Before you start investing in real estate, you have to be clear about your investment criteria. I call this your “trading rules”.
Many years ago, I spent a year or so trading options. I took a bootcamp and signed up with a mentor. I did OK (I made an average of 7% during this time, which is a lot better than most people, who lose their entire account), but I didn’t feel the results justified the time spent.
However, one thing I learned is to not only determine and WRITE down your trading rules, but to stick with them.
I did OK with writing them down, but when greed or fear take over, it was extremely difficult to stick to them.
What are your trading rules for your apartment building deals?
Consider things like size and location of the asset. Do you want a more stabilized asset or would you consider a re-position? What cap rate and cash on cash return do you want going into the deal? After one year? After 5 years? What returns are you looking for? If you have investors, what returns are they looking for?
These are a lot of questions, but you need to be clear about them and probably write them down, so that you don’t forget them when you’re analyzing a deal and asking the question “what is the most I can pay for this building?”
Understanding and meeting your investment criteria is the one thing that drives your purchase price. This is the trading rule that determines what your maximum purchase price is.
Once you’ve determined your investment criteria, analyzing a deal becomes a bit more science than art (though not entirely science!). Your financial model you use to underwrite a deal must allow you to meet your investment criteria. If not, you should adjust something about the deal (like negotiate a lower purchase price) to make it work, or you will need to move on.
You will need to be crystal clear what you will and will not accept in an investment.
Here’s an example. Let’s say you syndicate apartment buildings (like me). My over-arching trading rule is that I need to achieve an average annual return of 11% – 15% over the life of the investment, including cash flow distributions, amortization, and net proceeds from a sale or re-finance. I know at the level of returns, people will invest with me.
Everything else is secondary.
However, there are other key metrics that help me achieve those returns. For example, I know that to get to those kinds of returns (and still pay me something, too!) I need to achieve a cap rate of 10%. Even if I get into an investment at a lower cap rate (because it’s distressed, for example), once I stabilize it, it better be at least a 10 cap.
Then there’s the cash on cash return – also important! This determines how much cash the asset is throwing off as a percentage of the money invested. I like seeing a building throw off cash!
But some investments don’t throw off a lot of cash, at least at first. Does that mean you shouldn’t get into one like that? It depends.
If the building is 30% vacant with high expenses and below market rents because of mis-management, you may decide to go for it if you think you can achieve your criteria within a reasonable period of time.
At the end of the day, though, the one thing I look for more than anything else is the overall return, first and foremost for my investors, and then for me. I look for that 11% – 15% return for my investors with me owning at least 25% of the building. If I can’t make that work in my financial model, and despite my best efforts I can’t negotiate the price I need to make that work, I know that I need to move on.
You can see that determining your maximum buy price is part science and part art.
But the first step is knowing and sticking to your trading rule. Only that way do you have an objective way of determining the most you can pay for a deal.
This is one reason the Syndicated Deal Analyzer is so important. It forces you to focus on your investment criteria and (hopefully) removes some of the emotion.