Tag: real estate appraisal

10 Mistakes To Avoid When You Invest in Real Estate

I’ve been involved in real estate for more than 40 years, much of it teaching about real estate investing, answering questions online, and supporting folks who use my company’s investment analysis software —so I’ve gotten to see a lot about how people think (and sometimes don’t think). From that experience, I want to share my list of “greatest hits,” mistakes that can really trip you up:

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1. Admiring the King’s New Clothes

I see a lot of first-timers get wrapped up in the aesthetics of a property. Is it an attractive, solid building? Is it in a desirable location? Would I be proud to tell people that this my property? Unfortunately, for some new investors, that’s where their critical evaluation ends. They see only what they want to see.

It’s nice to feel good about the commitment you’re going to make, but that warm feeling will quickly turn cold if the property is a money-draining albatross. Start, at the very least, by estimating its initial cash flow—all the money that will come in for the first year minus all the money that will go out. If that number isn’t comfortably positive, reconsider.

 

2. Almost Doing Your Due Diligence

Most investors will check out the physical condition of the property. Most will also check out the rent data and verify at least some of the expenses. But have you actually read the leases? Are you going to get yourself locked into a dicey deal with below-market rents for a number of years; or maybe with a tenant’s right of first refusal if you want to sell, or even a tenant bail-out option?

 

3. Almost Doing Your Due Diligence, Part 2

OK, you did a good job vetting the property, its finances and its leases. So what did you forget? Maybe you forgot about the market. This property doesn’t live in a vacuum, so you absolutely need to be looking at the ecosystem around it.

What are other landlords getting for units in similar properties? What’s your competition for tenants? What is the prevailing cap rate for properties of this type? What’s the business climate—are companies moving in, moving out—is employment strong? As the anvil salesman says in The Music Man, “You gotta know the territory.”

4. Using the Wrong Lingo

Deals frequently unravel because the parties are not speaking the same language. Real estate investing, like other business professions, has a vocabulary all its own—terms whose meaning is agreed upon by those who buy, sell, broker, or finance property on a regular basis. I’ve seen things like “net operating income after debt service.” The rest of us probably call that “cash flow.” Who knew?

If you misuse standard terms, or if you use terms that don’t exist in nature, you’re either going to…

     … experience what I call the Cool Hand Luke Syndrome (“What we’ve got here is a failure to communicate”) and never reach a meeting of the minds, or

     …  paint yourself as someone who has never done a deal before, doesn’t know what he or she is talking about, and shouldn’t be taken seriously (and maybe should be taken advantage of).

 

5. Not Looking at the Deal from the Perspective of the Other Players

Whether you’re trying to buy, sell, finance, or raise equity, you have to recognize that your point of view isn’t the only one that matters. You need to put yourself in the shoes of the other interested parties.

Try to understand what are the sticking points, the potential deal killers from their perspective. Perhaps then you can come up with a solution. Do you have a property to sell, and does your potential buyer seem concerned about some vacant space? How about guaranteeing the rent for a period of time?

 

6. Can’t See the Forest… 

I notice this one with a lot with folks who are trying to vet their first income property. You can think of this as another “perspective” mistake—in this case you need to adopt the perspective not of a potential buyer but rather of someone who has already bought this property and now is trying to run it. It was nice that the seller or broker gave you a list of operating costs, and most of them were probably accurate, but is that list complete?

Go back to it and think about costs that nobody volunteered. Who gets rid of the snow, manicures the landscaping, vacuums the hallways, hauls the trash, services the HVAC? And often you’ll see no line item for property management (“Oh, I do that myself”), but you need to figure in an allowance for management even if no cash currently changes hands. An appraiser would routinely add management as an expense, and you should, too, because it will effect the estimate of value.

 

7. Thinking About Your Rental Property the Way You Think About Your Home

I usually ask my grad students how many own their own home. After a few proudly raise their hands, I tell them they’re at a disadvantage and need to try to forget what they think they know about real estate. Bummer.

The value of a personal residence is driven by economic factors—some national, most local. That’s why an appraiser will use the “comparable sales” approach when estimating the value of a home. If all your neighbors’ houses have sold for around $300k, then yours will probably sell for something like that as well.

But income-producing property is valued on its ability to produce net income. It’s not going to rise in value just because of the passage of time. Too many novice investors think their investment properties are going to “appreciate” on their own, over time, just because. Think again.

You can create value in an income property by enhancing its cash flow. Very few investment vehicles give you this power, but you have to understand how it works if you want to take advantage of this wealth-building potential.

8. Being Nearsighted  

Current-year data is important, but I hear a lot of investors who insist that they will focus only on the current income and expenses when evaluating a potential investment property. They say that this data is concrete and verifiable, and any prediction about future performance is just an exercise in fortune telling.

Yes, an appraiser is going to look at the current revenue, expenses, and market cap rate to estimate value. But remember this: The appraiser’s job is to estimate value at a point in time. You, on the other hand, are almost certainly investing for a period that extends beyond the current moment, and should be interested in how you believe this property will perform over a number of years.

So, in addition to looking at current performance, you should be making several projections as to future performance—best case, worst case, and in-between scenarios. This is a topic for more detailed discussion, so stay tuned for that.

 

9. Missing the Obvious in Your Analysis

You’ve taken my advice to heart and done both short-term and long-term projections of cash flows. Now, get your head out of your spreadsheet and use your common sense. Ask yourself if the figures in your analysis actually make sense. Do they look reasonable?

Is that cash flow way less than you expected, is your IRR in the stratosphere, is your mortgage payment merely a pittance? If so, then chances are you’ve either messed up a formula or a cell reference, or entered data incorrectly. When I look at my students’ work, it’s not uncommon to see that some of them have entered the total monthly rent, when they really needed the annual amount. Or they’ve put too many decimal places in the mortgage rate. Don’t assume, just because you used a spreadsheet, that the results are correct. Garbage in…

 

10. Forgetting that Real Property is a Real Business

After all that hard work—property search, due diligence, financial analysis, negotiation, financing, closing—you are finally the owner/operator of an investment property. Perhaps this is the first business you have ever run. You need to treat it like a business.

The top line of your P&L—revenue—needs to be the top line of your to-do list. Is someone not paying the rent, giving you excuses? Don’t let it slide. Your chances of collecting decrease exponentially with the passage of time.

Keeping records on sticky notes? Poor record-keeping can be your undoing, especially at tax time. Invest in some bookkeeping software, such as Quickbooks, rather than relying on a DIY spreadsheet. And once you’ve got it, use it.

Keep your tenant applications, leases and other documents in an organized file. If you really want to be good, scan them and store them on a removable hard drive.

In short, if you want your real estate investment business to succeed, then treat it like a serious business.

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These are the ten real estate investor mistakes I’ve seen most often, but maybe you’ve seen (or committed!) some of your own. I invite you to share your cautionary tales and add them to our list – let’s call it Everything Else that Real Estate Investors Should Avoid.

 

—-Frank Gallinelli

 

Your time and your investment capital are too valuable to risk on a do-it-yourself investment spreadsheet. For more than 30 years, RealData has provided the best and most reliable real estate investment software to help you make intelligent investment decisions and to create presentations you can confidently show to lenders, clients, and equity partners. Find out more at www.realdata.com.

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Copyright 2018,  Frank Gallinelli and RealData® Inc. All Rights Reserved

The information presented in this article represents the opinions of the author and does not necessarily reflect the opinions of RealData® Inc. The material contained in articles and blog posts that appear on realdata.com is provided as general information and is not intended to provide legal, tax or other professional advice or to substitute for proper professional advice and/or due diligence. We urge you to consult an attorney, CPA or other appropriate professional before taking any action in regard to matters discussed in any article or posting. The posting of any article and of any link back to the author and/or the author’s company does not constitute an endorsement or recommendation of the author’s products or services.

 

New Podcast: Investing in Income-Producing Real Estate

I had the privilege recently of recording a video podcast with REICLub, where we discussed investing in income-producing real estate: deciding what kind of property you should buy, how to begin the analysis process, understanding the income stream, estimating value or worth, dealing with long-term projections, recognizing common pitfalls, investing with partners.

I invite you to view it here:

http://www.REIClub.com/FrankGallinelli

—Frank Gallinelli

How to Look at Reserves for Replacement When You Invest in Income-Property

It may sound like a nit-picking detail: Where and how do you account for “reserves for replacement” when you try to value – and evaluate – a potential income-property investment? Isn’t this something your accountant sorts out when it’s time to do your tax return? Not really, and how you choose to handle it may have a meaningful impact on your investment decision-making process.


What are “Reserves for Replacement?”

Nothing lasts forever. While that observation may seem to be better suited to a discourse in philosophy, it also has practical application in regard to your property. Think HVAC system, roof, paving, elevator, etc. The question is simply when, not if, these and similar items will wear out.

A prudent investor may wish to put money away for the eventual rainy day (again, the roof comes to mind) when he or she will have to incur a significant capital expense. That investor may plan to move a certain amount of the property’s cash flow into a reserve account each year. Also, a lender may require the buyer of a property to fund a reserve account at the time of acquisition, particularly if there is an obvious need for capital improvements in the near future.

Such an account may go by a variety of names, the most common being “reserves for replacement,” “funded reserves,” or “capex (i.e., capital expenditures) reserves.”


Where do “Reserves for Replacement” Fit into Your Property Analysis?

This apparently simple concept gets tricky when we raise the question, “Where do we put these reserves in our property’s financial analysis?” More specifically, should these reserves be a part of the Net Operating Income calculation, or do they belong below the NOI line? Let’s take a look at examples of these two scenarios.

reserves for replacement, after NOI

Now let’s move the reserves above the NOI line.

reserves for replacement, befeore NOI

The math here is pretty basic. Clearly, the NOI is lower in the second case because we are subtracting an extra item. Notice that the cash flow stays the same because the reserves are above the cash flow line in both cases.


Which Approach is Correct?

There is, for want of a better term, a standard approach to the handling capital reserves, although it may not be the preferred choice in every situation.

That approach, which you will find in most real estate finance texts (including mine), in the CCIM courses on commercial real estate, and in our Real Estate Investment Analysis software, is to put the reserves below the NOI – in other words, not to treat reserves as having any effect on the Net Operating Income.

This makes sense, I believe, for a number of reasons. First, NOI by definition is equal to revenue minus operating expenses, and it would be a stretch to classify reserves as an operating expense. Operating expenses are costs incurred in the day-to-day operation of a property, costs such as property taxes, insurance, and maintenance. Reserves don’t fit that description, and in fact would not be treated as a deductible expense on your taxes.

Perhaps even more telling is the fact that we expect the money spent on an expense to leave our possession and be delivered to a third party who is providing some product or service. Funds placed in reserve are not money spent, but rather funds taken out of one pocket and put into another. It is still our money, unspent.


What Difference Does It Make?

Why do we care about the NOI at all? One reason is that it is common to apply a capitalization rate to the NOI in order to estimate the property’s value at a given point in time. The formula is familiar to most investors:

Value = Net Operating Income / Cap Rate

Let’s assume that we’re going to use a 7% market capitalization rate and apply it to the NOI. If reserves are below the NOI line, as in the first example above, then this is what we get:

Value = 55,000 / 0.07

Value = 785,712

Now let’s move the reserves above the NOI line, as in the second example.

Value = 45,000 / 0.07

Value = 642,855

With this presumably non-standard approach, we have a lower NOI, and when we capitalize it at the same 7% our estimate of value drops to $642,855. Changing how we account for these reserves has reduced our estimate of value by a significant amount, $142,857.


Is Correct Always Right?

I invite you now to go out and get an appraisal on a piece of commercial property. Examine it, and there is a very good chance you will find the property’s NOI has been reduced by a reserves-for-replacement allowance. Haven’t these people read my books?

The reality, of course, is that diminishing the NOI by an allowance for reserves is a more conservative approach to valuation. Given the financial meltdown of 2008 and its connection to real estate lending, it is not at all surprising that lenders and appraisers prefer an abundance of caution. Constraining the NOI not only has the potential to reduce valuation, but also makes it more difficult to satisfy a lender’s required Debt Coverage Ratio. Recall the formula:

Debt Coverage Ratio = Net Operating Income / Annual Debt Service

In the first case, with a NOI of $55,000, the DCR would equal 1.41. In the second, it would equal 1.15. If the lender required a DCR no less than 1.25 (a fairly common benchmark), the property would qualify in the first case, but not in the second.

It is worth keeping in mind that the estimate of value that is achieved by capitalizing the NOI depends, of course, on the cap rate that is used. Typically it is the so-called “market cap rate,” i.e., the rate at which similar properties in the same market have sold. It is essential to know the source of this cap rate data. Has it been based on NOIs that incorporate an allowance for reserves, or on the more standard approach, where the NOI is independent of reserves?

Obviously, there has to be consistency. If one chooses to reduce the NOI by the reserves, then one must use a market cap rate that is based on that same approach. If the source of market cap rate data is the community of brokers handling commercial transactions, then the odds are strong that the NOI used to build that market data did not incorporate reserves. It is likely that the brokers were trained to put reserves below the NOI line; in addition, they would have little incentive to look for ways to diminish the NOI and hence the estimate of market value.


The Bottom Line – One Investor’s Opinion

What I have described as the standard approach – where reserves are not a part of NOI – has stood for a very long time, and I would be loath to discard it. Doing so would seem to unravel the basic concept that Net Operating Income equals revenue net of operating expenses. It would also leave unanswered the question of what happens to the money placed in reserves. If it wasn’t spent then it still belongs to us, so how do we account for it?

At the same time, it would be foolish to ignore the reality that capital expenditures are likely to occur in the future, whether for improvements, replacement of equipment, or leasing costs.

For investors, perhaps the resolution is to recognize that, unlike an appraiser, we are not strictly concerned with nailing down a market valuation at a single point in time. Our interests extend beyond the closing and so perhaps we should broaden our field of vision. We should be more focused on the long term, the entire expected holding period of our investment – how will it perform, and does the price we pay justify the overall return we achieve?

Rather than a simple cap rate calculation, we may be better served by a Discounted Cash Flow analysis, where we can view that longer term, taking into account our financing costs, our funding of reserves, our utilization of those funds when needed, and the eventual recovery of unused reserves upon sale of the property.

In short, as investors, we may want not just to ask, “What is the market value today, based on capitalized NOI?” but rather, “What price makes sense in order to achieve the kind of return over time that we’re seeking?”

How do you treat reserves when you evaluate an income-property investment?

—-Frank Gallinelli

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Your time and your investment capital are too valuable to risk on a do-it-yourself investment spreadsheet. For more than 30 years, RealData has provided the best and most reliable real estate investment software to help you make intelligent investment decisions and to create presentations you can confidently show to lenders, clients, and equity partners. Learn more at www.realdata.com.

Copyright 2014,  Frank Gallinelli and RealData® Inc. All Rights Reserved

The information presented in this article represents the opinions of the author and does not necessarily reflect the opinions of RealData® Inc. The material contained in articles that appear on realdata.com is not intended to provide legal, tax or other professional advice or to substitute for proper professional advice and/or due diligence. We urge you to consult an attorney, CPA or other appropriate professional before taking any action in regard to matters discussed in any article or posting. The posting of any article and of any link back to the author and/or the author’s company does not constitute an endorsement or recommendation of the author’s products or services.

Podcast: “Learn the key principles to effectively analyzing and evaluating your real estate deals”

I had the pleasure of recording a podcast recently with real estate entrepreneur Kevin Bupp. We discussed what I feel are some of the key principles that every real estate investor ought to understand — and so, I invite you to listen to that podcast here.

Using Cap Rate to Estimate the Value of an Investment Property

In recent posts I’ve been revisiting some key real estate investment metrics. Last time I discussed the finer points of Net Operating Income, and that topic should serve as an appropriate run-up to the subject of capitalization rates (aka cap rates). What are they and how do you use them?

Income capitalization is the technique typically used by commercial appraisers, and is a part of the decision-making process for most real estate investors as well. I invite you to jog over to an article I’ve written on the subject:

Estimating the Value of a Real Estate Investment Using Cap Rate

In addition, you can download Chapter 10 of my book, Mastering Real Estate Investment, which discusses cap rates and gives you several examples you can work through.

—Frank Gallinelli

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Your time and your investment capital are too valuable to risk on a do-it-yourself investment spreadsheet. For more than 30 years, RealData has provided the best and most reliable real estate investment software to help you make intelligent investment decisions and to create presentations you can confidently show to lenders, clients, and equity partners. Learn more at www.realdata.com.

Copyright 2014,  Frank Gallinelli and RealData® Inc. All Rights Reserved

The information presented in this article represents the opinions of the author and does not necessarily reflect the opinions of RealData® Inc. The material contained in articles that appear on realdata.com is not intended to provide legal, tax or other professional advice or to substitute for proper professional advice and/or due diligence. We urge you to consult an attorney, CPA or other appropriate professional before taking any action in regard to matters discussed in any article or posting. The posting of any article and of any link back to the author and/or the author’s company does not constitute an endorsement or recommendation of the author’s products or services.

Refi Existing Investment Property to Purchase Another?

One of our Facebook fans, Tony Margiotta, posed this question, which I’m happy to try my hand at answering here:

“Could you talk about refinancing an income property in order to purchase a second income property? I’m trying to understand the refinance process and how you can use it to your advantage in order to build a real estate portfolio. Thanks Frank!”

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The Good News

Your plan – to extract some of the equity from an investment property you already own and use that cash as down payment to purchase another – is fundamentally sound. In fact, that’s exactly what I did when I started investing back in the ‘70s, so to me at least, it seems like a brilliant idea.

Of course, you need to have enough equity in your current property. How much is enough? That will depend on the Loan-to-Value Ratio required by your lender. The refi loan has to be small enough to satisfy the LTV required on the current property, but big enough to give you sufficient cash to use as the down payment on the new property.

For example, let’s say your bank will loan 70% of the value of your strip shopping center, which is appraised at $1 million. So, you expect to obtain a $700,000 mortgage. Your current loan is $550,000, which would leave you with $150,000 to use as a down payment on another property.

Given the same 70% LTV, $150,000 would be a sufficient down payment for a $500,000 property, i.e. 70% of $500,000 = $350,000 mortgage plus $150,000 cash.

But Wait… Some Issues and Considerations

Unfortunately, it’s not the ’70s or even ’07 anymore, so while the plan is sound, the execution may present a few challenges. Best to be prepared, so here are some issues to consider:

    • In the current lending environment, financing can be hard to find, and the terms may be more restrictive than what you experienced in the past. Notice that I used a 70% LTV in the example above. You might even encounter 60-65% today, while a few years ago it could have been 75-80%.  In order to obtain the loan, you might also have to show a higher Debt Coverage Ratio than you would have in the past – perhaps 1.25 or higher, compared to the 1.20 that was common before.
    • How long have you had the mortgage on the current property?  Some lenders will not let you refinance if the mortgage isn’t “seasoned” for a year or even longer.
    • How long have you owned the property? A track record of stable or growing NOIs over time will support your request for a new loan.  You need to make a clear and effective presentation to the lender showing that the refi makes sense, especially in a tight lending environment.
    • You need to run your numbers and not take anything for granted. For example, will your current property have a cash flow sufficient to cover the increased debt?
    • Keep in mind that you’re adding more debt to the first property, so the return on the new property has to be strong enough to justify the diminution of the return on the first.
    • Have you compared the overall return you would achieve from the two properties using the refi plan as opposed to the return you might get if you brought in some equity partners to help you buy the new property?

In a nutshell, refinancing an existing income property to purchase another is a time-honored and proven technique, but it in a challenging lending environment be certain you do your due diligence and run your numbers with care.

Of course I never miss an opportunity to promote my company’s software, so consider using that not only to analyze the deal and its variations, but also to build the presentations that will optimize your chances of obtaining the financing and/or the equity investors.

Frank Gallinelli

My latest: Mastering Real Estate Investment

I’m hoping that, by now, you’ve heard I have a new book out: “Mastering Real Estate Investment: Examples, Metrics and Case Studies.” It was released just a few weeks ago, and like any proud author I’m pleased to say it’s doing well.

And so…  what’s it’s all about?  An why did I think anyone would read it?

I’d probably describe it best as being two books in one.  Quite a few readers of my first book, “What Every Real Estate Investor Needs to Know About Cash Flow…,” told me they wanted to see more examples of the 37 key calculations I discussed there. That’s an entirely reasonable request; most of us learn better from examples.

So, I began with the idea of creating a workbook of sorts.  For each of my 37 metrics I created a series of sample problems that the reader could work through.  And, of course, I provided the step-by-solution for every problem.

I would humbly submit (all right, maybe not so humbly) that this was a good idea, because to master anything you have to roll up your sleeves and get involved with it.  You can’t just read about these concepts, you have to practice them if you expect to internalize them as part of your approach to investing.  And that, by the way, is how “Mastering” got into the title.

It’s one thing to master these concepts, but it’s yet another to understand how to integrate them and apply them — and that’s why I wrote the second part of the book, the case studies.  I took four different type of properties — a single-family rental, a development project, and apartment building, and a commercial property.

What I tried to do here was to take real-life situations, where you have to deal with asking prices that may be realistic or not; where you encounter seller representations that may be accurate or not; where you have to make judgments and forecasts using imperfect current knowledge.

One of my goals in this part of the book was to show you how to play, “What if…” with your forecasts so as to give you a sense of the range of possible outcomes for your investment if things like rent projections, interest rates, resale costs varied.  Also, in a departure from some of my usual topics, I tried to show how to look at a re-hab project — specifically, how to estimate an appropriate price for a property that you plan to re-develop into an income-producing investment.

Part 2 of the book can stand on its own, so if you’re comfortable with concepts like NOI, cap rate, discounted cash flow and IRR, go ahead an read this part first.

You’ll find more about this book, and my others, here.

Welcome, Real Estate Investors and Developers

… to RealData’s blog. You probably know that we’ve always tried to provide a lot of useful content on this site, with educational articles, newsletters, and the like.  We want this blog to be a logical extension of that mission, but we also want it to be a place for more informal discussion.

This is a place that welcomes beginners, experience investors, and real estate professionals alike.  If a topic is pertinent and meaningful to you as a real estate investor, developer, appraiser, consultant, or educator, then it belongs in this blog.

So we may talk about where we think the real estate market is headed.  We’ll certainly discuss  nuts-and-bolts topics, like, “What exactly is a profitability index?” and “What’s a back-door approach and when do you use it?”

We want to tell you about useful resources as soon as we discover them (and so you won’t have to wait for our not-so-rigorously scheduled newsletter).  We definitely will talk about technology.  Do you know about the hidden gotchas lurking in Excel 2007?  And there are plenty of useful tips we can give you about using our RealData software to best advantage.

We’ll do our best to keep the conga line moving, but urge you to jump in with your comments.

Welcome aboard.