“I can do it myself!”

These are the words that I would hear from my grandson when, as a toddler, he would try to pour juice from a large container into a cup. Grownups aren’t much different. It is a well-documented fact that no one of my gender will ever ask for directions. I’m not lost. I can find it myself.

Most of us (with the possible exception of investment bankers receiving TARP money) value our independence, self-sufficiency and self-reliance. Investors generally possess an independent and entrepreneurial spirit, so it is not surprising that they are at times reluctant to rely on brokers or lawyers to handle matters that they believe they can manage on their own – and at a lesser cost. Indeed, there are some situations you can take care of yourself, while others are best left to specialists.  The trick is recognizing the difference.

Your thinking may depend upon whether you invest in residential or non-residential (aka commercial) property. Let’s look at each separately.

Residential Property Investors

Using Brokers:

It is no secret that the Internet is changing the role of the residential real estate agent. Agents no longer have a near monopoly on information about single-family homes for sale. A survey by the National Association of Realtors® suggests that 88% of homebuyers search the Internet for properties. This kind of public access to information would have been unthinkable when I entered the real estate business in the 1970s. Then, the coveted multiple listing book was the only comprehensive source of information and was available only to agents.

So, if you’re a buyer of single-family properties, you should be able to accomplish most of your discovery on your own. Selling, however, is another matter. I won’t recite all of the justifications a well-trained agent will give you for using his or her services except to say that many of them are true. At the very least, selling a property is a labor-intensive undertaking, and after the dust settles you may not be much better off financially for having done the work yourself.

Using Lawyers:

Landlord-tenant relationships can be challenging for those who rent out residential property. It’s foolish not to have a written lease agreement to govern such a relationship – but do you need a lawyer to draft one? The short answer is yes. An off-the-shelf or do-it-yourself lease can prove dangerously inadequate. Every state has some type of landlord-tenant statute, and several cities have their own additional regulations. For example, some may require the lease to be in “plain language.” Speaking of language, most courts (if you have the misfortune to end up there) will interpret any ambiguous lease language in favor of the residential tenant. Their reasoning is that you, the landlord, produced the lease, so it was your responsibility to make it’s meaning clear.

How you handle funds can also have legal ramifications.  Most states have specific and detailed rules governing security deposits. What is the maximum amount you can take? Must you keep deposits in a separate escrow account? Do you have to pay interest, and if so, how much and when? How soon must you return a deposit after the end of the lease, and how must you document amounts withheld?

If your leases and security-deposit procedures are not in conformity with the rules of your jurisdiction you can end up with some nasty surprises, such as unenforceable lease terms and triple damages in the event of dispute.

Your best approach is to use an attorney who is familiar with landlord-tenant issues in your city and state to give you initial guidance and to draft a lease that is appropriate for your particular situation. You may need some provisions that are specific to a certain property type. For example, when renting single-family house, is the owner required to keep the water bill in his or her name? Who is responsible for exterior issues like snow removal or lawn cutting?

Once you have a suitable lease, then you can usually feel comfortable cloning that document for use with other tenants in the same or similar properties. Still, laws change so you should keep your ear to the legislative ground, or at least ask your lawyer to do so for you.

Commercial Property

Using Brokers:

The world of commercial property presents a challenge that is quite different from that of residential.  Yes, there are some national commercial databases like CoStar and LoopNet. (At this writing, the former has apparently just won U.S. antitrust approval to buy the latter.) In general, however, there is a great deal of information about commercial property that you cannot get by clicking a mouse, and so the role of the broker is often paramount.

Anyone who has tried to sell anything fully understands the need for exposure, but owners of commercial property also recognize the need for discretion. Most commercial properties house businesses – offices, retail stores, service establishments.  Putting a “For Sale” sign on a building, a “For Lease” sign in a store window, or an advertisement in a newspaper can have a serious negative impact on the businesses in that building. Even if all concerned agree that it is acceptable to make the availability of a building or a leasehold public, they may still be reluctant to reveal underlying financial data to anyone other than a bona fide prospective buyer or tenant. In short, commercial property is not an open book.

Hence, unless you have a substantial network of your own, you should not underestimate the benefit of using a  commercial broker and his or her network of investor and business contacts to get the word out to legitimate prospects. Likewise, buyers and tenants can use the broker as a primary source of information about available properties.

Commercial property brokerage is different from single-family home sales in yet another way. If you walk up to a house, knock on the door and say, “Sell me your house,” you generally won’t get an enthusiastic reception. Does the number “911″ spring to mind? If the homeowners weren’t already thinking about packing up their stuff, pulling their kids out of school and relocating to a different district, then your surprise visit probably won’t get them to do so. (Before you raise your hand to make a comment, I know what’s on your mind. Yes, in today’s hundred-year-storm market with so many homes underwater, you just might find someone anxious to take you up on this; but in general and certainly in more normal times, it’s a long shot.)

On the other hand, a good commercial broker should be aware of properties that are not currently listed for sale, but whose owners would let the broker “knock on their door,” i.e., give the broker an open listing in order to entertain a realistic proposal.   Information about such properties is part of the commercial broker’s stock in trade.

Using Lawyers:

Commercial leases typically differ from residential in a number of important ways:

• They often involve greater dollar amounts, especially over the full term of the lease.
• The lease term is usually longer and may contain interim increases in rent, as well as options to renew.
• While there may be some standard covenants, commercial leases are more complex, seldom cookie-cutter, and often the product of paragraph-by-paragraph negotiation.

If the first two reasons don’t convince you to use an experienced attorney, then the last one certainly should. I always thought I was pretty good at doing this sort of thing on my own until I needed to negotiate a lease with a national tenant.  There was nothing at all simple or straightforward about the process, and the dollars involved were too great to risk making a mistake. Even though I had already negotiated the general terms of the agreement, the devil, so the saying goes, was in the details. So get an angel, or at least a good lawyer, to sit on your shoulder.

Come back soon for Commandment #9

Previously: Ten Commandments for Real Estate Investors: Commandment #7

(c) Copyright 2012 Frank Gallinelli All Rights Reserved
All content in this blog is provided for entertainment and informational purposes only and with the understanding that the writers are not engaged in rendering, legal, professional, financial or investment advice. The owner of this blog makes no representations as to the accuracy or completeness of any information on this site or found by following any link on this site.

Among the many famous quips of H. L. Mencken was this: “For every complex problem there is an answer that is clear, simple, and wrong.”

Novice real estate investors – indeed, probably novices in almost anything – long for simplicity.  A simple approach is fine if it leads to meaningful and reliable results; but most real estate investments involve serious money and so they deserve a more serious and detailed plan of attack.

Investing in real estate is all about the numbers. I rail about this in my books and articles, and in the classes I teach – from continuing ed through grad school finance.  The point I try to make in all of these is that you, as an investor, are not really buying a building, despite what your closing attorney says. You are buying an income stream, the present and future cash flows.

This is very different from the reasoning you use when buying or selling a single-family home. There you look at market data, so-called “comparable sales.”  If other houses similar to this one and in this same neighborhood sold recently for $400,000, then this house also should be worth about $400,000.  On the other hand, two office buildings, similar in size and style and in the same general location, could have very dissimilar leases and thus have very different income streams. Their physical similarities notwithstanding, they would then command different values and probably perform differently as investments.  The only way you would recognize the differences would be to do the math, i.e., run projections of their income streams.

Many potential investors I encounter, and some active investors as well, believe that they really don’t need to do any heavy mathematical lifting at all. Simple and familiar chestnuts are good enough: “As long as I can finance 100% of this deal, I’ll buy it.”  “Any apartment building that costs me less than $20k per unit will make money.” “I only want a property if I can get it for less then seven times the gross rent.”

To be sure, in a given market at a given moment, you might occasionally survive using guidelines like these. For example, if you have enough data on a particular market to identify an appropriate multiplier, then “x times the gross rent” might yield an approximate measure of value for a two- to four-family rental property. For most income-property investments, however, oversimplification seriously diminishes your understanding of a property’s financial dynamics and your chances of success.

What kind of financial work-up do you need to do in order to make an informed decision about buying, selling or financing a particular income property? A proper answer to that requires a good deal more depth than one can fit into a blog post, but the short answer is that you want to do a pro forma analysis going out at least seven to ten years and possibly more. It needs to deal with projections of revenue, vacancy, operating expenses, Net Operating Income, debt service, cash flows, resale value, sale proceeds, and Internal Rate of Return.

To be a bit more specific:

• Start, as always, with your due diligence. Obtain an accurate current rent roll and a list of current operating expenses. Investigate what similar units are renting for in this location, and how much vacant space is on the market. Find out what the prevailing capitalization rate is for properties of this type.

• Build an Annual Property Operating Data form (aka “APOD”), showing revenue, vacancy allowance, operating expenses, and Net Operating Income (revenue minus vacancy minus opex). Project these amounts as you think they might grow or decline over your investment timeline. Try a set of best-case, worst-case, and intermediate assumptions.  Here is an example of an extended APOD (this and the others below are screenshots from my company’s investment analysis software):

• Estimate your annual debt service from all mortgages and subtract that from the property’s Net Operating Income to get your projected cash flow. Add or subtract any other items that might represent a cash inflow or outflow, such as money spent on capital improvements or leasing commissions. If the annual cash flows are minimal or negative, tear up your papers and go play a round of golf instead. Or maybe try to find a lower price at which the property will throw off a positive cash flow.  Here is an example of a detailed cash flow analysis:

• Estimate the resale value of the property by applying a capitalization rate to the projected Net Operating Income in future years. You can use the current market cap rate; or you can use one that is a bit lower or higher if you believe the market will improve or decline in the future.

• Estimate your proceeds from sale of the property by taking its resale value and subtracting all mortgage balances and any expected costs of sale, such as a broker’s commission. Take back any cash you’re holding in reserve. These sale proceeds are really your final cash flow.  Here is an example of a resale analysis with IRR:

There is nothing glamorous about doing the math, and for many people it is probably a chore; but as I’ve emphasized several times in this series of “commandments,” investing is a goal-driven enterprise where you need to identify your specific objectives and map a course to reach them. Whenever you invest, you expect a return on your invested capital. If you don’t run projections like these then you won’t really know what kind of income stream this property might produce, and whether or not that income stream can give you the return on your investment that you’re trying to achieve.  It can be an effort to do the math, but it’s a lot better than going off a cliff with a bad deal.

Come back soon for Commandment #8

Previously: Ten Commandments for Real Estate Investors: Commandment #6

(c) Copyright 2012 Frank Gallinelli All Rights Reserved
All content in this blog is provided for entertainment and informational purposes only and with the understanding that the writers are not engaged in rendering, legal, professional, financial or investment advice. The owner of this blog makes no representations as to the accuracy or completeness of any information on this site or found by following any link on this site.

As you know, the shin bone’s connected to the knee bone, and the knee bone’s connected to the thigh bone.

You may find a similar taxonomy in the field of real estate, where your personal and financial circumstances are connected to your investment objectives, and those in turn are connected to your investment choices. Unfortunately, many investors fail to make or even to think about these connections; but, of course, they should. What might your options be?

It’s simplistic and not particularly helpful to say that your objective is to make money. That’s a bit like saying your personal objective today is to continue breathing. You need to bring greater clarity and specificity to the process. Let’s indulge in a thought experiment. Consider some possible objectives you might have, and the type of property those objectives might draw you toward:

1. Your objective is to begin quickly to build substantial wealth; you recognize that great reward implies great risk and typically involves a significant commitment of time and personal effort.
2. Your objective is to build wealth slowly, with a horizon of anywhere from ten to thirty years.
3. Your objective is supplement your regular income with a steady and growing cash flow from your investment property.
4. Your objective is to diversify your investment portfolio with real estate that provides a modest but stable cash flow, and requires minimal commitment of personal involvement.

I do not want to suggest trafficking in stereotypes, but let’s hypothesize on who these investors could be and what kinds of property they might seek out:

The person with objective #1 doesn’t consider herself an investor at all, but more of an entrepreneur. Her goal is to build a full-time business. This person might rehab or flip houses, or choose to develop a condo project or perhaps a commercial building in the central business district. She might buy a piece of land, slog through the process of subdividing, and sell off lots or spec houses.

The second person might be an income-property investor with a very specific goal in mind. He may have small children and wants to build up a nest egg to pay those gazillion-dollar tuition bills ten or fifteen years down the road. He may be thinking about his own retirement thirty or more years hence. If we’re guessing right so far, then he probably is not looking at real estate as a career; so he could choose to buy income property that has a good upside but requires just a part-time commitment in regard to his personal involvement. A few multi-family houses or an apartment building with decent cash flow might meet his objectives. Likewise, a strip shopping center in a good location could suit his needs.

Our third investor is looking for current cash flow, and that would seem to imply a willingness to devote a bit more hands-on effort to maximize revenue and to stay on top of expenses. Residential property typically has shorter leases than commercial, and so offers more opportunities to enhance the income stream. An apartment or mixed-use building might be the investment of choice for this person.

Our final investor seems willing to trade off maximum return in exchange for least volatility and lowest-impact management. This could be a good addition to anyone’s portfolio, but might have particular appeal to a person nearing retirement. A triple-net-leased property could be a good choice here. The lease is typically long term with the tenant responsible for most if not all expenses. (Some landlords will retain responsibility for some exterior aspects of the building.) Hence, the cash flow tends to be stable and the management responsibilities minimal.

You should recognize that the purpose of this exercise is not to “profile” investors or to provide a prescription for who should buy what type of property. If anything, it should provide a template for how to think about your investment choices: First, assess your personal and financial circumstances. Next, given those circumstances, decide what your objective is – what you’re trying to accomplish with your investing or with your entrepreneurial plunge into real estate. Then, identify the type of properties or real estate activity that’s most likely to square up with your objective.

Finally, keep in mind that change is the greatest constant. Your personal circumstances will certainly change at some point, and so will your investment objectives. The kids are out of college. Make a new plan.

There is a well-known paraphrase of a famous passage from Lewis Carroll’s Alice in Wonderland: “If you don’t know where you’re going, any road will get you there.” In real estate investing, as in Wonderland, it’s essential to keep your destination in mind.

Come back soon for Commandment #5

Previously: Ten Commandments for Real Estate Investors: Commandment #3

(c) Copyright 2012 Frank Gallinelli All Rights Reserved
All content in this blog is provided for entertainment and informational purposes only and with the understanding that the writers are not engaged in rendering, legal, professional, financial or investment advice. The owner of this blog makes no representations as to the accuracy or completeness of any information on this site or found by following any link on this site.

I have no problem with the idea of getting rich quickly. If you can do it, ethically, legally and honorably, then please go right ahead.

However, there are a number of ways to make money in real estate, and I believe there is some value in differentiating among them.  The differences, you may say, are semantic, but that’s all right.  Words convey meaning, and meaning reveals purpose.

Rehabbing houses is one way to make money in real estate. Rehabbing is a business. You acquire inventory, add value, mark it up, and sell for a profit, all in a relatively short time.

Flipping houses is a speculative endeavor. You acquire inventory at what you believe is a significant discount below market, mark it up to what you believe is the true market value, and again expect to sell for a profit.  You can make a great amount quickly, but all speculation is risky because the market can go down as well as up. If it does you can be stuck with unsold inventory and high carrying costs. Remember that Ford Edsel franchise you bought in 1958?

Getting rich slowly, aka investing, is another approach. It doesn’t have to be to the exclusion of other ways of making money.  You can be a stock day-trader and still have a mutual fund account. You can be a rehabber or flipper, and also an investor.

Back to our semantics. I look at an investment this way:

An investment is the commitment of capital, time and effort in the expectation that it will throw off future income and grow in value. Issues accompanying most real estate investments include cash required, leverage, degree of risk, rate of return, liquidity and the ongoing commitment of time and effort (i.e., management).

When you acquire income-producing real estate as an investment, your mindset should be long term. By that I mean holding on to a property for at least several years and perhaps even many years. Your goal is to have an ongoing and growing cash flow from the property. As the income stream increases over time, the value of the property should increase along with it. If you can be proactive about enhancing that income stream, then you can literally create equity.

Leverage makes it possible for you to acquire an asset whose growth in value over time is disproportionate to the cash you invest. An income-property investment does not offer the liquidity of a stock investment, but that may counterintuitively work to your advantage. How many times have you seen a stock investor panic during a downturn, and sell at the bottom of a market? Your longer time horizon as a “buy and hold” investor means you are less vulnerable to market volativity. With a decent cash flow and a little discipline, you can ride out the economic cycles that invariably occur, and choose to sell when it is to your advantage.  Time, to paraphrase Mick Jagger, is on your side.

Come back soon for Commandment #4

Previously: Commandment #2: Thous Shalt Be Clear.

(c) Copyright 2012 Frank Gallinelli All Rights Reserved
All content in this blog is provided for entertainment and informational purposes only and with the understanding that the writers are not engaged in rendering, legal, professional, financial or investment advice. The owner of this blog makes no representations as to the accuracy or completeness of any information on this site or found by following any link on this site.

“I want to make something perfectly clear.”

How many times have you heard someone say that? Parents say it, trying to get a message past their kids’ MP3 players.  Politicians say it, signalling the impending arrival of a dense, rolling smoke screen.  Real estate investors ought to say it much more, and mean it.

And so our second commandment addresses an issue that is essential for all investors: Clarity.  The need for clarity is important not only in regard to your own personal objectives, but also in how you communicate with other parties in a transaction. I invite you to read a longer article that I’ve written on this subject, but for now, just some high points:

When you analyze an investment opportunity, you usually do so first to decide if you want to go forward and, if so, on what terms.  You need to be clear about your overall investment objectives (more about that in another “commandment”) so that you’ll have some rational basis for a decision.  Do you have a rate-of-return target, a required cash flow, a goal for growth in value?

Presumably, you’ll do some sort of financial analysis to get to that decision, and if you choose to go forward with the deal, your next task may very well be to “sell” your point of view to a third party. You need to be clear about your objective here as well so that you can tailor your presentation to be appropriate for your intended audience. Are you trying to convince the seller that your offer is reasonable? Trying to make your case with a lender to provide the financing? Looking to attract an equity partner to invest along with you?

Different parties will want to focus on different issues. For example, if your purpose is to get financing, you want to be sure that your presentation clearly shows items that a lender wants to see – for example, Debt Coverage Ratio and cash flow. If you’re soliciting an equity partner, it’s essential that you can demonstrate not only that the property makes economic sense in general, but also that your proposed allocation of partnership benefits – cash flow, preferred return, sales proceeds – holds out hope of a suitable return for the partner.

When you start to build your case, you need to be clear and precise in your use of terminology. I have often seen the misuse of terms that have very specific meaning to real estate professionals – “operating expense,” “NOI,” and “cap rate” to cite some of the more common examples of scrambled usage. Nothing can ruin your credibility and sink your deal faster than the improper use of terminology.

Finally, your actual presentation – pro forma or other financial workup – also requires clarity. You can’t expect other parties to a transaction to accept your analysis of a deal if you present them with a disorganized jumble of numbers.  Even if you have all the right calculations and all the right data, it’s of little value if your recipient has to go on a scavenger hunt, struggling to find the key information.

Your takeaway here should be this:  You must first be clear about your own personal objectives when you consider a potential investment property. Then, when you decide to move forward, you need to convey your analysis of the deal in terms that are accurate and unambiguous, and that will provide your target audience with exactly the information they need in a format they can understand.  Clarity trumps fog every time.

Come back soon for Commandment #3

Previously: Commandment #1: Thou Shalt Take Nothing for Granted.

(c) Copyright 2012 Frank Gallinelli All Rights Reserved
All content in this blog is provided for entertainment and informational purposes only and with the understanding that the writers are not engaged in rendering, legal, professional, financial or investment advice. The owner of this blog makes no representations as to the accuracy or completeness of any information on this site or found by following any link on this site.

“Could you talk about refinancing an income property in order to purchase a second income property? I’m trying to understand the refinance process and how you can use it to your advantage in order to build a real estate portfolio. Thanks Frank!”

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The Good News

Your plan – to extract some of the equity from an investment property you already own and use that cash as down payment to purchase another – is fundamentally sound. In fact, that’s exactly what I did when I started investing back in the ‘70s, so to me at least, it seems like a brilliant idea.

Of course, you need to have enough equity in your current property. How much is enough? That will depend on the Loan-to-Value Ratio required by your lender. The refi loan has to be small enough to satisfy the LTV required on the current property, but big enough to give you sufficient cash to use as the down payment on the new property.

For example, let’s say your bank will loan 70% of the value of your strip shopping center, which is appraised at $1 million. So, you expect to obtain a $700,000 mortgage. Your current loan is $550,000, which would leave you with $150,000 to use as a down payment on another property.

Given the same 70% LTV, $150,000 would be a sufficient down payment for a $500,000 property, i.e. 70% of $500,000 = $350,000 mortgage plus $150,000 cash.

But Wait… Some Issues and Considerations

Unfortunately, it’s not the ’70s or even ’07 anymore, so while the plan is sound, the execution may present a few challenges. Best to be prepared, so here are some issues to consider:

• In the current lending environment, financing can be hard to find, and the terms may be more restrictive than what you experienced in the past. Notice that I used a 70% LTV in the example above. You might even encounter 60-65% today, while a few years ago it could have been 75-80%.  In order to obtain the loan, you might also have to show a higher Debt Coverage Ratio than you would have in the past – perhaps 1.25 or higher, compared to the 1.20 that was common before.

• How long have you had the mortgage on the current property?  Some lenders will not let you refinance if the mortgage isn’t “seasoned” for a year or even longer.

• How long have you owned the property? A track record of stable or growing NOIs over time will support your request for a new loan.  You need to make a clear and effective presentation to the lender showing that the refi makes sense, especially in a tight lending environment.

• You need to run your numbers and not take anything for granted. For example, will your current property have a cash flow sufficient to cover the increased debt?

• Keep in mind that you’re adding more debt to the first property, so the return on the new property has to be strong enough to justify the diminution of the return on the first.

• Have you compared the overall return you would achieve from the two properties using the refi plan as opposed to the return you might get if you brought in some equity partners to help you buy the new property?

In a nutshell, refinancing an existing income property to purchase another is a time-honored and proven technique, but it in a challenging lending environment be certain you do your due diligence and run your numbers with care.

Of course I never miss an opportunity to promote my company’s software, so consider using that not only to analyze the deal and its variations, but also to build the presentations that will optimize your chances of obtaining the financing and/or the equity investors.

Frank Gallinelli

Trying to reduce a course to a single word might seem unrealistic (because it is), but I really had more than one angle on the notion of clarity in mind. Even combined, those notions would not replace the real content of a course in investment analysis, but they might express some essential principles that are sine qua non — “without which, nothing” — for investors.

Be Clear About Your Objectives

Before you fire up your spreadsheet program or sharpen your pencil, you need to be very clear about your objective (or objectives) in analyzing the property. For example:

• Are you a potential buyer, trying to establish a reasonable offer on a particular property?
• Are you seller or broker trying to justify your asking price?
• Are you a buyer or broker, trying to demonstrate to a seller that his or her price and terms would not be acceptable to a reasonable and prudent investor?
• Are you seeking financing, or refinancing and need to demonstrate to a lender that this loan will meet their underwriting expectations?
• Are you assembling a partnership and trying to show potential equity investors that this deal will make economic sense to them?

You are not trying to create alternate realities, but you might be harboring more than one objective in a given situation. For example, for your private use you might want to look at a range of possible offers by creating best-case, worst-case and in-between scenarios; but in making a presentation to the seller, you would surely not begin by volunteering what you believe to be the highest price at which the investment might have a chance of success.

In making a presentation to a lender, your focus must be to ensure that your presentation includes items like debt coverage ratio, allowance for possible vacancy, and projected cash flows — items that will have an immediate impact on an underwriting decision. For equity partners, you want to be sure that you can demonstrate not only that the property itself makes sense, but that the particular investor, considering allocations and preferred return, can expect an acceptable rate of return on cash invested.

You are typically trying either to make a personal decision about a property or to “sell” your point of view to a third party. Being clear in your own mind about the purpose of your pro forma allows you to focus on how you analyze the property and what information is of greatest importance to your intended audience.

Be Clear About Your Use of Terminology

Real estate, like most businesses and professions, has its own language – terms that carry very specific meaning. The misuse of real estate investment terminology can have several possible consequences, all of them bad.

• You can substantially skew the results of an analysis by not being clear in your understanding of important terms. Some of the more egregious examples I have seen include:
• Not understanding the real-estate-specific definitions of terms like “operating expense” and “Net Operating Income.”  I have often seen investors try to include mortgage payments, capital improvements, or reserves for replacement as operating expenses. This mistake can drastically affect your estimate of a property’s worth.
•  Not understanding an important term like “capitalization rate.” I have seen investors try to estimate value by applying a cap rate to the property’s cash flow instead of its Net Operating Income. Big mistake.

• You can bring a dialog or negotiation to a grinding halt by being unclear and offhand in your use of what should be unambiguous terms.  Yes, “price” is a legitimate English word. But if you use it as part of an analysis or presentation, you will leave your reader stumped.  Do you mean the seller’s asking price, the buyer’s offered price, the actual closed selling price?  You can tell me that a building has 20,000 square feet, but do you mean usable square feet or rentable square feet?  It makes a difference.

• You can establish your identity as a rank amateur. Nothing will earn you a sandwich board with the word “newbie” on it quicker than misusing terms or lapsing into incomprehensibly vague language. Credibility matters — just ask your lender or your equity partners.  Be clear. Be precise.

Be Clear When You Build Your Pro Forma or Presentation

If you insist on being a do-it-yourselfer, and you plan to give your pro forma or presentation to a third party, keep in mind that nothing will unsell your argument faster than a jumbled pile of numbers.  Your information should flow and be segmented in a logical order (e.g., don’t show someone the income after the expenses, or the debt service after the cash flows). The reader should be able to apprehend the key metrics with a quick scan of the page, then go back and fill in the details. If your report turns  into a scavenger hunt for vital information, then you will fail to deliver your message. No loan, no partner, no deal.

Your success as a real estate investor requires serious number crunching, but it doesn’t stop there. You must be able to convey your analysis of a property in terms that are unambiguous, accurate, and relevant to your audience. Clarity is what you need.

–Frank Gallinelli

Get some clarity, as well as accurate calculations and industry-standard reports. Use RealData’s Real Estate Investment Analysis, a market leader for almost 30 years, to run your numbers and create your presentations.

The “Express Edition” of the software dovetails nicely with my books, but some instructors recently asked for inclusion of a few of the features from its big brother, the Pro Edition. Happy to accommodate.

And so… we released a new version of REIA Express which does just that.

If you teach real estate finance or investment, note that we have an academic version of the software available for classroom use. Your students can use that to work through many of the problems and case studies in the books.

If you would like to find out more about academic use of this software, please contact me via our online contact form.

Those of you who follow our content at RealData.com – newsletters, books, Facebook and software — know that we stress maximizing your chances for success through understanding the metrics of investment property. We don’t tell you that you’ll get rich by thinking positive thoughts, raising your self-confidence, and charging fearlessly into the fray. Instead we urge you to learn about the the financial dynamics that are at work in income-producing real estate. Whether you’re scrutinizing a piece of property you already own, one you want to sell, or one you may choose to buy or develop, you need to master the metrics. The numbers always matter.

And so here are our “6 Rules of Thumb for Every Real Estate Investor.”

1. Vacancy

– Let’s begin with a simple one. What percentage of the property’s total potential gross income is being lost to vacancy? Start off by collecting some market data, so you will know what is typical for that type of property in that particular location. Does the property you own or may buy differ very much from the norm? Obviously, much higher vacancy is not good news and you want to find out why. But if vacancy is far less than the market, that may mean the rents are too low. If you’re the owner, this is an issue you need to deal with. If you’re a potential buyer, this may signal an opportunity to acquire the property and then create value through higher rents.

2. Loan-to-Value Ratio (LTV)

– When the financial markets return to some semblance of normalcy, they will probably also return to their traditional standards for underwriting. One of those standards is the Loan-to-Value Ratio. The typical lender is generally willing to finance between 60% – 80% of the lesser of the property’s purchase price or its appraised value. Conventional wisdom has always held that leverage is a good thing — that it is smart to use “Other People’s Money.”

The caution here is to beware of too much of a good thing. The higher the LTV on a particular deal, the riskier the loan is. It doesn’t take much imagination to recognize that in the post-meltdown era, the cost of a loan in terms of interest rate, points, fees, etc. may rise exponentially as the risk increases. Having more equity in the deal may be the best or perhaps the only way to secure reasonable financing. If you don’t have sufficient cash to make a substantial down payment, then consider assembling a group of partners so you can acquire the property with a low LTV and therefore with optimal terms.

3. Debt Coverage Ratio (DCR)

– DCR is the ratio of a property’s Net Operating Income (NOI) to its Annual Debt Service. NOI, as you will recall is your total potential income less vacancy and credit loss and less operating expenses. If your NOI is just enough to pay your mortgage, then your NOI and debt service are equal and so their ratio is 1.00. In real life, no responsible lender is likely to provide financing if it looks like the property will have just barely enough net income to cover its mortgage payments. You should assume that the property you want to finance must show a DCR of at least 1.20, which means your Net Operating Income must be at least 20% more than your debt service. For certain property types or in certain locations, the requirement may be even higher, but it is unlikely ever to be lower.
Not to preach, but planning a budget with a bit of breathing room might be a good principle for every government agency, financial institution and family to follow.

4. Capitalization Rate

– The Capitalization Rate expresses the ratio between a property’s Net Operating Income and its value. Typically it is a market-driven percentage that represents what investors in a given market are achieving on their investment dollar for a particular type of property. In other words, it is the prevailing rate of return in that market. Appraisers use Cap Rates to estimate the value of an income property. If other investors are getting a 10% return, then at what value would a subject property yield a 10% return today?
Remember first that the Cap Rate is a market-driven rate so you need to interrogate some appraisers and commercial brokers to discover what rate is common today in your market for the type of property you’re dealing with. But you also need to recognize that Cap Rates can change with market conditions. In our long and checkered careers we have seen rates go as low as 4-5% (corresponding to very high valuations) and as high as the mid-teens (very low valuations), with historical averages probably bunched closer to 8-10%. If you are investing for the long term, and if the cap rate in your market is presently pushing the top or the bottom of the range, then you need to consider the possibility that the rate won’t stay there forever. Look at some historical data for your market and take that into account when you estimate the cap rate rate that a new buyer may expect ten years down the road.

5. Internal Rate of Return (IRR)

– IRR is the metric of choice for many real estate investors because it takes into account both the timing and the size of cash flows and sale proceeds. It can be a bit difficult to compute, you may want to use software or a financial calculator to make it easy. Once you have your estimated IRR for a given holding period, what should you make of it? No matter how talented you are at choosing and managing property, real estate investing has its risks — and you should expect to earn a return that is commensurate with those risks. There is no magic number for a “good” IRR, but from our years of speaking with investors, we think that few would be happy with anything less than a double-digit IRR, and most would require something in the teens. At the same time, keep in mind the “too good to be true” principle. If you project an astoundingly strong IRR then you need to revisit your underlying data and your assumptions. Are the rents and operating expenses correct? Is the proposed financing possible?

6. Cash Flow

– Cash is King. If you can first project that your property will have a strong positive cash flow, then you can exhale and start to look at the other metrics to see if they suggest satisfactory long-term results.

Negative cash flow means reaching into your own pocket to make up the shortfall. There is no joy in finding that your income property fails to support you, but rather you have to support your property. On the other hand, if you do a have a strong positive cash flow, then you can usually ride out the ups and downs that may occur in any market. An unexpected vacancy or repair is far less likely to push you to the edge of default, and you can sit on the sideline during a market decline, waiting until the time is right to sell.

Overambitious financing tends to be a common cause of weak cash flow. Too much leverage, resulting in greater loan costs and higher debt service can mark the tipping point from a good cash flow to none at all. Revisit LTV and DCR, above.

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Copyright 2009, RealData® Inc. All Rights Reserved

A. The first point to make about real estate partnerships – whether limited, general or LLC – is that there is certainly no single, pre-defined structure used by all investors. In fact, you may be hard pressed to find two partnership agreements whose provisions are exactly the same.

Not all partnerships include a preferred return but, in those that do, its purpose is to counterbalance the risk associated with investing capital in the deal. Typically, the investor is promised that he or she will get first crack at the partnership’s profit and receive at least a X% return, to the extent that the partnership generates enough cash to pay it. In most partnership structures, the cash flow is allocated first to return the invested capital to all partners. The preferred return is paid next, before the General Partner or Managing Member receives any profit.

There are some variations as to exactly how the preferred return might be set up. If the partnership does not earn enough in a given year to cover the preferred return, the typical arrangement is to carry the shortfall forward and pay it when cash becomes available. If necessary it is carried forward until the property is sold, at which time the partners receive their accumulated preferred return before the rest of the sale proceeds are divided. Again, that assumes that the sale proceeds are in fact sufficient to pay the preferred return. If not, the limited partners have to settle for whatever cash is available.

The return may also be compounded or non-compounded. In other words, if part or all of the amount due in a given year can’t be paid and has to be carried forward, the amount brought forward may or may not earn an additional return (similar to compound vs. simple interest). The usual method is for it to be non-compounded. Hence the unpaid amount carried forward does not earn an additional return, but remains a static amount until paid.

An alternative but less common approach is to wipe the slate clean each year. If there isn’t enough cash to pay the preferred return, then the partnership pays out whatever cash is available and starts over from zero next year.

Real estate partnerships will typically define percentage splits between General (i.e., managing) and Limited (i.e., non-managing) partners for profit and sales proceeds. These splits do not come into play until the obligation to pay the preferred return has been met.

For example, let’s say that a limited partner invests $100,000. She is promised a 5% preferred return (non-compounded), 90% of cash flow after the return of capital and payment of preferred return, and 70% of sale proceeds. In the first five years, the partnership generates just enough cash to return the invested capital to all partners. Hence, all future cash flows represent profit. The partnership has a $16,000 cash flow the sixth year, a $20,000 cash flow the seventh year and also sells the property at the end of the seventh year with total proceeds of sale of $150,000. Here is what happens:

The Limited Partner should receive a preferred return of $5,000 per year (5% of her $100,000 investment). By the end of year 6 she hasn’t received any of this return so she is owed $30,000. In the sixth year the partnership cash flow is only $16,000, so that is all she gets; the balance due is carried forward to year 7. In that year the partnership cash flow of $20,000 is sufficient to pay the $14,000 owed from year 6, the $5,000 from year 7 and still leave enough ($1,000) to split 90/10 with the General Partner. Finally, the property is sold at the end of year 7 with $150,000 proceeds to split 70/30 with the General Partner.

Regarding the question, “To whom does the preferred return go?” it is of course possible to structure a partnership so that it goes either to the General or the Limited partner or to Donald Duck if you think that’s a good plan. However, I have never seen a real estate partnership where the return actually went to the General or Managing Partner. The presumed purpose of the preferred return is to encourage non-controlling investors to risk their capital in your project; and that encouragement often takes the form of a conditional promise of a minimum return, the “preferred return.” It seems to me that you would have a difficult time raising money from investors if your underlying message were, “This deal is so shaky that I need full control plus first dibs on the cash flow. If there’s anything left, you can have some.”

Run the numbers, but think beyond them. A good partnership is one where all the parties can enjoy a reasonable expectation of success.

Copyright 2009, RealData® Inc. All Rights Reserved

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