How to Buy Your Property
This is Part 6 of a series on how to get started in real estate. Each new installment will be a bite-sized tutorial gleaned from 30 years of investing experience. The goal is to remove as much doubt and fear as possible, so you’ll begin, or continue, the process of creating enough passive income to change your life. If you missed previous posts, you may access them at www.richdoctor.com
You’ve gone through all the steps, and you’ve finally found the piece of real estate that will work for you.
What do you do next?
Buy it!
How to Make the Offer
If you’ve gotten to this point and have followed the principles in the previous lessons, you know this is a market you like, and this property fits your criteria.
This could be single-family home that you intend to rent, or it could be a small to medium apartment complex. (Generally, a larger apartment complex will require investors, and we’re focusing on personal acquisitions with this series.)
The offering mechanics are different for each.
Single Family:
If you are buying a single-family home, you or your broker will submit a signed contract to the seller. If they like your offer and they countersign, you have a binding contract.
If they don’t like your offer, but it’s close enough, they will send back a counteroffer with changes to your original contract. Eventually, if the deal is meant to happen, you and the seller will come to an agreement.
Multifamily (Over 4 units)
If you are pursuing an apartment complex, you will likely use a Letter of Intent (LOI) to indicate your interest in the property.
The LOI is non-binding, yet it indicates your intent to execute a binding contract and purchase the property. The LOI should contain the property information, your initial purchase price, the amount of earnest money and whether it is refundable or not, due diligence requests, financing contingencies, and timeframes for the entire process. (You can Google LOI forms, or use a template if you’re an Inner Circle member.)
This is where you make an educated offer, based on the facts and numbers that are available to you. You should have the market information already because that’s what you used to choose this market. If not, this is the time to tighten up that information.
The rest of the numbers come from the seller. While you will use the seller’s numbers for your LOI, you will use the actual property numbers to adjust your offering price during the contract due diligence phase. (This will be discussed in more detail in a separate article.)
If you’re experienced, you can sometimes submit an LOI before seeing the property. However, most of the time, you’ll walk the property before you submit your offer. This is a time to engage members of your team, such as your property manager and your contractor. They will help you adjust your offer based on the outward physical condition of the property.
Once the LOI is negotiated and countersigned by the Seller, you then proceed to the execution of a Purchase and Sale Agreement (PSA). The PSA is the binding contract for the sale.
Keep in mind that, prior to the execution of the binding PSA, you can continue to negotiate with the seller. This is where earnest money is agreed upon and whether it is refundable. At certain phases of the real estate cycle, it might be a seller’s market and you will not be able to win a contract without putting non-refundable deposits at risk. This is called “hard” earnest money and the seller legally can keep your deposit if you don’t buy the property. So, know your property and your market.
Other parameters are negotiated such as the length of due diligence, required loan terms, exit clauses and date of closing. Once everything is agreed and countersigned, you now have a binding contract. It is at this point that you deposit your earnest money and begin the more detailed research into the property.
Keep in mind that, though the contract is binding, it will contain clauses that allow termination or renegotiation based on facts discovered during due diligence.
A real estate contract attorney is strongly suggested if you are buying multifamily property. They will keep you out of trouble by covering things that you wouldn’t know to look for. In the case of single-family home purchases, your broker can help you with the standard real estate contract, but it never hurts to have an attorney look at it.
How to Determine the Price
How do you know what to offer or if the price is right?
For multifamily and single-family, it is assumed that you know the market and have researched the demographics, demand for that product, comparable properties, jobs, population growth, median income, crime, and walkability, to name a few.
With that as a backdrop, this is where you begin your pricing journey.
Single-family
In the case of single-family, duplexes and fourplexes, the seller will typically have a stated offering price. You, or you and your broker, will begin by offering a fair price that fits your financial parameters. Depending on your needs, the price of the property and the state of the local market, that offering price could be less than asking price, full price, or even above what was advertised.
It’s at this point that you commence your due diligence to see if the numbers and the condition of the property support your original offer. If they do, you have a deal. If they don’t, you begin negotiations with the seller based on the facts that you’ve uncovered.
Sometimes you obtain a price reduction and sometimes the seller doesn’t lower the price. It’s at that point that you either buy at a price higher than you feel is appropriate, or you move on to the next deal. (I suggest the latter.)
Multifamily
If you’re buying a multifamily property, most of the time the selling price is left blank and is listed as “TBD” or “Market.” This means it must be calculated.
To be fair, there is typically what is sometimes referred to as a “whisper price.” That’s an unpublished number, but it’s a price that your broker, or the selling broker knows that the seller is shooting for. It’s a reference point for your calculations.
The value of MF properties is based on the cash flow it produces and the market conditions at the time of sale.
If it’s a hot seller’s market, with high buyer demand and low product supply, you’ll pay more for a particular cash flow stream. If it’s a slow buyer’s market, you’ll pay relatively less.
The indicator for market demand in the multifamily space is the capitalization rate (Cap Rate). It’s a difficult concept to grasp at first, but once you have it in your head, it makes perfect sense. It’s also an important part of the price calculation.
Properties that have higher rents and lower expenses produce more cash flow and will sell for more. The opposite is true for those that have lower cash flow.
The indicator for cash flow is the Net Operating Income (NOI). This number documents the income left over after operating expenses are deducted from property revenue. This number does not include debt cost.
So, to determine the value of a multifamily property, the formula is this:
Net Operating Income/Capitalization Rate = Property Value
To determine your initial offering price, you’ll plug known numbers into this formula to see if the property fits your parameters.
Cap rate can be obtained from your broker because he or she will know how other similar properties have transacted. If you don’t have a broker, you can do the calculations on comparable sales by using the formula above.
The remaining revenue and expense numbers are obtained from the buyer. These are usually found in the operating memorandum or the 12-month Profit and Loss statement if you have one.
For example, if the NOI is $300,000 annually and the selling Cap Rate for similar properties is 4%, the presumed value of this example property would be $300,000/0.04 = $7,500,00. If the “whisper price” is $7,500,000, you would feel comfortable that, based on the information you have, this might be fair deal.
The final piece of the puzzle is to determine if it’s a fair deal for YOU. To do this, you must determine if the investment will produce a profit for you. For that, you must know your debt costs. Your broker will have contacts and information to help you, or you can discuss the deal with a lender. In either case, they will give you the typical loan parameters for this type of property.
Once you have the property and debt numbers, you subtract the projected cost, including debt, from the projected revenue to determine if the number is positive. If it is, you have a potential cash-flowing investment. If it’s not, you must adjust your offer, or move to another opportunity.
Remember, we’re calculating these numbers to formulate an initial offer, so this might not be the final contracted selling price. Numbers that are offered publicly by the seller do not always match with the actual numbers produced by the property. If you have structured your PSA with proper due diligence contingencies, and there is a discrepancy, you can adjust your final offer. One bit of advice is to utilize your team to make the most educated and conservative offer at the beginning.
We’ll address the details of due diligence and renegotiation, as well as full underwriting, in separate articles. For now, we’re trying to arrive at a reasonable price, so that we can begin the fact-finding mission of due diligence.
The Goal
The goal is to purchase a property for a price that will result in positive cash flow and a positive return on investment. This creates passive income which is the key component of your journey to freedom.
Cash flow is determined by dividing the annual positive cash flow by the cash outlay to purchase.
Assume your down payment and closing costs are $50,000 and your monthly cash flow after all expenses, including debt, is $400, or $4,800 annually. Annualized cash flow is determined by the formula below:
Annual Cash Flow/Cost of Purchase X 100 = Annualized Cash Flow
So, $4,800/$50,000 = 0.096 or 9.6%. This is the return on your cash investment. If that fits your parameters, you know you’re on the right track.
Full Return on Investment includes amortization gains and tax benefits, which will generally be higher than the cash flow number.
Summary
In summary, you must be comfortable making offers. If you don’t make offers you won’t buy property. Many (or most) of your offers will be rejected. It’s not personal and it’s part of the game.
If you’re buying single family to fourplexes, the price will be stated, and you’ll need to validate it.
If you’re buying multifamily, you’ll be asked to determine the price, but you’ll have a good idea of what is expected.
These are only offers. Though you will have binding contracts, there will be contingencies for you to exit the deal if your due diligence is not satisfactory. The one exception is in the multifamily value-add market today. Many of those contracts require “hard” earnest money deposits to secure a contract. Thus, your education and experience will be required.
One final word.
The real work in making a purchase comes next and is a crucial part of the process. Once you have secured a contract, it is time to do your due diligence. This is where you dig deep into the facts of the property, and it is where you make your money!
So don’t miss the next article!
To your success!
Tom
