Recently, at a get-together with some old friends, the topic of the sale listing of an old local watering hole came up. This property had been on the market for over ten years with an asking price that was way above market, and it got me to thinking about the factors to consider before buying real estate.
- Like a good stock, you would expect that a well-planned real estate investment strategy would yield a good return on your money. One thing to consider before investing is Net Operating Income (NOI). Net operating income is rental income of a property after operating expenses. These expenses would include real estate taxes, cleaning and maintenance, insurance, advertising, management, etc. The anticipated net operating income should cover at least one and a half times the mortgage payment before it is even considered. For the property I mentioned, the annual debt payment would be close to $32,000. Net operating income would need to be close to $50,000 to qualify for the loan and to cover the debt payment.
- What is the risk? You can get a good feel for risk by observing the capitalization rate of the property. Capitalization rate is simply the anticipated NOI over the next twelve months divided by the value of the property. How does that tell us the risk? Let’s say the property you are considering has higher-than-market rent contracts signed before the market dropped. Those rents are at a greater risk because tenants may want to consider moving somewhere with lower rents. As a result a potential buyer will pay less for this property than for a similar property with less risky rents, which in turn, raises the capitalization rate. Investigate capital rates in the market, and if your potential investment significantly exceeds market cap rates, it makes sense to investigate why. In the case of the neighborhood bar, based on the asking price, the cap rate is 6.5%, in a market where cap rates are probably closer to 8.0%. This might be an indication that the asking price is too high, relative to the rent they are getting.
- Quality of tenants. Find out the rental history of the property. Has it stayed occupied for the past three to five years? How many long-term tenants do you have, and is there a lot of turnover? Do the tenants pay on time? It is expensive to find new tenants. Answers to these questions may save you money in the long run.
- Of course none of us has a crystal ball. But what can we tell about the future market by observing current trends? Does our property conform to market standards? What types of supporting facilities are nearby? Have there been any recent developments or zoning changes? What does the city planning commission envision for the area? What trends are selling prices, rental rates, and days to close a sale following?
These are just some items to consider when purchasing investment real estate. Working with a competent broker can help you decipher current trends in the market and help you identify good candidates for investment. Valuation professionals do a more in-depth analysis of these, and many other factor to determine market value.
Would you like more information? Please Contact Us Today!