Establish and follow guiding principles
When you’re looking at many types of income properties and analyzing them, you need to have a set of guiding principles for investment. Without them, you’d probably wander aimlessly in the real estate investment game.
We’ve used the following standards for years ourselves and with our clients, and we’ve saved many people, including ourselves, from passing up that great once-in-a-lifetime deal or buying that deal that really stunk. Your guiding principles are basically fail-safe measures to guide you into cash-flowing, wealth-building investments and to keep you out of negative cash-flowing ones.
FIGURE 3-2: The breakeven point in this example is 55 percent.
Here are our guiding principles:
Make sure that you have a positive cash flow. We believe that having positive cash flow keeps your momentum going. Positive cash flow allows you to leave your day job if that’s your goal. Positive cash flow allows you to invest more money, and it opens doors for the next investment to flow right in.
Have a cash-on-cash return of 8 percent or greater. A good cash-on-cash return puts velocity on your money. It keeps your cash flow positive when you have those not-so-good months. A good cash-on-cash return allows you to brag to your investor buddies about what a well-run property you have.
Have a cap rate of 7 percent or greater. A great cap rate means your NOI is healthy. A healthy NOI is stable and growing, which means your property value is doing the same. A great cap rate also gets you the best loan terms.
These are only starting guiding principles of investment. You have to start someplace, right? You may be thinking, “But you won’t find any 7 caps in my city!” And you may even believe that it’s impossible to find higher cash-on-cash returns. Or you may be convinced that it’s impossible to cash flow positively unless you put down 50 percent. Well, our reply to that type of thinking is this: Sooner or later, you’ll be convinced and support the theory that at any one time, great deals are out there waiting for you.
Running the Numbers on Some Properties
Now that you have some basic commercial property investment terms and principles under your belt, we want to walk you through analyzing two properties. This is where it gets fun!
Look at the price per square foot. When analyzing retail, one of the first things we look at is the price per square foot. It’s an easy way to compare apples to apples and oranges to oranges. It’s also a way to get a reality check to see whether you’re paying too much for the property compared to other recent sales.
Be conservative in your number crunching. What you’ll find when you own a few retail centers is that incomes given to you by either the broker or seller are overstated, and expenses are understated. Really take a hard look at each item given and then take a conservative approach when running your numbers.
Replace your reserves. One of the most overlooked expenses when analyzing retail is the replacement reserve. Replacement reserve is an amount set aside every month to pay for property items that wear out and need to be replaced, such as roofs, siding, sidewalks, parking lots, heating/air-conditioning equipment, and so on. When these items come up for repair or replacement three to five years after you take ownership, the money has to come from somewhere — refinancing, your pockets, your partner’s pockets, or a reserve account you cleverly set up ahead of time.
Look at the parking ratio. The parking ratio for your retail center is more important than you think. The standard to begin with is four spaces per 1,000 square feet. If you don’t have enough parking, it can create a problem down the road.
Consider class. All commercial properties fall under classifications — A, B, C, or maybe even D. Class A properties are newer, have top-of-the-line features, are in the best locations, and attract the highest-quality tenants. As you go into the lower classes, location, age, and construction become less desirable. Pay attention to what class property you’re evaluating because as classes differ, so do location, price, rent, and occupancy.
Match rent rolls to estoppels. The rent roll is a list of tenant names showing what they pay in rent, in addition to when the lease agreement expires. Estoppels are letters sent to the tenant by someone other than the landlord to confirm in writing the terms of the lease, including rent amount, lease expirations, and any other options they have agreed on.Estoppels are used because the tenant may not be paying the landlord the appropriate rent (for whatever reason), or the landlord may have made a side agreement with the tenant that can’t be confirmed or enforced by new owners. When the tenant-signed estoppels are received, you can compare them to the rent rolls and actual signed leases for income verification.
Check in with your lender early. Before digging too deeply into your analysis, call up your lender and present the rent roll, the type of tenants, and financials to them. Have the lender review this deal from their perspective. Some lenders may not like certain businesses. For example, securing a loan for a shopping center with a dry cleaner or automotive repair place has been more difficult lately because of environmental concerns. Even movie theater chains and office buildings have come under scrutiny because of recent changes in the marketplace.
Analyzing an apartment deal
Unless we're taking some time off, most days you'll find us analyzing deals along with our Mentoring Clients. Apartments are a great place to start since they're easy to analyze and everyone needs a place to live. Let's look at a sample deal together so you can follow along with the process.
Cool Heights Apartments is offered at $1,650,000. It’s a well-maintained 20-unit (all 2-bed/1-bath) complex located in an up-and-coming area one block from City Hall. Each unit is rented for $1,575 per month, and the building is currently 100-percent occupied. The owner has spent more than $100,000 in rehab and upgrades in the last 12 months. All new furnaces and air conditioners were installed. The owner is retiring to Florida, which is the reason for selling. Professional property management is in place, and the building is managed very well. It has a good rental history. Covered parking is included. Tenants are responsible for their own electric and heat utility bills; the owner pays for the property’s water and garbage removal. The total building square footage is 22,160 square feet.
The following financial data was given for yearly operating expenses:
Insurance: $13,500
Real estate taxes: $28,830
Maintenance: $44,700
Electrical (common area): $3,900
Water/sewer: $28,200
Property management (5 percent): $18,630
Garbage removal: $3,450
Supplies: $8,100
Reserves: $18,000
Accounting: $4,200
So, adding that up, the total operating expenses are