Real Estate Case Study: Cutting Through the Bullshit

They listed the complex at $3 million. Our bank appraised it at $3 million. But when I looked at it, I could see that we’d have to replace all of the roofs within two years. The estimate for that came to a quarter of a million dollars.

There were a few other things, too. My partners and I did some calculations and determined that the property was a good value at $2,650,000. So we offered $2,550,000 and secured a 30-day inspection period.

Their broker told us that they wouldn’t even consider our bid. He said they had already turned down three higher offers.

That is typical of the bullshit you are likely to hear when you negotiate real estate deals – especially with sellers who are relatively inexperienced.

We responded by raising our bid by $50,000.

They responded by claiming that they were currently considering several “serious” offers that were even higher.

More BS.

Blah, blah, blah, blah, blah.

A week has gone by. And unless these guys flake out again, we’ll probably get the property at our price. That’s going to set us up for profitability from the get-go.

Starting Out With the Odds in Your Favor

In the world of commercial real estate investing, it is often said that you make your profit when you buy, not when you sell.

The problem for most amateur real estate investors is figuring out how to value a particular property. What they typically do is look at comps (the selling prices of comparable properties in the area) and consider the trend. If the asking price is “comparable” and selling prices have been rising, they buy.

This is dumb for two reasons.

  1. Comps don’t tell you how much a property is really worth – what it is likely to be worth in the future. They tell you what other people are currently paying. Those people could be smart or they could be fools.
  2. The trend is your friend only so long as it doesn’t reverse. And trends always reverse.

My real estate partners and I don’t value properties that way. We base our estimates on current income (how much rent the property is generating now) and potential income (how much rent we would be able to collect if we made improvements).

We have a shortcut for doing that which I’ve explained many times. It’s a simple formula: We are usually willing to pay up to 8 times the property’s current gross rents. It’s a rough ratio but it works pretty well. It assures us that we can make between 6% and 8% cash-on-cash return, starting from year one. And that usually converts to 12% to 15% after financing. (More than that if we can upgrade the property and increase rents.)

The takeaway: Negotiating a buy is much easier and much safer if you know beforehand the “right” price. And the only really reliable way of knowing the right price is by calculating it in relation to cash flow (i.e., rental income).