A young real estate investor occasionally queries me for advice; here is my answer to one of his questions.
Which of the following make a deal good to you?
Cap Rate is simply an estimated return on value at a point in time i.e. Net Operating Income (NOI) divided by Market Value. I’ve seen “great” cap rates on lousy investments: horrible locations or undesirable communities (crime, maintenance issues, obsolesce, declining neighborhoods) i.e. I can’t imagine the cap rate that would attract me to Detroit.
Size of bedrooms:
Factor only to the extent that impacts rents/ability to attract Residents i.e. Secondary
Age of property:
Age is a factor but usually only from need for renovations, Capital Expenditures or future accelerated maintenance expenses or possible obsolesce (not enough baths, changing architectural styles etc.)
MAJOR factor though I’ve picked up meager cash flows in the belief I could turn it around i.e. unlike most REITs I will buy something that is not immediately accretive to earnings if the long term potential is there.
The first four categories were his, the next two are my response to the ending catchall of “what else?”
Opportunity to Create Substantial Increase in Value:
This is the biggie. The opportunity to create value comes in many forms and there are loads of smart investors looking to do the same. That is the bad news; the good news is that real estate is a very local business in many respects and there is a LOT of it and thus the market place is not always efficient in some respects. This of course, means that I’m hoping to eventually get a nice cash flow else where the value creation?
Will it be easy to get to, to manage, does it fit in with my existing geographic region. Further away, greater risk especially if problems develop. Theoretically, there is price that is good enough to run the risk of hiring 3rd party management to operate if it is too far from home base and there certainly are intelligent investors who use 3rd party management. Not my style though plus anytime I see an investment that I think is that attractive, I’ve got to ask myself what am I missing that everyone else is seeing? This really ties into cash flow and value creation because if the site is challenging to get to or to manage then it is harder to create value. That said I live in Florida and one of my best investments is in Oklahoma and I’ve had things go south, far far south a lot closer to home! No firm and fast rules.
As always, I share what I most want/need to learn. – Nathan S. Collier