Broad Question: How do you evaluate real estate investment opportunities?
I've found this forum to be particularly helpful in terms of real estate education, so just wanted to ask:
On an abstract level, how does one go about evaluating real estate opportunities and picking the "right" investments? What are your steps in developing an investment thesis/story, and what particular risks/factors do you like to focus on? From my understanding, real estate can be a very inefficient asset class given that investment considerations can vary significantly between property types, locations, state of capital markets, etc. so I am curious as to how one goes about adequately predicting inherent disconnects in value, then capitalizing on the opportunity.
I just finished reading The Real Estate Game, which was immensely helpful in shaping my perspectives as a hypothetical investor, but would love to hear the opinions from both owner/operators and LP investors that have been in this industry for a while.
I think it is tough to answer this question since it is so broad and will differ for everyone, but ultimately, investing in general comes down to one thing price...I'll go to the worst neighborhood in my city and buy the worst property if the price is right. I would do the same thing for stocks/bonds if I knew those assets as well as I do about real estate. So this naturally leads to the question of "how do you know the right price?" I won't talk about securities because I don't know enough about them and you have all the efficient market theories, but real estate is much less efficient than securities because it is so illiquid and there are so many factors/information that cannot be easily measured such as location/condition of property/tenant quality etc... The most important step in real estate investing is knowing your market and product. Investing is about finding a needle in a haystack...if you are looking for undervalued 2-unit properties, you need to be able to differentiate hay from needles. For me, I invest primarily in 3-unit properties in about 10 sub-markets of my city. Each of these markets are very safe neighborhoods, but there are 4 neighborhoods in these markets that are premium neighborhoods that I consider "condo conversion neighborhoods" because they sell at a $/SF that justifies the land/construction cost and if I were to rent them, the cash-on-cash return does not meet my requirement. Then the remaining 6 neighborhoods I consider rental markets because the $/SF is not at the level that justifies the land/construction cost, but the rents are not significantly different from the premium markets, but the cost of land is significantly lower. For example, a renovated 3BR in one of my rental markets generally rents for ~$3,000 whereas in a premium market it could rent at $3,600 and maybe up to $4,000, but this is not common. However, the cost of land in a premium market can easily be 50%-100% more expensive than in the rental market. Of the 5 properties I acquired in the last 1.5 years, 3 of them were under market value by 5%-10% and one of them by ~30%-40%. I bought them because I knew they were undervalued...how did I know? I know my market/product and also because the agent told me I wasn't the highest offer but I was able to win the properties by having no contingencies, early closing, etc... As for my process, I can eliminate 99% of properties instantly by looking at the price, size, and location. The remaining 1% I usually do a walk through, estimate my construction cost, and build a very simple rental model and see what my cash-on-cash is or sell-out model and see what my profit margin is and then back into the highest price that I am willing to way. I'm not really sure if this answers your question...I sort of started rambling, but hopefully this gives you a better idea of how I look at real estate investments
Definitely second this, I had a professor who loved to say you make money when you buy the building, not when you sell, because the price you enter the project will dictate the rest of the terms of the project. If you buy at the right price you can make a deal of it, if you buy too high you need to get lucky.
Dirty little secret of investments: you put a bid in on 90% of properties in the location and investment type you like. And than you buy the bids you win. Just make sure the price you bid at is a price that makes you comfortable based on the risks.
Yeah this isn’t true for all good investors OP just shops that have an ungodly amount of capital. Just a caveat.
My shop underwrites maybe 1 in 5-10 deals that come across our desk, and bid on maybe 1/5 of those. We are a development shop though to be fair so we are very picky on location, the surrounding market, feasibility of entitlements, etc. So many deals that meet our criteria at face value we might cut for some seemingly arbitrary reason even though it should be something we bid on based on our thesis.
Yeah if I’m not within 10% of asking, I usually don’t bother
Yeah but are you passing bc the broker says the price is $10 and you are only willing to pay $6? The shops I’m talking about will still bid $6 even if the broker says the price is $10 because on the chance no one bids, they are than in the mix. Many many shops operate this way.
When I was at a firm doing $10 billion per year, we passed on tons of deals. But many times we also put a bid in where we thought it made sense. I than moved to a small PE shop doing opportunistic deals. We basically put a bid in on everything that came out, but at a number that worked for us. To clarify by put a bid in-it means saying to the broker we could do it at this number-if so, we will write up a bid. If not, we will move on. So we lost almost every deal. But it wasn’t really a loss. It was just at a number that worked. Brokers love that because they get ‘feedback’ even if the number is not what they want. They get to go back to their seller and show them the market feedback. If you can consistently provide feedback, brokers will come back to you with their next deal. It’s part of developing the relationship.
Many lenders operate this way too. They’ll quote everything. Sometimes you quote to come in second, but many times you quote everything because it’s viewed, in some respects, as a service business. You provide capital at a safer part of the stack and service your clients by providing capital. On the equity side, if you’re buying from brokers, you need to provide the service of answering where you bid. It’s not just saying no, but saying-this deal doesn’t work for me for these reasons. But if the price were this, it works (if the price makes up for the issues with the deal).
Some people will say the method above is good. Some won’t. It depends on the firm. On the other side of the spectrum are firms that will only bid when they can win and know it’s a deal they want. This thought process is that someone doesn’t want to waste anyone’s time and so brokers know if they are bidding, they are 100% serious. Both methods work. It’s about it finding the method that works for you / your firm.
For instance in certain areas, where there is less deal flow - self storage and mobile home / RV parks. Many operators bid on everything at a price that works for them (or provide feedback at a price that works for them). Due to less deal flow, you need to be aggressive on everything to get scale. In assets like multifamily and office, there are significantly more assets. Therefore, you can be a little pickier on deals because there is always another deal down the block coming up for bidding that might be a little better.
So this is how it worked when I was an analyst at a fairly large development shop before I left to go on my own.
Usually one of the VPs would send me an email about a new land opportunity, on market or off market (sometimes I would find deals on my own, but those never got very far). First step would be to check out the existing rental rates in the immediate area, if they weren't above a certain threshold, we probably wouldn't even bother (we built multifamily, however I'm sure there's some overlap way with other product). Towards the end of my time there we were getting crushed on construction costs.
Then I would check into the existing zoning - how many units could we build, what height could the product be built at?
And then smaller details, although important - what are the sales comps in the area, what about occupancy rates of multifamily in the immediate area?
And then I'd walk over to our construction team, - "Hey Bill, I'm looking at a garden style multifamily deal here in Atlanta. What do you think we could build it for?" - "Well, we just finished a project near there at $136 PSF. Add 10% to that and then another 3% on top of that just to be safe."
Edit- Then we would look at yield on costs assuming no leverage. We generally wanted to be at least125-150 basis points above the current cap rate for the area - so if deals were selling for 4 caps we wanted to be around 5.25 - 5.50% yield on costs. Some people would say that's pretty low and I agree, however we had a large fund to use and needed to place money, plus we were planning on holding some of these projects for 10-20 years in A+++ areas with 90+ walk scores, so those projects we could afford to build at lower yields.
And then all that tells us how much we can pay for the land and it still be a good deal. I always thought it was interesting that you basically determined that piece last - how much could we pay for the land?
This is basically 100% on point
This holds for other asset classes as well
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