Whether you are thinking about buying a single-family rental, a duplex or four-unit, or a 200-unit apartment complex, there comes that moment when you must decide a dollar figure to write in the purchase agreement.
Calling “heads” or “tails” as your half-dollar is spinning is the air is one method. Another is to pin the tail on the donkey. I recommend a bit more scientific approach.
In my last article, “Commercial Real Estate Investing: Who do you turn to for advice?” recommended having a team of experienced real estate advisors:
1. Certified Public Accountant
2. Real Estate Attorney
3. Property Maintenance Company
4. Property Management Company
5. Commercial Investment Realtor®
Establishing a value for a real estate investment is where your advisors earn their stripes.
There are five critical pieces of information you must before you can make a smart offer:
1. Historical Income and Expenses
2. Projected Income and Expenses
3. Projected Profitability
4. Projected Return on Investment (ROI)
5. Minimum Return Required
A handy-dandy gizmo for laying out all of the above information is a form called an APOD, an acronym for Annual Property Operating Data form.
Ask your real estate agent what an APOD is. If he/she doesn’t know, it’s a pretty good bet they’ve never seen one or used one to help their clients determine real estate investment values.
The APOD lists virtually every conceivable source of income on one side – rent payments, vending machine profits, coin laundry revenue, late fees, etc. – and on the other side, every conceivable expense, from utility’s costs to property maintenance, vacancy cost, attorney fees, property management service fees, and so on.
First, you must obtain the income and expense figures from current owner. If the owner is unwilling to share that information – in the form of tax returns or statements from their C.P.A. – be extremely cautious about proceeding. Any smart, experienced investor will ask for these items and any owner/seller who is unwilling to share that information is probably hiding something from a potential buyer.
The two most frequent reasons owners/sellers are reluctant to provide tax returns or income statements from their C.P.A. is 1) the property hasn’t been profitable for years, and therefore isn’t worth the price they’re asking or 2) it is profitable but the seller has been under-reporting its profit to the IRS.
In either case, determining the value of an investment becomes much more difficult without the co-operation of the seller. However, that doesn’t mean it is impossible; it just takes more legwork and a really smart group of advisors.
If you truly believe the project is worth pursuing, skip Step One and go directly to Step Two: Identify the Projected Income and Expenses.
How much are renters paying in the area for similar apartments? Does yours measure up in terms of condition, amenities, etc? If not, how much money will it take to make your units competitive? How much will it cost to keep them in good condition?
As you can see, the property maintenance and management part of the team is essential, especially if you cannot get accurate historical data. So, too, are the C.P.A. and Realtor. They are the part of your advisory team that will be helping you identify market rents, supply and demand and industry norms for expenses.
Once you have projected your net income (Projected Income minus Projected Expenses), slash 20% from it. Can you still make a profit? If not, is the project still paying for itself? If not, be cautious.
Where did I get the arbitrary 20%? Mom & Dad. It was always a figure they used as their “safety cushion.” If the rental market declined 20%, they wanted to know they could still pay loan and expenses.
40 years have passed since I sat at the kitchen table, watched them sip coffee and heard them calculate what they were going to offer on a property, but their advice still works.
Back to the Five Steps: Once you know your projected income under normal market conditions, calculate your Return on Investment (ROI). Pull out your calculator and key in the amount you expect to be left with at the end of the year based on the Projected Net Income figure on your APOD. Divide that number by the dollar amount of your investment.
Let’s say you plan to buy a duplex, dress it up with new carpeting, paint, etc, and rent each side for $800 a month.
Assuming no vacancies, your Projected Annual Gross Income would be $19,200, right? If your Projected Annual Expenses – maintenance, utilities, debt service, insurance, property taxes, marketing, etc. – amounted to, say, $12,000, your Projected Net Income would be $7,200.
If you bought the property for $120,000 and put another $20,000 into it to make it rentable, your initial investment was $140,000.
Divide your Projected Net Income ($7,200) by your Investment ($140,000) and you will get your Return on Investment – about 5% per year. Notice that even when you plug in the 20% “safety cushion” formula, the project continues to be profitable, albeit the ROI is cut in half to about 2.5%.
It’s still better than most investments in stocks over the past couple of years, but is that acceptable to you based on your investment expectations? Only you can answer that.
But now you know how to figure it out.
