Why Assuming the Worst is Best When Buying Real Estate
Awhile back I implemented the following saying in all aspects of my life, business and personal, and it has served me incredibly well: Plan for the worst, pray for the best. This article explains as it pertains to real estate.
Why Assuming The Worst Is Best When Buying Real Estate
Let’s start by saying that I am an optimist by nature. I see the glass three-quarters full, not half, and I am passionate about real estate and its role in growing my wealth. That being said, I often speak with investors about their real estate investments, and often hear how optimistic they are about the multifamily real estate market and how they don’t see any reason to doubt that the prosperity and price appreciation will continue. Don’t get me wrong: I believe multifamily is one of the most recession-proof asset classes out there. But at this stage of the cycle, over-optimism is not always the best approach. As a former lawyer, I a firm believer in staying conservative and preparing for the worst.
Yes, we are in the tenth year of unprecedented economic growth. The market continues to rise, and unemployment remains at an all-time low. But when buying real estate, you have to take a step back and think about what might happen several years down the road. Many investors like to hold properties for several years, and then sell at a profit. Most investors assume that the property cash flow will increase once rents are increased, and that the value of their property will go up over time. While that has been the case for the past 10 years, there are exceptions to that trend.
Every investment starts with an analysis. All the current financial information about the property’s income and expenses and future projections about how it will perform are loaded into a model that projects the returns of every investment. If you are optimistic, or inexperienced, the model will falsely predict higher returns that the ones you will actually get.
How Long Will We Stay In A Seller's Market?
Right now we are in a strong seller's market: More buyers than deals bring high property prices. But if you assume that this trend will continue even when you want to exit, you might be surprised. You should assume that the market will not be as strong, and if the deal still works in a weaker market, then it’s a winning deal. How can you predict that? By assuming a higher capitalization rate when you exit the deal than the cap rate you’ve purchased it with.
The projection I determine is based on experience as to what a good exit price will be after the hold period is completed. As a conservative investor, I base my pricing analysis on the worst-case scenario. What is that worst-case scenario? It’s simply an assumption that buyers will only be willing to pay a lower price relative to the net operating income (NOI) than they are today. I am basically working under the assumption that the market will not be as strong as it is today when it’s time to sell the property. Assuming a conservative resale price, I determine the price and adjust the max price that I’ll pay in order to obtain optimal returns.
A cap rate is used to help evaluate real estate investments, as it shows the potential rate of return on the investment. The cap rate is calculated by dividing the NOI by the current sales price of the property. Investors want a high cap rate, which means that the property’s value is low. Sellers, on the other hand, want a low cap rate, because it means the selling price is higher.
There’s no way to accurately predict buyer demand, and the demand can be seasonal, which complicates the process even further. However, there are some things you can do in order to get a sense of what the property will sell for down the road.
You can conduct a market analysis to see what similar properties are selling for, do comparative cap rates, see what the economic growth forecast is for a particular market and determine whether there is multifamily development coming online in the near future. All these factors can play a significant role in projecting what the property may sell for, which in turn can help determine the price you’re willing to pay.
Other external factors can influence property prices in coming years. These factors include governmental policy changes, population shifts and demographic changes, immigration, availability of affordable housing in key areas and many others. Until they actually play out, their impact on the projected real estate prices won’t be known.
There are many different factors and metrics that can impact your real estate goals and anticipated returns. By taking a more conservative approach to projecting potential cash flow and appreciation, I have avoided the unpleasant task of informing investors that we didn’t achieve appreciation goals set out at the start of our syndication. Make sure you don’t fall into the buyer “frenzy” as multifamily prices escalate, and stick to your investment goals based on the internal rate of return (IRR) you want for your deal. By assuming the worst, you won’t have to do that either. Just remember, if a deal works in a down market, it will certainly work in a good market as well.