Evaluating a Real Estate Investment

Secyh62's picture
Rank: King Kong | 1,791

Alright so I don't know much about real estate other than what the CFA curriculum details and what I've read on this forum/google. I'm considering starting to invest in real estate provided the returns are adequate enough relative to the risk and illiquidity. Trying to look at it from all possible angles and have put together a list of questions I hoped some of you could help me with listed below in no particular order:

1.) I plan on running the numbers on the three states that myself and my potential partner are interested in (3 states that are within a driving distance that we would be willing to make). What would be my best source to compile some demographic data like population growth, income trends and what not? Plan is to compile these numbers on a state wide basis and from there come up with some target areas to look in and watch for new opportunities. So far I've really just looked at U.S. Census data but was curious if there is a better source. Somewhat related to that, is there like a Bloomberg for real estate investors at the professional level?

2.) As far as sourcing potential investments once target locations are established, what are some good resources to find properties? Obviously there are a lot of residential websites but what about commercial or listings that are targeted towards investors? So far I've found loopnet.com to be decent, anything similar to that?

3.) To derive NOI, I've got: Rental Income at Full Occ + Other Income - Vacancy/Collection Loss - Operating Expenses = NOI. What else goes into that? Operating expenses I'm assuming cover mortgage payment/property taxes, insurance, maybe like a contribution to a maintenance reserve account. What else is included in operating expenses assuming I would not use a property manager (have read quite a few posts against using a property manager and never had good experiences with them as a tenant in college)? Vacancy loss 5% a reasonable estimate? What would be a good % of the rental income to contribute to a maintenance reserve account?

4.) Why is cap rate a consideration in evaluating an investment? Wouldn't cash on cash return be what you would really judge the investment by? Also, does the growth of your equity get included in the cash on cash return? Most of what I read only mentions the NOI against your initial investment.

5.) Was considering at first forming an LLC with my potential partner but after reading more on it, seems like its better to finance it in my name (at least the first property, finance the next in his name) using an FHA loan as a primary residence and then taking out liability insurance. How does that work with primary residence, would I then be taxed as a resident of the town the property is in? What changes for you personally if you list it as a primary residence? Reason I ask is that I live at home and would most likely continue to do so for the immediate future so I wouldn't be physically living there and it wouldn't be an issue to get my mail there or pay that town's taxes or whatever I would have to do.

6.) When sourcing tenants, what can you legally require them to disclose? Can you run their credit, background check? What do people usually do to find and then screen their tenants? Would most likely try and avoid using real estate agents. In regards to real estate agents, when purchasing a property how does the commission work for the listing agent if I'm sourcing the property directly? From my understanding when someone sells a property the commission is like 5% and then the listing agent and the buyer's agent split that. Would the guy still just get 2.5% or would he keep the whole 5%, applies more to exiting the investment?

7.) In reference to commercial real estate loans and properties, how does that process differ from residential? What kind of down payment would you need and whats the spread on a commercial rate relative to a residential? If we hypothetically did start an LLC, would the lender evaluate our collective credit scores when coming up with a rate? Is personal credit score weighted as heavily, if at all, in a commercial loan?

Again pretty new to this and tried to answer as many questions as I could ahead of time before making this long post. Really appreciate any answers and advice you guys have. Have a good weekend!

Comments (35)

Jul 7, 2017

1) It's not free, but I really like STDB for market research.

2) Make friends w/ brokers & ppl in the business. The best deals tend to be off-market.

3) Potential Gross Income (PGI) - Vacancy/credit loss + other income (vending machines, etc.) + Expense Recoveries = Effective Gross Income (EGI) - Operating Expenses = NOI. Cap X is a below the line item, so conduct due diligence to make sure that a property's NOI isn't going to get eaten up by needed Cap X improvements that aren't in a broker's provided numbers.

4) Cap rates are a relative valuation tool. They're inverse P/E ratios, so they tell you what similar RE assets in the area are trading at. You should use cap rates to ascertain your purchase and sale price. When you run a pro forma on an income producing property to hold for a period and sell you should use several valuation methods. I use IRR, an Equity CF Multiple, and Partitioned IRR (operational CFs & reversion CFs) in my pro formas. If you're developing P/E ratios and development yield are good metrics.

5) Usually a limited partnership, but partnership formation is above my pay-grade.

6) Never had a problem getting that info for retail tenants, not in MF, but everyone has applied to and been screened by apartment owners. Commissions vary a lot.

7) Debt market guys will have better answers on this. 80/20 LTV is pretty standard, recourse vs non-recourse varies, DSCR (debt service coverage ratio or NOI/debt service) covenants are standard.

I come from down in the Valley, where Mr. when you're young, they bring you up to do like your daddy done.

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Jul 8, 2017

Thanks this is very helpful, how would an off market deal work? Wouldn't there be incentive for the seller to list a property to get competitive bids?

Jul 8, 2017

The incentive for sellers to sell off-market is typically speed of sale and elimination of marketing/listing costs. In some cases property owners can just reach out to investors that they know and cut brokers out, reducing cost.

I would recommend trying to find a partner who is experienced in RE and has the rolodex to prove it. The financial side of it is not all that complicated, but it's a particularly relationship driven business.

I come from down in the Valley, where Mr. when you're young, they bring you up to do like your daddy done.

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Jul 7, 2017

Maybe you should wait a year or 5 before you invest. Those are a lot of simple terms that you don't know.

A lender will evaluate your credit scores, cash in the bank, career, and real estate owned. This is called Global Cash Flow. If it is not a single family of FHA loan then you need at least 6-12 months P&I in an account at the bank. You don't, but "you" probably will. Down payment will be 25% of Sales Price. If you source a deal yourself then you don't pay commission and you'd have to really be on the numbers to know if the FSBO did or did not include it in the price.

Jul 8, 2017

ya they're probably simple terms if you're in real estate, but for me it's all new. Legitimately the first time I've ever seen the term "global cash flow" so I appreciate the response. Trying to learn as much as I can before I do anything expensive and stupid haha

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Jul 8, 2017
C.R.E. Shervin:

Maybe you should wait a year or 5 before you invest. Those are a lot of simple terms that you don't know.

A lender will evaluate your credit scores, cash in the bank, career, and real estate owned. This is called Global Cash Flow. If it is not a single family of FHA loan ....

+100

Also, related to #7, agency debt(Fannie/Freddie) has minimum liquidity/net worth requirements for individual signing for the carve outs.

Jul 10, 2017

You've done a great job of identifying a lot of the questions that need to be asked, but I would recommend finding pros to answer them and help guide you. I am a big proponent of paying for professional advice. In my opinion, your first step once you identify a market and asset-type that you want to invest in is to start reaching out to brokers and soliciting their help/advice. If you can identify a good broker, they can be invaluable to helping with deal flow and with answering some of the questions above. They should also have connections with debt providers who can help you figure out what you need to do to help qualify for a loan (or if you can). For entity formation/tax questions I would find a good attorney and/or CPA. Trying to save money by going at all of these things alone can end up costing you more in the long run. I would also try to make contacts with people who are experienced in real estate investing so you can have a mentor of sorts to bounce any questions off of when you are getting advice that you aren't so sure about. (Obviously there are online resources for this too - biggerpockets might be more applicable than WSO when you are discussing buying single family rentals)

Real estate investing can be complicated, time consuming and can have pretty high barriers to entry. REITs exist because of this. With a REIT (or fund or retail syndication) you are basically forgoing a bit of the upside to pay an experienced manager to handle all of these questions - as well as allowing yourself to diversify with less capital.

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Jul 11, 2017

Thanks for the advice, never heard of biggerpockets before but at first glance it seems like that would be the place to ask these things. One other quick question, when you say identify a good broker, how would you go about doing this? I'm assuming we're not talking about a William Raveis or Berkshire.

Jul 11, 2017

3) Operating expenses include real estate taxes because they are annual or semiannual expenses. Debt service (mortgage payments) are after NOI. This is because debt service isn't required to operate the property. You can acquire a property with 100% equity financing, and then your cash flow would equal your NOI. For a small MF property, a credit loss of 5% could be reasonable since a single instance will have a larger negative impact.

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Jul 11, 2017

Some brokers send out email blasts about listings mostly to people they've already worked with. You could email/call your local cb/jll/cw etc and ask if they have something like that you could get.

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Jul 11, 2017

8 + 6 = 14
14 - 6 = 8
-8 + 14 = 6

Hope this helps.

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Jul 11, 2017

what

Jul 11, 2017
inspiredanalyst:

what are the formulas for determining the returns associated with income and appreciation? in other words, lets say total return on the property is 14%, income returns at 6% and appreciation return is at 8%...how do I derive those percentages? Sorry if this is a simple calc....

take each of the numbers and submit them to the Zoroastrian chart of numerical forecasting as directed by the sun God

Jul 11, 2017

@inspiredanalyst - I think every firm calculates their income and appreciation returns differently. Here is a general equation. Hopefully this helps with your question.

Income Return = (NOI) / (BV + 1/2Capex - 1/2PartialSales - 1/3NOI)
Appreciation Return = [(EV-BV) + PartialSales - Capex] / (BV + 1/2Capex - 1/2PartialSales - 1/3NOI)

BV is "beginning market value"
EV is "ending market value"
Sales is "partial sales"

Jul 11, 2017

Internal rate of return (IRR) is industry standard for calculating returns. It takes into account initial investment, periodic cash flows, and either terminal value or final cash inflow from sale of the asset.

Google IRR and learn it. It's a critical measure in real estate.

Also, compound annual growth rate (CAGR) is another plausible, though less common, tool used to measure returns.

Jul 11, 2017

Is the total return IRR = 14%? Or are you simply talking about bought in Year 0 at $100, with $1 income for 4 years and sale price of $110? ($110 + $4/$100) = 14%?

Robert Clayton Dean: What is happening?
Brill: I blew up the building.
Robert Clayton Dean: Why?
Brill: Because you made a phone call.

Jul 11, 2017

I did not follow that

Year 0 Year 1 Year 2 Year 3 Year 4

-100 1 1 1 111

IRR: 3.3769%

Jul 11, 2017

thanks everyone who gave quality responses. I found this closest to be the answer I was expecting. Thanks @nestle22

https://www.ncreif.org/download.aspx?file=Defining...

Jul 11, 2017

It sounds like he is well connected. Possibly he could make introductions for you and the interviews can come that way. You have to have a conversation with the guy and tell him you want to work for a larger firm to get some institutional training before going back to a place like his. This is a plausible story to tell without offending anyone.

If he sets up the interviews, then you could tailor your resume accordingly because the interviewers will know enough about his businesses to not overlook the experience.

Otherwise, there are a lot of people who work for small companies that make it into larger firms. If you did what you say you did then I would consider you quite experienced for an undergrad.

Jul 11, 2017

I appreciate the compliment, it certainly eases a lot of tension.

My only fear was going into an interview, and then the company conducting a background check, realizing theres no website, etc. and thinking I'm some liar. I know it's a big world, but in reality it's really small and someone from one company more than likely knows someone from anther company who is also hiring. I didn't want to be anther case of a person lying on their resume otherwise their forum would probably hear about me, but not in the "success stories section." lol

I'm not so sure if he would be keen on setting me up with a banking interview since he is very strong on maintaining "his talent" plus has trained me for the past two years in order to be able to essentially run his business a long side him. It sounds glorious but I'm significantly more interested with investment banking since it's more exciting to me. Keep in mind with what I do now, if I were to work the same sort of hours I could more than likely maintain a similar lifestyle in terms of income, so my interests have nothing to do with financial gain, etc. I'm interested in working within M&A, at a big bank, working on big deals (aren't we all.) It just sounds a lot better to me.

With that sort of experience should I forget about any other sort of internship unless it's working for a bulge bracket. My fear was it had no accounting or real "hardcore" finance involved on my resume, however I'am an accounting major. I just want to be the complete package.

Jul 11, 2017

Welcome to WSO Anuj!

Jul 11, 2017

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Jul 11, 2017

I mean, it's pretty simple for me. Have a few small MF's, few SFR's, couple small (2-3 unit) retail buildings. I don't have anything considered class A, Local space type retail, nothing single tenant but the SFR's, and everything underwritten EXTREMELY conservatively, especially the retail. Most of my MF's are quads, so when underwriting it(and explaining it to my wife) I write it at as if I have a vacant unit. If I'm at least breakeven on that, and it makes sense, I'll move forward into real DD. If not, move on. Do something similar for the retail space. Eventually I'll probably end up with a small office park too. Diversification. I also have the standard portfolio outside of RE that EVERYONE SHOULD HAVE. A normal percentage of assets, based on my age, is in appropriate asset classes. Well, I'm a little skewed to RE, but it's what I do for a living. I imagine if I was a trader it would be similar in that direction.

Jul 11, 2017

I've never understood owning real-estate as an investment for a personal portfolio. A growing dividend stock or a basket of dividend stocks has a really good yield.

Best Response
Jul 11, 2017

And you're right in a lot of cases. But it's your field. I work in real estate all day, every day. Most of my investments have been things I worked on. Bought a quad, lived in one, fixed up and rented out the others, that kind of thing. It cost me a lot less to get into it, I wasn't writing checks for 200k down to buy an apartment building. More like 20k. Plus it's tangible and people will always need somewhere to live and blah blah all the other reasons people do real estate. My retail space is value add shit I got cheap because I'm in brokerage and I can run a spreadsheet if I need to. I saw it, knew the area, did some napkin math, and then went back to my office to put together a model. The numbers made sense, and if I could rent the rest of the space it would be pure profit. It's like a PE firm buying a company and turning it around. Same shit, different words. But instead of H/S/W I went top 20 and I didn't start at GS, so here I am. Works for me in my market.

Jul 11, 2017

I own a portfolio of real assets, and I focus my efforts on three trophy assets within that portfolio. One asset is a below-grade parking garage, which I try to park my car in every night (except when they're closed for maintenance ~1 week a month). The other two are a set of contiguous mid-rise towers, which I make sure to seismically test on a daily basis. My portfolio doesn't really shake off any income, in fact it's operating at a loss at the moment. What's more is that I hear 10 to 20 years down the road, I'll start incurring all kinds of cap-ex spend! I think I'm in over my head

Jul 11, 2017

I'm curious as to why more junior/mid-level guys don't start their personal investments earlier on. Once you've learned how to crunch numbers, have a general understanding of the DD/closing process, and feel comfortable raising the necessary capital to do some deals, why not start browsing/underwriting deals immediately?

This business isn't rocket science, and you definitely don't need a decade(s) of experience to do your own thing.

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Jul 11, 2017
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Jul 11, 2017