Those interested in investing in real estate often ask the question, “How do you know whether a specific investment is a good investment?” Many investors may state that they have a formula that they abide by – They may look at lease length, city, location, tenant financial strength, local economic strength, tenant guarantee, demographic information, etc. To the novice investor, this may sound like it would be a good idea to have such a formula when you are looking at dozens of potential investment opportunities; it can help weed out deals quickly. However, I have found that this approach can actually result in lost opportunities. Here’s why.
The university system often uses a method called “Ceteris Paribus” in teaching concepts. What this means is that when looking at the concept like real estate, you isolate one variable and observe how it effects a particular scenario.
In theory, this can help investors understand how different variables can impact the future of a property. Practically, doing this is a HUGE MISTAKE in analyzing or comparing deals. There are numerous variables to consider when investing, so to have true full understanding of the assets with an open mind will make a better decision. This being the case, you have to understand that every deal has unique benefits and challenges; even if they are next door neighbors with similar traits.
Let’s look at four examples, all which are questions that I often ask myself when assessing properties. In particular, take a look at how thinking within a formula doesn’t always work; and many times can sway you to make the wrong choice if you don’t think outside the box. Here are some examples of how thinking within the confines of a formula may close doors that may actually be worth walking through.
Question #1: Is the cap rate a good return for a particular deal?
Many investors would simply say “I want a property at a 6% cap or higher.” That is overly simplified. There are factors that must be analyzed when determining if the cap rate is good for the deal. For example, if the lease is going to expire soon, you should ask yourself if the market rents are above or below the current rent. If they are below, then restructuring the rents upon expiration could help improve cash flow. If they are above, then the opposite may occur, and your initial desired cap rate on a deal may be lower than expected. The cap rate is a function of the rent, so understanding the future potential of the rent is often more important than the cap rate of today
Question #2: Does the property have enough parking?
The importance of parking will vary by deal. In a broad sense, in commercial properties, more parking may allow you to select from a larger range of tenants or charge your tenants more; in a highly trafficked but not highly walked thoroughfare, parking may be essential for a business to operate. Nevertheless, this is not the case for every deal. What about deals with ample street parking, or properties located in major cities that have city owned parking structures nearby? In the end, the importance of parking depends on the location, available access and market demands. One of my best acquisitions was a property in Carmel-By-The-Sea, California. It had zero parking spots and is prime real estate.
Question #3: What is optimal amount of years left on the lease?
The belief is that if you are seeking a long-term stable asset, then you will want to find a deal that has a long lease term. This however is not always true and can vary depending on tenancy and market trends. For example, lease term will not matter for a struggling company or a company that is becoming obsolete due to e-commerce trends. For those types of assets, the location is often more important to ensure that you can fill vacancies if necessary. Also, at times, a lease has a lot of time left which with a strong tenant, the property may quality for a longer term loan. Every deal underwrites differently, so you have to look at the big picture.
Question #4: How can I leverage the deal?
Personally, when I look at a deal, I rely on little leverage – 15% to 30% LTV. This often helps me satisfy certain objectives. When I consult with a loan broker for commercial properties, lenders have their own discretions. For example, they may look more at the deal size rather than the cash flow of the property. In the past, life insurance lenders offered the best rates but they may required a minimal loan size, say $1 million. So, if you are purchasing a Taco Bell for $1.5 million, your LTV would need to be very high. If you want to keep a low LTV, you would then need to turn to alternative lending options, such as banks or private lenders. These options, for this type of purchase, tend to offer higher rates (at the time of writing this article), which would impact the numbers on your end. So, depending on the terms and rates that you can get from a lender will impact the opportunity for each deal.
In the end, it all just depends.
When I was younger, my father, who was also my real estate mentor, would give me the same answer to almost every question. He would constantly respond with “It depends.” Now, it is apparent that this is a constant truth and that with every deal, the importance of one variable always just depends on how it impacts the overall structure of the deal. The idea is to always keep an open mind.
At the end of the day, every deal needs to be assessed from the ground up. It is imperative that every question is considered and all variables are analyzed. Remember: Every property is unique and every situation is truly different, so analyzing each deal individually from the ground up is the key to finding opportunities.
In addition, most savvy investors become accustomed to saying NO to deals. Read why The Best Deal Is Often No Deal.
