you intended would be =(A1+B1)/C1, where the sum of A1 and B1 is treated as a single value, divided by C1.

2. The Modern Art Syndrome

Even if you get all of your formulas correct, your job is only half done. I harangue my grad students constantly with this pearl of wisdom: Sometimes you create a pro forma analysis of a property strictly for your own interest. You will never show it to anyone else. Most of the time, however, successful completion of a real estate investment deal means you have to “sell” your point of view to one or more third parties:

• You may be the buyer, trying to convince the seller that your offer is reasonable;
• You may need to convince the lender that the deal should be financed; or
• You may need to show an equity partner that his or her participation would be profitable.

Most of the homebrew presentations that I see look to me like a Jackson Pollock painting with numbers superimposed. The layout usually has a logic that I can’t discern, and I find myself hunting for the key pieces of information that the presenter should have designed to jump off the page.

The layout needs to be orderly and logical: revenue before expenses and both before debt service.

Labels need to be unambiguous:

• If you mention capital expenditures, are they actual costs or reserves for replacement?
• Is the debt service amortized or interest only?
• When you label a number as “Price,” are you talking about the stated asking price, or your presumed offer? Be clear.

Lenders and experienced equity investors will be looking for several key pieces of information before they scrutinize the entire pro forma, items like Net Operating Income, Debt Coverage Ratio, Cash Flow and Internal Rate of Return.  If these items don’t stand out, or if the presentation is disorganized, you might as well add a cover page that says, “ I’m Just an Amateur Who Probably Can’t Pull This Deal Off.”

3. Errors, We Get Errors, Stack and Stacks of Errors

You may be too young to know Perry Como’s theme song (by the way, it was “letters,” not “errors”), but the tune goes through my head when I look at some investors’ spreadsheets.

• The #NUM error can appear when you try to perform a mathematically impossible calculation, like division by zero, or also when attempting an IRR calculation that can’t resolve.
• #VALUE usually occurs when you type something non-numeric (and that can include a blank space, letters, punctuation, etc.) into a numeric data-entry cell. If there are formulas in your model that are trying to perform some kind of math using the contents of that cell, those formulas will fail. In other words, if you try to multiply a number times a plain-text word, you’re violating a law of nature and Excel is going to call down a serious punishment on your head, a sort of high-tech scarlet letter.

It can get really ugly really fast because every calculation that refers to the cell with the first #NUM or #VALUE will also display the error message, so the problem tends to cascade throughout the entire model. Unfortunately, I often see investors who then go right ahead and print out their reports with these errors displayed and deliver the reports to clients or lenders.

Your objective in giving a report to a third party is typically to try to convince the recipient to accept your point of view. You will not accomplish that if your report has uncorrected errors.

4. What’s Wrong with This Picture?

It’s the errors you overlook – the ones that don’t have nice, big, upper-case alerts like #VALUE – that can cause the greatest mischief of all; and these can be troublesome even if the analysis is for your eyes only.

It may be an unwanted and unintended side effect of the computer age that we tend to accept calculated reports at face value. Be honest: How often do you sit at a restaurant with a calculator and verify the addition on your dinner check?

This presumption of accuracy can be dangerous when you are evaluating a big-ticket item like a potential real estate investment. As I discussed earlier, you could have bogus formulas that give you inaccurate results. But even if you use a professionally created tool like RealData’s Real Estate Investment Analysis software, you are still not immune to the classic “garbage in, garbage out” syndrome.

The mistake that I see far too often is a failure to apply common sense. For example:

• “Gee, this investment looks like it will have a 175% Internal Rate of Return. Looks good to me.”  (Reality: You entered the purchase price as \$1,000,000 instead of \$10,000,000. You should have been saying to yourself, 175% can’t be right; what did I do wrong?)
• “Wow, this property shows a terrific cash flow.” (Reality: You entered the mortgage interest rate as 0.07% instead of 7%.) Again, results outside the norm, either much better or much worse than you would reasonably expect, are your tip-off that a mistake is lurking somewhere. It is essential that you develop the habit of examining every financial work-up – those you create, and also those that are presented to you – very closely to see if the calculations appear reasonable.

5. What You Don’t Know CAN Hurt You

The final item in our list of big-time mistakes goes beyond the mechanics of spreadsheets and formulas and into the realm of fundamentals. You can be the most proficient creator of spreadsheet models on the planet, but if you don’t really understand the essential financial concepts that underlie real estate investment analysis, then you will neither be able to create nor interpret an analysis of such property.

The examples that I’ve seen are numerous – I can’t possibly list more than a few here – but they all revolve around the same issue:  A lack of understanding of basic financial concepts as they apply to real estate.  Some of the most important:

• Net Operating Income – This is a key real estate metric, and calculating it incorrectly can play havoc with your estimation of a property’s value. Basically, NOI is Gross Operating Income less the sum of all operating expenses, but I have frequently seen all kinds of things subtracted when they should not be. These have included mortgage interest or the entire annual debt service, depreciation, loan points, closing costs, capital improvements, reserves for replacement, and leasing commissions. None of these items belongs in the NOI calculation.
• Cash flow – I have seen NOI incorrectly labeled as “cash flow,” and have seen cash flow miscalculated with depreciation, a non-cash item, subtracted.
• Capitalization rate – Cap rate is another key real estate metric and is the ratio of NOI to value. Unfortunately, I’ve encountered some folks who have used cash flow instead of NOI when attempting to figure the cap rate and have ended up with a completely erroneous result – not only for the cap rate itself, but then also for the value of the property.

Clearly, there are two vital problems with these kinds of basic errors. First, is that they completely derail any meaningful analysis. If your NOI is not really the correct NOI and your cap rate is not really the correct cap rate, then nothing else about your evaluation of the property can possibly be correct. And second, if you give this misinformation to a well-informed investor or lender, your credibility will evaporate.

The Bottom Line

What is our take-away from these five disasters waiting to happen? You could avoid many of these errors by using the best, professionally developed analysis models – but then, of course, you would expect me to say that because that’s what we do for a living.

Let me suggest three other important steps you can take:

• Understand that there is no substitute for careful scrutiny of any financial presentation, whether it is someone else’s or your own. Be diligent always and  apply the test of reasonableness.
• Recognize that any real estate analysis you create is likely to be a representation to a third party of the quality of your thinking and professional competence. You wouldn’t be careless or casual with a resume; you should give the same care to your real estate presentations.
• Finally, recognize that you need to make a commitment to mastering the fundamental concepts and vocabulary of real estate investing. There is no substitute for knowledge.

####

## For Real Estate Investors: A Lesson in Clarity

Recently, I was conducting the last class in my course on real estate investment analysis that I teach in Columbia’s MSRED program.  I had assigned my 55 students a series of case studies (much like those in my book, Mastering Real Estate Investment) and told them to build financial pro forms and discuss the reasoning behind their analyses. After reading and commenting on all those analyses, I felt there was one overarching theme on which I wanted to focus my final remarks to the troops: The theme was “clarity.”

Trying to reduce a course to a single word might seem unrealistic (because it is), but I really had more than one angle on the notion of clarity in mind. Even combined, those notions would not replace the real content of a course in investment analysis, but they might express some essential principles that are sine qua non — “without which, nothing” — for investors.

Before you fire up your spreadsheet program or sharpen your pencil, you need to be very clear about your objective (or objectives) in analyzing the property. For example:

• Are you a potential buyer, trying to establish a reasonable offer on a particular property?
• Are you seller or broker trying to justify your asking price?
• Are you a buyer or broker, trying to demonstrate to a seller that his or her price and terms would not be acceptable to a reasonable and prudent investor?
• Are you seeking financing, or refinancing and need to demonstrate to a lender that this loan will meet their underwriting expectations?
• Are you assembling a partnership and trying to show potential equity investors that this deal will make economic sense to them?

You are not trying to create alternate realities, but you might be harboring more than one objective in a given situation. For example, for your private use you might want to look at a range of possible offers by creating best-case, worst-case and in-between scenarios; but in making a presentation to the seller, you would surely not begin by volunteering what you believe to be the highest price at which the investment might have a chance of success.

In making a presentation to a lender, your focus must be to ensure that your presentation includes items like debt coverage ratio, allowance for possible vacancy, and projected cash flows — items that will have an immediate impact on an underwriting decision. For equity partners, you want to be sure that you can demonstrate not only that the property itself makes sense, but that the particular investor, considering allocations and preferred return, can expect an acceptable rate of return on cash invested.

You are typically trying either to make a personal decision about a property or to “sell” your point of view to a third party. Being clear in your own mind about the purpose of your pro forma allows you to focus on how you analyze the property and what information is of greatest importance to your intended audience.

Real estate, like most businesses and professions, has its own language – terms that carry very specific meaning. The misuse of real estate investment terminology can have several possible consequences, all of them bad.

• You can substantially skew the results of an analysis by not being clear in your understanding of important terms. Some of the more egregious examples I have seen include:
• Not understanding the real-estate-specific definitions of terms like “operating expense” and “Net Operating Income.”  I have often seen investors try to include mortgage payments, capital improvements, or reserves for replacement as operating expenses. This mistake can drastically affect your estimate of a property’s worth.
•  Not understanding an important term like “capitalization rate.” I have seen investors try to estimate value by applying a cap rate to the property’s cash flow instead of its Net Operating Income. Big mistake.
• You can bring a dialog or negotiation to a grinding halt by being unclear and offhand in your use of what should be unambiguous terms.  Yes, “price” is a legitimate English word. But if you use it as part of an analysis or presentation, you will leave your reader stumped.  Do you mean the seller’s asking price, the buyer’s offered price, the actual closed selling price?  You can tell me that a building has 20,000 square feet, but do you mean usable square feet or rentable square feet?  It makes a difference.
• You can establish your identity as a rank amateur. Nothing will earn you a sandwich board with the word “newbie” on it quicker than misusing terms or lapsing into incomprehensibly vague language. Credibility matters — just ask your lender or your equity partners.  Be clear. Be precise.

Be Clear When You Build Your Pro Forma or Presentation

If you insist on being a do-it-yourselfer, and you plan to give your pro forma or presentation to a third party, keep in mind that nothing will unsell your argument faster than a jumbled pile of numbers.  Your information should flow and be segmented in a logical order (e.g., don’t show someone the income after the expenses, or the debt service after the cash flows). The reader should be able to apprehend the key metrics with a quick scan of the page, then go back and fill in the details. If your report turns  into a scavenger hunt for vital information, then you will fail to deliver your message. No loan, no partner, no deal.

Your success as a real estate investor requires serious number crunching, but it doesn’t stop there. You must be able to convey your analysis of a property in terms that are unambiguous, accurate, and relevant to your audience. Clarity is what you need.

–Frank Gallinelli

Get some clarity, as well as accurate calculations and industry-standard reports. Use RealData’s Real Estate Investment Analysis, a market leader for almost 30 years, to run your numbers and create your presentations.

## Social Media is Everywhere — Now RealData is in the Game

Finally!  RealData’s on Facebook. Our goal is to make this a hub for networking with our customers and colleagues, and with readers of my books — and for them to network with each other. Find us at facebook.com/realdata You can also follow me — Frank Gallinelli — on LinkedIn at linkedin.com/in/frankgallinelli and Twitter at twitter.com/fgallinelli

Facebook will be the place where you’ll find most of our educational articles and videos  (note the tabs on the left of our Facebook page). In coming weeks and months, you’ll also find free admission to webinars, special promo codes, ebooks, other educational materials, and more. But only on our Facebook page, so please be sure to check in often.

Allow me to start the conversation with a question: What resources or content would you like to see on Facebook — things that will help you become a more successful real estate investor?

## Help Us to Help Toys for Tots

The bad economy — and particularly the unemployment crisis — have taken a real toll on many American families. During the holidays, it’s especially tough on families with children. Recently I was delivering a toy to a local charity, thinking about the smile that I hoped would come over that child’s face, and wishing I could multiply that smile many times over. Grandpas have a tendency to get like that.

My plan is very modest, and won’t cure the world’s financial ills, but I hope you will help: I will take 50% of the proceeds of our December 7, 8, and 9 RealData software sales and send that money to the charity run by the U.S. Marines, “Toys for Tots.”

So, if you were thinking about buying one of our programs next week or next month or next quarter, I urge you to do it instead during these three days — December 7-9. You’ll get the powerful software you need, and we’ll send “Toys for Tots” half of what you paid us. You’ll be helping yourself make better investment decisions with our software, but perhaps equally important I believe you’ll help us do something good for a  worthy cause — and maybe together we can put smiles on a lot of kids’ faces.

Thank you, and wishing you peace during this holiday season and beyond,

Frank Gallinelli

President, RealData, Inc.
www.realdata.com

## MIRR — How It Works

From our experience, it appears that Internal Rate of Return (IRR) is the metric of choice for many, if not most, real estate investors. However, you may be aware that there are a few issues with IRR that can cause you some vexation: If you expect a negative cash flow at some point in the future, then the IRR computation may simply fail to come up with a unique result; and with your positive cash flows, IRR may be a bit too optimistic about the rate at which you can reinvest them.

For these reasons, a variation on IRR, called Modified Internal Rate of Return (MIRR), can be very important. When you see how it works, then you’ll also see that it gives you the opportunity to deal with IRR’s shortcomings.

Our support folks have had a number of calls from users of our Real Estate Investment Analysis software asking for guidance in using and understanding MIRR. How does it work, and how do I choose the “safe” and “reinvestment” rates that it asks for?

safe rate The interest rate obtainable from relatively risk-free investments, such as U.S. Government Treasury Bonds.” source: The Complete Real Estate Encyclopedia by Denise L. Evans, JD & O. William Evans, JD; 2007, McGraw-Hill (btw, this is an excellent reference book)

reinvestment rate When analyzing the value of an income producing property, it is the rate an investor is assumed to be able to earn on intermediate cash flows. …” Ibid

There is an alternative name sometimes used for the safe rate — “finance rate” — and the rather opaque definition given in the Excel help for MIRR doesn’t seem particularly helpful: “…the interest rate you pay on the money used in the cash flows.” Frankly, I’m not sure I understand what that is supposed to mean, but I believe if you focus on the term “safe rate,” you will be able to follow this discussion easily. The reinvestment rate also sports an alias — “risk rate” — which seems clear enough, but I believe again that you will find it easier to stick with the more common term, “reinvestment.”

Let’s begin with the safe rate and pose the question, “Why and when does the safe rate come into play?” The answer has to do with negative cash flows. Usually, you expect an investment to put cash into your pocket (positive cash flow), but sometimes it pulls money out of your pocket instead (negative cash flow). In real life, you can’t leave a negative cash flow sitting there and just move on to the next year. The property has to pay its bills, so you as the investor have to pick up the tab. In other words, you have to make an additional cash investment in the property. Herein lies the key.

## Five More Rules of Thumb for Real Estate Investors

In a previous article – Six Rules of Thumb for Every Real Estate Investor – I offered some guidance that might reasonably be held dear by every income-property investor. Woe to him or to her who doesn’t take a property’s vital signs, such as Debt Coverage Ratio, Loan-to-Value, or Cap Rate, to heart before making an investment decision.

Hidden below these very objective measures, however, is a sub-stratum of more subjective issues to consider when you invest. It would be a stretch to suggest that these considerations apply to every investor or to every situation. Your mileage may vary. Still, these are issues that should be worthy of your attention whenever you invest in real estate.

#### Small Property or Large?

By “small” and “large” I am referring to the number of rental units, not to the physical size of the property. I often hear from people who are investing in real estate for the first time and are choosing to buy a single-family home to use as a rental property. I suspect that these folks have not taken a pencil to paper (or even better, used one of RealData’s investment analysis programs) to see if they could reasonably expect to enjoy a positive cash flow from that property.

Although it’s possible to get a good cash flow from a one-family house, it is certainly not something you should take for granted. Whether you’re purchasing a single-family house or a 40-unit apartment building, that structure is going to sit on a single piece of land; and typically, the land cost-per-unit is likely to be higher – perhaps much higher – with a single-family house.

The more you pay per unit for the land, the more rental revenue per unit you will need to generate to cover your costs. In short, generating a positive cash flow in this scenario could prove to be a challenge. The deck may be stacked against you, so run your cash flow projections before you buy. Add up the cost of your mortgage payment, property taxes, insurance, maintenance and miscellaneous expenses. Will your rent be greater than the total of these costs?

Another perilous characteristic of the single-family as a rental property concerns vacancy. Simply put, if you lose one tenant, then 100% of your property is vacant. Consider again that 40-unit apartment building: Lose one tenant there and you lose just 2.5% of your revenue.

Finally, there is the issue of what drives value. A single-family house’s value is customarily based on market data, i.e., comparable sales, while the so-called commercial property (generally defined as one having more than four rental units), is valued based on its ability to produce income. This difference is important to you as an investor because you have the opportunity to create value by enhancing the commercial property’s income stream, an opportunity you will not have with that single-family.

All this is fine and makes good sense, but you may just not be built for starting off your investment career on a large scale. If thatss the case, then consider a multi-family house – ideally one with more than four units, but even smaller if you must – as your starter investment. Learn from that, then move on to bigger things.

#### Residential or Commercial?

I used the term “commercial” above to refer to properties with more than four units. Such properties are commercial in the sense that they are bought and sold for their ability to produce income. In more common parlance, however, the term “commercial” is often used to describe real estate that is occupied for business purposes and not as dwellings for families or individuals.

In a separate full-length article, I discuss in some detail the pros and cons of investing in each property type, but for our discussion here let’s just consider a few key points. If you’re a first-time investor, the most basic issue is that of comfort level. It is very likely that you have a good deal of personal familiarity with residential property. Chances are that you already know something about residential rent, leases, security deposits, utility bills, and the like. If you have never had similar experience with commercial property – renting your own office or retail space, for example – then you may feel more comfortable dealing with a property type that is more familiar to you.

There are plenty of potential advantages to owning commercial property, such as longer-term leases with built-in escalations, and tenant responsibility for certain operating expenses. Once you have expanded your comfort zone by owning and operating investment property, commercial real estate can be a very good long-term strategy.

#### Local Market vs. Hot Market

It seems like everyone is telling you that the demand for real estate is running wild in Last Ditch, Wyoming. Should you head, checkbook in hand, straight for the Ditch or stay close to home? Keep in mind an old axiom that applies to all kinds of investing: By the time you or I hear of a great deal, all the money that’s going to be made already has been made by someone else.

I have no doubt that you can find investors who have made a killing in some remote real estate market. You can probably also find someone who has won the Irish Sweepstakes. An important part of your strategy should be to optimize your chances of success, and you will do that best by staying close to home – perhaps very close.

I usually tell new investors that they should choose a location where they know every crack in the sidewalk. Information that you may take for granted can prove to be truly priceless. You probably know how well local businesses are doing, if the city needs to spend money soon on new schools or infrastructure, if a major employer is thinking of moving in or out of town, if a new transportation hub is nearing the final stages of approval, or if the local college is increasing its enrollment. In short, you know the likely trends that will drive demand for residential and commercial space, and you have a sense of where local property taxes are headed. You’re plugged in to your market, and nothing is more valuable to an investor.

#### Equity Partner vs. Debt Partners

Unless you have the resources to buy property for all cash, you have partners. When you finance an investment property, the bank (or whoever is lending you money) is your “debt partner.” They will very definitely get a piece of the action. In fact, they will expect their piece even if there is no action – no cash flow – at all.

In the current economy and with the state of the financial markets as it has been, we see an increasing number of experienced investors looking for more equity partners and less financing. It may not be as romantic as going entirely on your own, but it can be more successful. Financing has been difficult to obtain of late; the less you ask for in relation to the value of the property, the better your chances of securing it and the better the terms are likely to be. With less financing, you improve your chances of achieving a positive cash flow, even if you have to share it with your partners. Partnering up may be a good strategy for the times.

#### Professional Management vs. Do-It-Yourself

The question of whether or not to hire a professional property manager is one that you need to answer on a case-by-case basis. There may be no better way to learn how rental property works than to roll up your sleeves and run it, personally, like a business. But as with any business, you need to weigh the risks of on-the-job training.

For example, it may be prudent for you to use an experienced agent to find tenants and to check their references. That can be time-consuming work, and signing up a troublesome tenant can prove costly and consume even more of your time.

On the other hand, getting involved directly in overseeing maintenance, repairs and general management can help you recognize if your property is a good and desirable product in the marketplace. What is the appeal of your property, compared to others that compete for tenants in the same market? Your tenants will probably let you know if you work with them directly.

In addition, I have always believed that most tenants will not respect your property unless you do. You are more likely to sign up and retain responsible tenants if they see that you care about keeping the property in top shape and that you will respond to reasonable requests for maintenance or repair. As in any business, when you are directly involved in setting the tone and the standards, you have best chance of seeing those standards met. Eventually, as you build your real estate empire, you may have too many units for this hands-on approach to be practical; but if you are just starting out, this can be an effective way to develop your set of expectations for whoever will manage in your name in the future.

#### The Bottom Line?

True confession: These five rules are not really set-in-stone rules at all, but options that every real estate investor needs to weigh on his or her personal balance scale. Unlike a nice metric such as Debt Coverage Ratio, there is not really an unambiguous choice for any of these. You must take into account your own personal skills, experience and resources, your available time, and the nature of the property in which you are investing – and then choose wisely.

## Six Rules of Thumb for Every Real Estate Investor

Life can be hard, especially as we try to climb out of the Great Recession. Real estate investing can be a challenge, as well; and while we surely won’t presume to suggest how to deal with life’s big issues, we can offer a few thoughts as to how you might maintain some equilibrium when you look at investment property.

Those of you who follow our content at RealData.com — newslettersbooksFacebook and software — know that we stress maximizing your chances for success through understanding the metrics of investment property. We don’t tell you that you’ll get rich by thinking positive thoughts, raising your self-confidence, and charging fearlessly into the fray. Instead we urge you to learn about the the financial dynamics that are at work in income-producing real estate. Whether you’re scrutinizing a piece of property you already own, one you want to sell, or one you may choose to buy or develop, you need to master the metrics. The numbers always matter.

And so here are our “6 Rules of Thumb for Every Real Estate Investor.”

#### 1. Vacancy

— Let’s begin with a simple one. What percentage of the property’s total potential gross income is being lost to vacancy? Start off by collecting some market data, so you will know what is typical for that type of property in that particular location. Does the property you own or may buy differ very much from the norm? Obviously, much higher vacancy is not good news and you want to find out why. But if vacancy is far less than the market, that may mean the rents are too low. If you’re the owner, this is an issue you need to deal with. If you’re a potential buyer, this may signal an opportunity to acquire the property and then create value through higher rents.

2. Loan-to-Value Ratio (LTV)

— When the financial markets return to some semblance of normalcy, they will probably also return to their traditional standards for underwriting. One of those standards is the Loan-to-Value Ratio. The typical lender is generally willing to finance between 60% – 80% of the lesser of the property’s purchase price or its appraised value. Conventional wisdom has always held that leverage is a good thing — that it is smart to use “Other People’s Money.”

The caution here is to beware of too much of a good thing. The higher the LTV on a particular deal, the riskier the loan is. It doesn’t take much imagination to recognize that in the post-meltdown era, the cost of a loan in terms of interest rate, points, fees, etc. may rise exponentially as the risk increases. Having more equity in the deal may be the best or perhaps the only way to secure reasonable financing. If you don’t have sufficient cash to make a substantial down payment, then consider assembling a group of partners so you can acquire the property with a low LTV and therefore with optimal terms.

#### 3. Debt Coverage Ratio (DCR)

— DCR is the ratio of a property’s Net Operating Income (NOI) to its Annual Debt Service. NOI, as you will recall is your total potential income less vacancy and credit loss and less operating expenses. If your NOI is just enough to pay your mortgage, then your NOI and debt service are equal and so their ratio is 1.00. In real life, no responsible lender is likely to provide financing if it looks like the property will have just barely enough net income to cover its mortgage payments. You should assume that the property you want to finance must show a DCR of at least 1.20, which means your Net Operating Income must be at least 20% more than your debt service. For certain property types or in certain locations, the requirement may be even higher, but it is unlikely ever to be lower.
Not to preach, but planning a budget with a bit of breathing room might be a good principle for every government agency, financial institution and family to follow.

#### 4. Capitalization Rate

— The Capitalization Rate expresses the ratio between a property’s Net Operating Income and its value. Typically it is a market-driven percentage that represents what investors in a given market are achieving on their investment dollar for a particular type of property. In other words, it is the prevailing rate of return in that market. Appraisers use Cap Rates to estimate the value of an income property. If other investors are getting a 10% return, then at what value would a subject property yield a 10% return today?
Remember first that the Cap Rate is a market-driven rate so you need to interrogate some appraisers and commercial brokers to discover what rate is common today in your market for the type of property you’re dealing with. But you also need to recognize that Cap Rates can change with market conditions. In our long and checkered careers we have seen rates go as low as 4-5% (corresponding to very high valuations) and as high as the mid-teens (very low valuations), with historical averages probably bunched closer to 8-10%. If you are investing for the long term, and if the cap rate in your market is presently pushing the top or the bottom of the range, then you need to consider the possibility that the rate won’t stay there forever. Look at some historical data for your market and take that into account when you estimate the cap rate rate that a new buyer may expect ten years down the road.

#### 5. Internal Rate of Return (IRR)

— IRR is the metric of choice for many real estate investors because it takes into account both the timing and the size of cash flows and sale proceeds. It can be a bit difficult to compute, you may want to use software or a financial calculator to make it easy. Once you have your estimated IRR for a given holding period, what should you make of it? No matter how talented you are at choosing and managing property, real estate investing has its risks — and you should expect to earn a return that is commensurate with those risks. There is no magic number for a “good” IRR, but from our years of speaking with investors, we think that few would be happy with anything less than a double-digit IRR, and most would require something in the teens. At the same time, keep in mind the “too good to be true” principle. If you project an astoundingly strong IRR then you need to revisit your underlying data and your assumptions. Are the rents and operating expenses correct? Is the proposed financing possible?

#### 6. Cash Flow

— Cash is King. If you can first project that your property will have a strong positive cash flow, then you can exhale and start to look at the other metrics to see if they suggest satisfactory long-term results.

Negative cash flow means reaching into your own pocket to make up the shortfall. There is no joy in finding that your income property fails to support you, but rather you have to support your property. On the other hand, if you do a have a strong positive cash flow, then you can usually ride out the ups and downs that may occur in any market. An unexpected vacancy or repair is far less likely to push you to the edge of default, and you can sit on the sideline during a market decline, waiting until the time is right to sell.

Overambitious financing tends to be a common cause of weak cash flow. Too much leverage, resulting in greater loan costs and higher debt service can mark the tipping point from a good cash flow to none at all. Revisit LTV and DCR, above.

We’re all thumbs, so to speak, so if you found these rules helpful check out more of our booksarticlessoftware, Facebook page and other resources.

## Commercial Real Estate Financing — What to Do Now

### An Interview with George Blackburne

We hear something like this from our customers almost every day: “It’s really a great time to buy property, and if I could get the financing I would certainly do more deals.”*

We hold ourselves out to know a few things about real estate finance, but we must confess that we don’t know where the treasure is buried. So we decided to ask an expert: George Blackburne, III , founder of C-Loans and Blackburne & Sons Realty Capital Corporation.

RD: George, we know you’ve been in commercial finance for decades. Give us your boots-on-the-ground assessment of where we are now.

GB: Clearly, it is much more difficult to finance commercial property than it has been in a very long time. But I don’t agree with the conventional wisdom that you simply can’t get a loan. It’s going to require a lot more digging, but if the deal is a good one then it’s not impossible.

RD: Who’s lending now?

GB: It’s pretty much the hard money lenders and the banks. Gone are the conduits, mortgage REITS and other players.

RD: But a lot of our customers say the banks they’ve always done business with don’t want to talk to them.

GB: They have to understand that it’s a whole new ballgame, a sea change. You can’t rely on your usual lenders anymore. Perhaps most important, you have to forget about visiting just two or three lenders and expecting to get a loan. Plan on submitting your deal to 30-50 lenders. That’s what it will probably take right now.

RD: 30-50?

GB: Yes. I know one guy who approached 112 lenders – but he got the loan and closed the deal.

RD: I want to ask you more in a minute about what borrowers should be doing when they approach these lenders – how they can improve their chances of success – but first I want to ask about terms and underwriting.

GB: Interest rates are still attractive. They depend very much on the deal, but probably somewhere in the 6.5% to 7.375% range. A term of 25 years with a 5-year balloon is typical. Also, expect to be asked for a personal guarantee.

RD: What about LTV and DCR?

GB: DCR is still around 1.25 for most property types, but loan-to-value is likely to be about 60%. Most banks will use whichever of these is more limiting.

RD: Are buyers willing and able to put down 40%?

GB: Sometimes, of course, a couple of investors pool resources. Another technique I’ve been seeing is this: The seller agrees to take a second on some other property that is owned by the buyer – not on the property being sold. That way the buyer gets his secondary financing, and the bank is still lending on a property that has 60% LTV.

RD: Getting back now to the topic I was on earlier: What does the borrower have to do to maximize his or her chances of getting the loan?

GB: There are several things you can do. One of the most important is to create an executive summary of your deal – property info, financial info, photos – and put it into a pdf file that you can submit as part of your loan request.

RD: George, you just gave a pretty good description of some of the reports we produce with our Real Estate Investment Analysis software. Thanks for the plug.

GB: That’s good, that’s the kind of stuff you need to send.

RD: What else can a borrower do to improve the chances of getting a loan?

GB: It seems to me that banks are much more interested than they were in the past in having a deposit relationship with the borrower. Go talk to the bank president or someone high enough up the food chain about bringing over some of your accounts – personal, business, IRAs. These can make a difference.

RD: So where should we be looking for these 30-50 banks to approach?

GB: In general, you have a better chance with banks that are local to the property being financed. Here’s a quick-and-easy: Go to maps.yahoo.com and put in the property address. Where it says, “Find a business on the map,” type in “bank” and click search. Then zoom out the map until you have a big enough radius to give you a nice list. You can click on “view results as a list” to print out your shopping list.

RD: Why didn’t I think of that? If you have a crystal ball, would you care to give any forward-looking advice?

GB: Sorry, no crystal ball, but I will say this: If you currently have a commercial loan that’s going to balloon in the next two years, don’t sit around. I would start looking now to stretch as long as possible.

RD: George, I really appreciate your sharing your expertise. Can you to tell us just a bit about C-Loans and how it might help our readers in their search for financing?

GB: C-Loans.com is a commercial mortgage lender databank, a portal where you can submit your commercial loan to 750 different banks and hard money lenders. It’s also free. Just go to c-loans.com.

RD: Thanks again.

You can contact George Blackburne at

C-Loans, Inc., Blackburne & Sons, and Realty Capital Corp.
Plymouth, IN 46563
(574) 360-2486 Cell (Best)
(574) 936-6387 Office
george@blackburne.com

## Real Estate Partnerships and Preferred Return

Q. Can you explain more about how preferred return works in a real estate partnership? Does it always have to go only to the limited partner or non-managing partner?

A. The first point to make about real estate partnerships – whether limited, general or LLC – is that there is certainly no single, pre-defined structure used by all investors. In fact, you may be hard pressed to find two partnership agreements whose provisions are exactly the same.

Not all partnerships include a preferred return but, in those that do, its purpose is to counterbalance the risk associated with investing capital in the deal. Typically, the investor is promised that he or she will get first crack at the partnership’s profit and receive at least a X% return, to the extent that the partnership generates enough cash to pay it. In most partnership structures, the cash flow is allocated first to return the invested capital to all partners. The preferred return is paid next, before the General Partner or Managing Member receives any profit.

There are some variations as to exactly how the preferred return might be set up. If the partnership does not earn enough in a given year to cover the preferred return, the typical arrangement is to carry the shortfall forward and pay it when cash becomes available. If necessary it is carried forward until the property is sold, at which time the partners receive their accumulated preferred return before the rest of the sale proceeds are divided. Again, that assumes that the sale proceeds are in fact sufficient to pay the preferred return. If not, the limited partners have to settle for whatever cash is available.

The return may also be compounded or non-compounded. In other words, if part or all of the amount due in a given year can’t be paid and has to be carried forward, the amount brought forward may or may not earn an additional return (similar to compound vs. simple interest). The usual method is for it to be non-compounded. Hence the unpaid amount carried forward does not earn an additional return, but remains a static amount until paid.

An alternative but less common approach is to wipe the slate clean each year. If there isn’t enough cash to pay the preferred return, then the partnership pays out whatever cash is available and starts over from zero next year.

Real estate partnerships will typically define percentage splits between General (i.e., managing) and Limited (i.e., non-managing) partners for profit and sales proceeds. These splits do not come into play until the obligation to pay the preferred return has been met.

For example, let’s say that a limited partner invests \$100,000. She is promised a 5% preferred return (non-compounded), 90% of cash flow after the return of capital and payment of preferred return, and 70% of sale proceeds. In the first five years, the partnership generates just enough cash to return the invested capital to all partners. Hence, all future cash flows represent profit. The partnership has a \$16,000 cash flow the sixth year, a \$20,000 cash flow the seventh year and also sells the property at the end of the seventh year with total proceeds of sale of \$150,000. Here is what happens:

The Limited Partner should receive a preferred return of \$5,000 per year (5% of her \$100,000 investment). By the end of year 6 she hasn’t received any of this return so she is owed \$30,000. In the sixth year the partnership cash flow is only \$16,000, so that is all she gets; the balance due is carried forward to year 7. In that year the partnership cash flow of \$20,000 is sufficient to pay the \$14,000 owed from year 6, the \$5,000 from year 7 and still leave enough (\$1,000) to split 90/10 with the General Partner. Finally, the property is sold at the end of year 7 with \$150,000 proceeds to split 70/30 with the General Partner.

Regarding the question, “To whom does the preferred return go?” it is of course possible to structure a partnership so that it goes either to the General or the Limited partner or to Donald Duck if you think that’s a good plan. The presumed purpose of the preferred return is to encourage non-controlling investors to risk their capital in your project; and that encouragement often takes the form of a conditional promise of a minimum return, the “preferred return.” It seems to me that you would have a difficult time raising money from investors if your underlying message were, “This deal is so shaky that I need full control plus first dibs on the cash flow. If there’s anything left, you can have some.”

Run the numbers, but think beyond them. A good partnership is one where all the parties can enjoy a reasonable expectation of success.

## Managing for Value – A Guide for the First-Time Landlord

Most of our articles have dealt with the analysis, development and acquisition of income property. It is easy to get wrapped up in the metrics of this process and to forget that eventually you’ll have to engage in the human and sometimes demanding business of actually managing the property you buy.

How you fulfill that task can go a long way toward determining the financial success of your investment. Property management is a complex subject, but if you observe some basic principles you can maximize your long-term profit and minimize some of the burden.

Existing tenants will naturally harbor some suspicion about a new owner. Ignore it. Eventually you won’t be the New Guy or they won’t be the tenants, so it doesn’t really matter. Conduct yourself in a businesslike manner starting on day one. Treat your lease agreements like the business contracts they really are. Don’t simply ask a new tenant to sign the lease. Explain the terms and translate the legalese. Doing so establishes the fact that the lease terms matter and you expect both sides to observe them.

The Aretha Franklin Principle

In more than 30 years of owning rental property (and watching others do the same), I have found one principle that has proved consistently valid: Don’t expect your tenants to treat your property with respect unless you treat it with respect. As I urge in my book, Insider Secrets…, “If something is broken, fix it. If something is dirty, clean it up. If something is dangerous, make it safe. You can be certain that very few tenants will put forward any special effort to take care of the property if your attitude is one of neglect.” The converse of this principle is also true. If you behave like a slumlord, you’ll get what you deserve.

Not only does this principle occupy the ethical high ground, it also makes very good business sense. Deferred maintenance is ultimately more expensive than aggressive maintenance and it will eat away at your investment return from several sides. The postponed repair will typically ring up a larger bill later. Consider the small plumbing leak you ignore today versus the additional damage you must repair when you finally fix the leak a few months hence.

A property with deferred maintenance also diminishes the amount of rent you can expect to collect. First, because few tenants will pay top dollar to occupy a poorly maintained property. And second because those who do, but feel they are not getting what they bargained for, are more likely to default in their payments.

Finally, on what should be your big payday – the day you sell the property for a handsome profit – you’ll find yourself making price concessions because of the property’s poor condition and its below-market revenue stream. By operating on the cheap you’ve bought your way into a lose-lose-lose trifecta.

Managing for Maximum Return

Your goal should be to manage the property for the greatest long-term gain. If you’ve read some of our earlier articles about Net Operating Income, capitalization rates and Internal Rate of Return, you understand that an income-property’s value is directly related to its income stream. Hence, your best chance to maximize that gain is to grow the property’s Net Operating Income. Doing so translates into at least two benefits: It’s likely to help your year-to-year cash flow, but even more important, NOI is fundamental to the valuation of the property. Hence, by increasing the NOI you create equity.

One way to optimize the growth of the property’s NOI is to buy it right. That’s not code for “look for properties you can steal.” It is not at all uncommon to find properties that earn below-market rents. This may happen because they have the kind of deferred maintenance discussed above, but it can also occur because the owner has simply not kept pace with the current market. Some landlords, especially those for whom real estate is a sideline, find it easier to renew the leases of good tenants at a nominal increase rather than demand market rents and take on the work and risk of finding new tenants.

When you locate such a property, you must not lose sight of the fact that you should purchase only if you can do so at a price that is very close to what its current income justifies. The seller will tell you that it should rent for more and therefore it is worth more. You could rephrase the seller’s position as, “Do my job and assume my risk, but pay me as if I had done it myself.” If you purchase a property with below-market rents at a price consistent with those rents and then proceed to bring them up to market, you will almost always create additional equity.

Implement Management Improvements

Unless the property you buy is a text-book case of managerial perfection, you can almost enhance it revenue stream (and therefore its value) by making management improvements. Not to beat a fallen horse further, start by cleaning up the previous owner’s deferred maintenance. After that, begin looking for ways to make the property more appealing to your pool of potential tenants. For example…

Common Area – For apartment and office properties, make sure the hallways and stairways are clean and well-lighted. Some artwork on the walls and furniture or other decorative items in the halls creates a more welcoming and less institutional atmosphere. They convey that the owner cares about creating a quality environment.

Security – For better or worse, we’ve become a very security-conscious society. Don’t take that concern for granted, but rather deal with it in a way that distinguishes your property from other with which it competes. The appropriate level of security varies a great deal from one type property of to another, but look for ways to improve whatever you have now. Exterior lighting, higher quality doors and door locks, controlled access to parking, and monitored fire and smoke detectors are just a few of the steps you can take.

Amenities – What do tenants really want? Can you wire the building for high-speed Internet access? Provide pooled secretarial and reception services for small office tenants? Pay for a series of newspaper ads promoting the businesses in your strip shopping center? Your goal is to maximum your income stream and to do so you need to distinguish yourself and your property from your competition. The numbers will add up quickly. Do the math:

#### Value = Net Operating Income / Capitalization Rate

Let’s say that, in your market, the prevailing cap rate is 10% (that is, if investors are buying properties for 10 times the NOI). You purchase such a property, make some of the management improvements suggested here and increase the Net Operating Income by \$1,000 per month, or \$12,000 per year.

#### Increase in Value = 12,000 / 0.10 = \$120,000

By making management improvements, you created \$120,000 in additional equity. Did you spend some time accomplishing this? Yes. Did you spend some money to make those improvements? Certainly. Did you spend \$120,000? Not likely, probably not even close.

People who buy single-family homes with intention of “flipping” them quickly for a profit in a hot market are relying on economic forces beyond their control to create that profit. Those who invest in equities are also relying on outside economic forces as well as the competence and integrity of company management.

The bottom line with income-producing real estate is this: If you manage your property intelligently, ethically and responsibly with an eye toward providing the kind of quality environment that can command optimal rent, you can do something that you could never accomplish with a stock or bond investment or even with a flip. You can use your own initiative and skill to create value. In the most literal of terms, you can make money.