How
to Mitigate Risk and Get a Great Deal!
By
Anesia
Springborn
The
Landloard System by Anesia
As a buy-and-hold real estate investor,
you generally want to purchase a property based on income and expense
numbers that are accurate and have been verified. The seller provides the
current and historical information, you confirm that it is accurate, and
then you apply your own buying criteria to determine if this is the deal for
you.
What should your buying criteria be? It
can be anything you want it to be, really, but you need to establish what it
is and then stick to it. This is how you keep yourself from making an
emotional buying decision. Some investors calculate the cap rate, and tell
themselves they will only buy properties that exceed a particular cap rate.
Some investors are looking for a specific cash on cash return – perhaps one
that exceeds whatever return they could get if their money was invested in
another investment vehicle, such as the stock market.
Once you establish your buying criteria,
you can weigh your deals against it and make a go or no go decision to
proceed with an offer and due diligence. In today’s marketplace, many
sellers capture a buyer’s attention by presenting “pro forma” information.
These projections are pure speculation based on best-case scenarios and what
the seller believes the profit potential could be. You must ask yourself,
“If the buyer knows the property has more potential, why is he not
maximizing it?” There may be valid reasons for this (he doesn’t have time,
he has no working capital, etc.) or the pro forma information may just be
hype.
You can use pro forma information
presented by a seller to your advantage sometimes. Let’s say you receive a
marketing sheet on a property that’s for sale, and pro forma numbers are on
it. Again, the seller is presenting numbers that he believes are realistic,
but these are not the actual numbers of today. Statements such as “The rents
could all be raised by $20 per unit and still be under market rate” might be
made by a seller operating in “pro forma mode.” Let’s say your pro forma
marketing sheet also has a cap rate on it. The seller has applied a formula
to his pro forma numbers and the resulting cap rate is 12%. Let’s say you’d
be very happy with 12% and you’d buy the property for that.
Here’s what you do: You throw away the
pro forma numbers altogether. Go ahead and gather all of the actual income
and expense numbers. Verify everything. Get copies of leases, electricity
bills, water bills, property management expenses, an insurance quote,
everything. Now that you have actual numbers, apply the 12% cap rate your
seller is willing to sell at, and voila! You have your offer price.
Let’s work through a quick example:
Here are the pro forma numbers the seller
gives you in the marketing sheet:
Income: $40,000
Expenses: $12,000
Cap Rate: 12%
Selling Price: $233,000
After you verify the numbers, you
determine that the actual income and expenses are:
Income: $37,560
Expenses: $16,000
Now, use these actual numbers and the cap
rate you were given to arrive at your offer price:
(Income – Expense) ÷ Cap Rate = Offer
Price
($37,560 - $16,000) ÷ .12 = $179,666
$179,666 is substantially lower than
$233,000!
What if your buying criteria states that
you are willing to buy at a 10% cap rate? You can negotiate with the seller,
show that you’ve verified actual numbers, and increase your offer price to
the 10% cap rate you are willing to pay:
($37,560 - $16,000) ÷ .10 = $215,600
You start out using actual numbers and
the cap rate the seller is willing to give you. The seller may accept this
offer of $179,666. If not, your fall-back position is to increase your offer
to what you would normally pay anyway, which is a 10% cap rate and $215,600.
You’ve conceded and you’re still getting a great deal that fits your buying
criteria. Your seller isn’t getting his asking price because that was based
on false information, but he is still getting a fair price.
Always buy a property based on today’s
truth. Look for deals with potential upside, but don’t take the seller’s
word for it. You must evaluate based on actual numbers that are true today.
Once you have the property, you can then fine-tune its cash flow for even
bigger profits. A bank will not lend based on future projections and your
best intentions. Banks mitigate their risk in part by using actual numbers.
You can mitigate your risk by doing the same.
|
About the author
This article has been written by Anesia Springborn, real estate
investor and creator of The Landlord System. Anesia teaches her
students how to leverage time and money to grown their passive
income stream. She may be reached by visiting
www.TheLandlordSystem.com
More Articles by Anesia
Springborn
|
