Investing in real estate can be a promising way to grow wealth, but not every opportunity is created equal. With a multitude of factors to consider, it’s essential to have a systematic approach to evaluating potential investments. Whether you're a seasoned investor or just starting out, understanding how to assess various aspects of a property can significantly impact your financial success. In the following article, we'll explore one key financial factor that impacts a deal.
Sellers frequently determine property prices based on pro-forma values. This method compensates the current owner for potential work that has not yet been completed to enhance property value. For instance, tenants are currently paying rent that is only 75% of the market rate. Additionally, the owner may price the property as though renovations have already been finished and paying tenants are in place. Such pricing strategies can mislead potential buyers about the actual value and condition of the property.
Case study of a mispriced deal:
A Realtor contacted me about managing a few local buildings for his client. My team was excited to take on some additional buildings to manage. We visited the property which was in good condition save for some foundation tuck pointing that was required.
Then...the deal fell apart. The lender was then asking for a much larger down payment in order to finance the deal.
I contacted the selling realtor to ask about the pricing on the deal and I immediately saw the problem.
Current rent | Pro-forma | |
4318 | $ 825 | $ 1,298 |
4320 | $ 825 | $ 1,298 |
4322 | $ 950 | $ 1,298 |
4324 | $ 1,298 | |
Monthly rent | $ 2,600 | $ 5,192 |
Annual rent | $ 31,200 | $ 62,304 |
50% expense rate | $ 23,388 | $ 31,152 |
NOI | $ 7,812 | $ 31,152 |
Price | $ 300,000 | $ 300,000 |
Cap rate | 3% | 10% |
Price/per unit | $ 75,000 | $ 75,000 |
Note: I use a 50% of incoming rent assumption for operating costs for apartments. Since there is one unit vacant in the "Current Rent"]scenario, I calculated the expenses assuming that the unit is rented at current market rent.
In this case, the interest rate is undoubtedly higher than the cap rate or ROI under the "Current Rent" scenario. The Buyer would be losing money and wouldn't have enough money to pay the mortgage from their net operating income or NOI. Therefore, the lender was asking for a rather large down payment in order to finance the deal.
Sellers should not be rewarded financially for work that the buyer will have to do to achieve the investment's potential. Assume that the existing tenants are paying as much rent as they can. If the Buyer increases the rent to market levels, the existing tenants may move out creating even more cost for the buyer. The units will require make ready costs in paint, repairs and potentially other renovation expenses.
The moral of the story is look for opportunities that are prices appropriately for their current condition; not pro-forma value. It helps to have a Realtor that has investment experience to help you evaluate opportunities.
If you are looking for a Realtor to help you evaluate opportunities, we possess that expertise. Our firm has been investing for over a decade, renovating properties, finding great tenants and maintaining properties for our clients.
Lisa Gallagher
Realtor at The Realty Center
St. Louis, Missouri
714-348-4301 Cell
314-281-9900 Realtor Office
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