How to Get Started in Real Estate – Part 7

This is Part 7 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 have now located a seemingly suitable property and made your offer based on information provided by the seller. Your offer has been accepted. Now it’s time to evaluate the property in more detail.

During this process, you will confirm or adjust assumptions and use that information to renegotiate your offer, if appropriate, after the completion of your due diligence.

When you are buying investment property, the assumption is that you are acquiring the asset to make a profit. So, you need to do the numbers to see if it will produce the result that you desire.

You can buy investment real estate for two broad reasons: 1) Appreciation and capital gain, or 2) cash flow. For each situation, you’ll want to know if the economics of the property fit your business plan.

If you’re holding for appreciation, you will want the property to produce a modest return, or at least break even, as you wait for prices to rise. My suggestion is to avoid buying property that does not have positive cash flow, no matter how good the predicted appreciation is. Nobody can predict the future.

If you’re buying for cash flow, you’ll want to know if the predicted income will fall within your acceptable parameters.

I each instance, you will want to underwrite the property numbers.

Underwriting

Working the numbers on a property is simple in some respects and challenging in others. The numbers are simple and can be plugged into a spreadsheet to spit out the results.

Sometimes the hard part is getting accurate numbers from your seller!

The first thing you need is the historical property numbers. This usually comes in the form of a 12-month profit and loss statement, often called a “T12.” If created honestly, this will give you most of the numbers you’ll need.

Here you’ll get expected revenue (gross potential rent), actual revenue, other revenue, bad debt, vacancy loss, loss to lease, operating expenses, debt expense, taxes, and insurance. You’ll also get a rent roll, which identifies each tenant and the amount of rent they pay, along with delinquency information.

These are the first numbers you plug into your spread sheet, though they could change as you dig deeper into your due diligence.

Why?

Sellers want to get the highest price possible, so they might underemphasize certain numbers or problems associated with the property. That’s a nice way of saying that sellers don’t always tell the truth or fully disclose everything. So, you must be a detective.

Some sellers are transparent and honest, but they also might be unsophisticated. If this is the case, often the numbers you need will not be recorded. This is common if the previous owner didn’t use professional management.

In either instance, you must verify the numbers in your initial underwriting and change them as you confirm the facts. Here’s a list of some numbers you’ll need:

• Gross potential rent – you can confirm these numbers by shopping comparable properties in the area. This will give you an idea of how much you can charge for rent and if the numbers match.
• Actual rent – This is confirmed with a lease audit. You inspect every lease for every tenant and verify that the rent on the lease is the same as represented in the rent roll.
• Other revenue – This will be noted on individual leases and should be documented in the monthly P&L’s. It should be corroborated with bank statements.
• Bad debt – This should be noted in the rent roll.
• Vacancy loss – This can be found in lease audit and the P&L.
• Loss to lease – This is the difference between verifiable market rents and actual rents
• Operating Expenses – These can be cross-checked with the bank statements. There are also common ratios that can be used as a rule of thumb for quick reference. This is where you might find value because you might be more efficient with your operations than the current owner. You can also find that the previous owner underspent on things like maintenance, which might need to be increased to run a top-notch property.
• Debt Expense – The seller’s debt should not concern you because you’ll have your own debt to consider. However, you should be able to plug in tentative numbers obtained from a prospective lender. You’ll need to know the typical loan to value, interest rate and how long it is fixed, amortization, and pre-payment penalties.
• Taxes – Taxes are easy to confirm through receipts, but this is where some buyers can get tripped up. Taxes will typically be higher after you purchase the property. You will typically be buying the property at a higher value than the tax valuation. For this reason, you must use your intended purchase price and multiply by the typical tax rate for that municipality. It’s usually higher than what is represented in the T12. You must plug in your new, higher tax rate or you’ll be surprised when you get the bill!
• Insurance – this can be verified by getting a quote from your insurance agent.

Once you have YOUR numbers in the analysis, you can determine the Net Operating Income (NOI). With the NOI and the prevailing cap rate for that type of property, you’ll be able to determine a preliminary price that meets your business plan.

That price might be different than the seller’s, but you’ll have facts to back up your request for a price adjustment.

Inspection

Now you have a preliminary purchase price, based on the actual numbers and operation of the property. Next is the physical due diligence, or the inspection.

Whether the numbers are good or bad, you must physically inspect the grounds and buildings of the property you’re evaluating. You must understand it’s physical condition and whether you will be required to spend money on things that need to be repaired. This is called deferred maintenance.

I suggest you walk each unit of a multi-unit property, and it’s in your best interest to have a contractor and a property manager with you. Between the two, they will be able to identify problems and predict what will likely need repair. These are added costs you must be aware of before you close the deal.

Other important data points will come from your roof, plumbing and electrical inspections. I suggest you have these trades lined up before you make the offer.

Once you have a list of necessary repairs, you can obtain bids and prices to ascertain how much it will cost you to bring the building up to proper standards.

This number can be another fact that you can use to renegotiate and obtain a fair price that fits your plan.

The final piece of the puzzle is third-party reports. You’ll need these so that you know what you’re buying and to avoid government regulatory issues going forward.

These reports include:

• Phase I environmental report
• Phase II (if necessary)
• Survey (typically provided by seller)
• Tax report
• Insurance loss run report
• Appraisal

Final Negotiation

At this point, you should have all the information you need to negotiate a fair price. You have the hard facts and are not negotiating from an emotional position. If the seller agrees, he or she will adjust the purchase price or make other concessions that will make this a win-win for everybody.

Often the seller will be unaware of problems because they haven’t recently inspected their property as intensely as you have just done. This is good for both of you. He or she gets a factual idea of their property’s worth, and you know exactly what you’re buying.

If you and the seller don’t agree, you have the choice to buy at a less desirable price, or walk away, because you set those parameters in your PSA.

It doesn’t always work out, but most of the time, if due diligence is performed properly, and the facts are explained to the seller, a deal is consummated.

Success in real estate is often a factor of when and how you buy your properties. Proper due diligence is your hedge against a poorly performing asset. It doesn’t guarantee success, but it gives you the best chance possible.

To your success!

Tom