Deciding to invest in a piece of real estate involves a lot of different questions and answers. There’s a lot of insight and knowledge you need before you decide to purchase or buy a prospective property. There are a lot of variables and factors in play when it comes to purchasing a piece of real estate. The different climates of the financial markets, political dynamics, and environmental forces all play a role.
As the purchaser, it’s on you to figure out and answer all the questions you have before you purchase. There’s a lot of due diligence that happens before closing…
How are you going to grow the rent?
Understanding and taking a deep dive into the investment property’s average rent growth, the rent growth in the real estate market, and the amount you’re able to raise rents will have a major impact on your investment return. How well you do on a piece of property is often linked to the amount you’re able to raise the rent roll. Every market has a different growth rate, and in certain markets, there are limitations to the amount you can increase the rent at a property. Sometimes this is due to different rent restrictions, different political laws, or different increases allowed per unit type.
The investment angle you take on a property has a major effect on the way you grow your rent. What we mean is, how are you going to unlock any untapped value or potential? Are you going to upgrade some of the investment property to get higher rents? Are you going to develop or add space to the property to generate more rent? Are you going to convert the property to raise rents? These are just a few of the questions and ideas that need to be considered and thought of during your due diligence period.
Is the surrounding area growing or shrinking?
A major factor in real estate is location. The location your property is in, the housing market it’s in, often determines a lot of the property’s value. It’s important for people to want to live or to rent in the market you’re buying in. After all, you’re going to be needing tenants or people to fill your space.
The area around a piece of real estate will be one of the most essential factors in determining its value. If the area is experiencing high job growth, increases in population, and a rising area median income, real estate values will follow. Real estate values usually are directly linked to the economic well-being of a general area. The better the area, the more people in the area make, the more people will be willing to spend on real estate.
What is the political dynamic like in the municipality?
Some real estate markets or areas are significantly affected by the political dynamic that they’re in. If an investment property is in an area or region that’s pro-development, and inviting towards real estate landlords and investment, it will encourage people to invest in real estate in the area. If the political dynamic is anti-landlord, meaning they are not friendly or looking for real estate investment, the demand for real estate in that area will probably head downward.
The Real Estate Game is a very political business, involving permits, transfers, deeds, rent restrictions, regulations, and a multitude of other political factors. The more restrictive a political municipality is, the more it will cost and the less likely you’ll be able to develop or increase the value of a property as easily. Every municipality has a political process, that usually involves a city council, town board, or an approval process that must be complied with in order to upgrade, develop, or add to a piece of real estate.
What is your projected return?
Returns are an important factor when valuing real estate. It’s indicative of the amount of money you project or estimate to make on a property. A lot of it depends on the size of the investment property, the rents in the market, and the type of growth you’re able to capture. A lot of investors look to real estate to generate a return and produce cash flow. Everyone is trying to make money, and the way to do it in real estate is by producing returns.
The return is how you measure the success of the investment. There are a lot of different metrics like IRR (Internal Rate of Return), ROI (Return on Investment), and Cash on Cash Return that show you the type of return you’re able to generate. A lot of these metrics are calculated by real estate analysts. These metrics are used by investors and owners of real estate to see the amount of money the property has the potential to make based on the dollars invested.
What is the average rent psf? Per door?
This is an important metric to get an idea of how expensive or costly a property is. The amount you pay per foot or per door gives you an idea of how good of a deal the property is, and how it stacks up to the deals in the marketplace.
The type of asset, whether it’s an office building, a development site, or a multifamily property, will determine if you’re likely to use price per door or price per square foot. Most often multifamily utilizes price per door, hotels use price per key. Office, industrial, and development properties use prices based on a price per square foot basis. In college markets, or where the market is student housing based, it’s often calculated by bed. The metric people value properties or real estate off of is price per bed. These metrics are important because they give you an idea of how much you’re paying per apartment, per foot, or per room.
What are the expenses like?
Every investment property has different expenses. The type of property, the location, and the condition of the property will determine the amount of expenses the property has. Taxes will be different in each county or municipality. Insurance will cost more in certain areas or regions due to earthquakes, floods, or hurricanes.
General and administrative expenses will depend on the type of investment property and the costs associated with renting or organizing the property. Repairs and maintenance will depend on the condition level of the property, the upgrades needed at the property, and any repairs that must be completed. And if the investment property is large enough in size, there’s a payroll component. Maintaining and managing a property often requires employees, which will have an effect on expenses as well.
What is the condition of the property?
The property’s condition is a major factor in determining the market value of the property. The condition of the property will be indicative of how much capital needs to be invested in order to get the property up to the standards of the marketplace, or up and running ready for a tenant to move in. The more capital that needs to be invested, the less the property will be worth in the marketplace.
The condition of the investment property will also have an effect on the amount of rent you’re able to charge. The finishes, the amenities, and the quality of the property will allow a landlord to charge more rent or charge less.
What is the real estate market going to look like in 5 years?
This is very important to consider when you’re trying to figure out the potential growth of a piece of real estate, and whether to invest or not to invest in a given market. The type of asset, the location of the asset, and the growth or declines in the area surrounding it will determine a large amount of the return you’ll make. A lot of what you’re buying when it comes to real estate is the direction of the market.
If you’re able to buy before the market takes off, the property will look like a great buy. If you buy at the wrong end of the market, and the market is in a downward trajectory, then it might end up being a poor buy. The direction of the market and its future outlook a few years down the road is something that is important to consider in every decision that involves real estate.
What’s driving the market?
This is important to understand in a growing or fast-changing market. In order to see where the market is going, or why the market is changing, you have to understand what’s moving the market. Whether that’s an increase in jobs, a tax cut, or an influx of capital, understanding what’s driving the market will give you important insight into whether it will continue or slow down. If the driver behind the real estate market is going to consistent, and steady over the course of the future, then it’s a great market to invest in. If what’s driving the market is artificial or only a one-time thing, then it might not be such a great market to invest into. Understanding the core principles and fundamentals behind what’s driving the market are going to be able to give you a sense if it’s sustainable or not.
Are people moving to the neighborhood or away from it?
Population growth is a big driver behind real estate and real estate values. If people are moving toward the neighborhood, and there’s a positive influx of people, that means there’s going to be more demand and competition for real estate. Real estate like a lot of other businesses is a supply and demand-based business. The more buyers and demand there are in the market, the more the supply is going to be valuable and rise is value.
If more people are moving to the neighborhood, that’s a good sign for real estate. If people are moving away from the neighborhood, that’s a bad sign for real estate. The fewer people are looking for or demanding real estate, the less it’s going to be worth. Also, there will be less money invested in and around the neighborhood in other areas like retail, hospitality, and offices.
What is the average median income of the area?
The average median income in an area plays a large role when it comes to real estate values. It’s an important metric to analyze when it comes to the amount of rent you can charge, and whether the rents you’re looking at are in line with what people in the area can afford.
The more money people make in the area, the more they’ll be able to pay for their rent, and for housing. It also works on the commercial side, because the more money people in the area make, the more expensive the goods and services the businesses in the area can make. That means more luxurious items, higher prices for rent, and more spending in retail locations. They’ll likely be spending more money and living a more expensive lifestyle than those areas with lower area median incomes.
It also plays a major factor in the affordable housing area of real estate. Depending on the area, the median income will determine the rent you’ll be able to charge in an affordable housing development. The lower the area median income, the less you can charge for rent. The higher the area median income, the more you’ll be able to charge in rent in affordable developments.
Are there new developments or spaces in the area coming online?
Real estate is a supply and demand-based business. New supply, new spaces, or new developments coming online are going to increase the supply available in the marketplace. This means people are going to have more options, more of a selection to choose from, and more negotiating power when deciding which space to pick.
The price, value, or the cost of a space is going to decline, as a result of more supply coming online. This means there will be more competition for the same number of tenants or prospective renters.
By having a sense of the different spaces or properties becoming available, you’ll know if there’s enough demand to absorb all of the space available. If real estate isn’t occupied, it isn’t making money. The more supply in the marketplace, the less demand there will be for each space, causing real estate or real estate values to go down.
What are the environmental factors at play?
It’s important to have a strong understanding of what environmental factors are influencing the investment property. Has there been any asbestos? Has there been any hazardous materials or waste at the property? Do there need to be any removals or remediations at the property? These are all the types of questions you have to ask and answer before you purchase a property.
With every property, there are a variety of different tests that are part of the due diligence process. It’s the responsibility of the purchaser to know and understand the environmental status and history of the property. This means during the due diligence process, the purchaser has to uncover and understand the uses of the property by engaging various third-party reports and environmental testing companies.
How has the rent growth been in the market?
It’s important to have an idea of how much the rent has grown in the market you’re purchasing an investment property in, to get an idea of what type of future rent growth you can predict. The best way to see what type of rent growth you can expect is to look at the past rent growth in the recent past. Every real estate market has different patterns and trends in regard to rent growth. The previous rent growth in a market shows you the level of demand in the marketplace, the percentage rents have risen in a market, and the type of growth you can expect to capture over the coming years.
The previous rent growth in a market acts as a good baseline to try and understand future rent growth in a market. If a market has experienced lots of rent growth, then there might be a slowdown in store. If the market has been volatile with lots of ups and downs, then there’s a good chance that’s what you should expect. If the market has had consistent rent growth, then there’s a good chance you can expect to see slow and consistent rent growth.
It’s also important to keep in mind that rent growth compounds over time. Every 1-2% increase, slowly rises over and with the prior year’s rent growth as well. Over time, this tends to add up and show a substantial increase from the time it began.
What is the going-in cap rate?
Knowing the going-in cap rate is important to understand what type of return you should expect the property to produce in year one. It’s the first or the beginning amount of money the investment property will produce based on the purchase price. The going-in cap rate is calculated by dividing the NOI by the purchase price. The metric shows you the type of money the property will produce for you. It’s similar to evaluating the dividend of an equity or debt purchase.
It’s also an important metric to see how expensive the property is, or whether you’re overpaying or underpaying relative to the market. If the cap rates in the real estate market are higher, you might be overpaying. If they’re lower, you might be getting a good deal. It’s important to note that the going-in cap rate can sometimes be misleading if you’re buying something that has a lot of vacancies or is undeveloped. The going-in cap rate is more utilized with cash flowing or rent-producing property. There are times where it isn’t a very valuable metric or way to understand the type of value you’re getting from an investment property.
Will you have to upgrade or renovate the property at all? If so, how much investment does it need?
A lot of this depends on the condition of the property, and the housing market you’re competing in. If the property is in fairly good shape, doesn’t need much work done, like a boiler, kitchens, roofs, or anything else that could need work, you might not need to do much to get it up and running. If the property is in poor shape and needs a lot of work to get running, then you’re going to need to be spending money. The price you pay is often a good indicator of the type of work or investment a property needs. Often times, investment properties that need a lot of work will be cheap and inexpensive relative to the market.
The other important area to consider when analyzing a property’s condition is the market you’re competing in. If the price you’re trying to charge or the customer you’re trying to attract is accustomed to a luxurious lifestyle, then your property is going to need those levels of finishes, amenities, and luxuries. Ultimately, the type of condition or level a property needs to be in depends on the level prospective tenants are looking for.
What condition are the competing rental properties in?
This is important because you’re in competition with the surrounding or nearby rental properties for the same tenants. The rents charged and the condition of the properties will determine whether prospective tenants choose your property or a different one. The price you’re charging for rent, the space you have, and the amenities you have are the factors that are going to be debated and weighed when deciding between rental properties.
Understanding the surrounding properties and the level or position the prospective property has in the marketplace will be a major factor in prospective tenant’s decision making. They are ultimately going to have to live or work there and will be looking for the best deal or opportunity possible. It’s important to keep in mind.
What are the rents in the market like? What are the rents at the property like?
Every real estate market is going to have different rents. The location, the property class, and the rents people are paying are all going to have an effect on the feasible rent you can charge. Seeing the rents at the property before purchasing it is important because you’re essentially buying those rents when you buy the investment property.
The rent roll is a large part of what you’re purchasing in a cash-flowing asset. It’s where you’re able to see if the rents are below market or above market. Below market rents will offer you an upside to raise rents in the future. If the rents are above market, you’re probably going to have rents decline or slow down after the purchase. It’s very difficult to sustain or maintain above market rents in a market that’s competitive with multiple different options.
How has the property historically performed?
The way an investment property has performed over the course of its recent history or in the last three years is the single most important part of buying a property. The last few years of operations give you insight into the property’s performance, and what you can expect to generate. It gives you context into different expenses, income levels, tenants, collections, and real performance. The recent numbers and metrics are the baseline and the basis of your future calculations or projections.
A lot of what is analyzed and evaluated in a commercial setting is done by a real estate analyst. What does a real estate analyst do with these historical numbers? They enter the numbers or data into a financial model to try to predict what the property will produce in the future, or what the project will look like under certain assumptions.
A lot of what goes on behind commercial real estate transactions is based on the property’s past performance. It’s the best way to get an idea of how the property will perform in the future and the expense levels. It also gives you great insight into the property’s position in the marketplace.
What is the property’s vacancy rate?
One of the metrics that affect how much a property generates is the vacancy rate. The vacancy rate gives you an idea of how much of the property is vacant or unoccupied. The more a property is vacant, the less space it is utilizing to generate income. The vacancy rate gives you a glimpse of the way the property has been run, maintained. If the property is run well and by experienced management, they’ll find ways to occupy the property and fill up the space.
Part of what affects a property’s vacancy rate is the condition of the property. Most often, the worse a property’s condition is, the higher its vacancy rate is. If a property is in good condition, more people are going to be interested in renting or occupying a space, over one that’s in poorer condition.
A great way to measure how well a property is performing is by comparing the properties vacancy rate to the average vacancy rate in the market. This way you’re able to have a benchmark to measure against and see how the property fares in the market. Some markets are more occupied than others due to demand, population growth, or the desire to live in the market.
What government regulations, restrictions, or programs are involved?
The types of tax breaks or financial benefits a property has received from the government in the past, present, or future has a large impact on the types of restrictions or programs that involve the government. There are lots of buildings that have received tax benefits in exchange to keep buildings more affordable. The goal is to try and get the developer or owner to keep a property’s rent low, in exchange for tax credits or a tax break.
How much debt can the property support?
The level of debt an investment property can support is highly dependent on its value and its cash flow. The more income a property generates, the more debt it will be able to cover. The property type, the housing market, and the lender will determine what kind of debt service coverage ratio the property can support. The lower the coverage ratio, the higher the proceeds.
Another way banks or lending institutions try to determine how much of a loan the property can support is by value. Loan to value is a metric that banks or lenders like to see in order to tell how much equity the landlord has in the property, and what their basis would be if they have to take the property back.
What type of interest rate will the property get?
The interest rate you get depends upon the indices the day it gets locked, the ownership team, the financing product selected, and the type of property. The interest rates and interest rate indices are constantly changing every day, every minute, every second. It’s impossible to know the exact rate at the exact date you’ll get until you’re ready to lock your rates. The best you can do is estimate what the indices will be.
Analyzing a piece of real estate comes with lots of questions. There are lots of variables at play and lots of different factors affecting the value of the real estate. It’s important to have a good understanding of the current marketplace, the property’s position within the marketplace, and the property’s historical operations. These will all play a critical role in trying to generate the desired return and trying to get a real understanding of the property’s performance.
As the purchaser or the prospective buyer, there’s a lot of responsibility that falls on you to find or figure out the answers to these questions. The prospective purchaser is going to be held responsible for knowing what’s going on at a property and to be comfortable with it.
A lot of these questions will vary deal to deal, transaction to transaction. It’s one of the reasons behind the long due diligence periods that have become a norm with purchasing real estate. In order for a buyer to get their ducks in a row, they have to do a lot of leg work, a lot of document collecting, and really understand the property before purchasing.
Everyone has their own process, and their own unique way of doing things, but when it comes to purchasing real estate, there are lots of questions to consider, and to answer before you decide to purchase a property. We hope you were able to take away some value from this article and are better prepared to purchase a piece of real estate.
This article has been contributed by Howie Bick.