7 Things to Consider When Evaluating Real Estate Deals Now
Today’s real estate markets are shifting quickly, which has required a lot of pivoting from operators, syndicators, and investors alike. They’ve all had to develop a deeper understanding of underwriting and use careful consideration when selecting your next deal.
We’ve seen rents softening, new inventory about to hit the market, rapidly rising interest rates, and billions of loan maturities on the horizon, there will be opportunity to acquire high-quality assets with attractive terms.
That doesn’t mean it will be easy. Filtering and identifying the right deals is becoming more challenging, especially without any clear direction (yet) in the markets.
Here are 7 of the most important factors to consider when evaluating deals in today’s economy and help ensure you’re acquiring strong deals and great assets.
Location, Location, Location.
Talking about the significance of location in real estate investing may sound cliche, but now it is even more important than ever.
When evaluating a deal, leverage external resources to familiarize yourself with the location. Don’t just limit your search to the physical location of the asset, learn more about the demographics, the school system, and surrounding area that future residents consider when selecting their next place to call home.
Strong demographics will help you uncover the most important piece of location: a strong tenant base. You want tenants who can pay the rent and are, historically, more resilient during economic downturns.
Today, that means looking for areas with a base of jobs related to government, education and healthcare that may be less susceptible to job cuts, will help keep occupancy levels high and bad debt levels low.
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2. Supply & Demand
You’ll also want to understand the supply/demand dynamic of the location.
Start by identifying the average vacancy rate within a 1-mile and 3-mile radius of the property, how many units will be delivered over the next 12 months, how many properties are waiting for permits to begin construction, and so on.
One important trend to be aware of is that there are a lot of construction projects underway nationally, which will bring a near-record amount of supply to the market.
What does this mean for multifamily real estate as a whole?
The bulk of the projects are concentrated in some of the hottest markets from the previous cycle, but there are many attractive submarkets that will be less affected by new inventory.
The addition of new Class A properties to markets could actually create opportunity for Class B/B+, especially for operators who focus on value add. The new units will raise the rent ceiling overall, and renovated assets at slightly lower rents should look very attractive to good tenants.
With the cost of single family home ownership continuing to outpace rents, we expect demand to continue to be very strong for rentals and feel the new inventory won’t keep up with demand for long.
3, The Local Economy
You will want to really understand the strength of the local economy, which is closely related to finding that strong tenant base.
Here are some common considerations that are important to our model:
Who are the major employers in the area?
Have there been announcements of expansions or new entrants into the local economy?
Does the property have access to major thruways and offer a reasonable commute to work?
How accessible are major retailers, shops, grocers, and entertainment?
You’ll need to develop your own criteria based on your business model to identify if the property you’re evaluating has the characteristics you’re looking for, but first and foremost you want to have confidence that you can attract good tenants.
4. Market Demographics
We’ve talked about market demographics, but the importance of understanding the demographic data can’t be overemphasized.
Quantitative data can be incorporated into your evaluation that ensure you’re getting an asset in a great market.
Examine the underlying data around questions like:
Is the population growing at or above the state and national averages?
What are crime and poverty rates like in the area?
What do median income and home values look like within a 1-3-5 miles radius?
How are the school systems in the areas?
Look for growing markets with lower crime and poverty rates with good income, home values and schools.
Submarkets with those characteristics tend to attract high-paying residents that will be able to support rent growth and increase property values.
With such rapidly increasing rates, pricing has become even more important to consider. The triple play, “buy right, finance right, manage right” is how investors deliver strong risk-adjusted returns and it all starts at the beginning, price.
We are coming out of a period of double digit rent growth, low vacancy, cheap debt, and compressed cap rates resulting in inflated property values. This is causing a wide bid-ask spread amongst buyers and sellers, so validating pricing through underwriting and sale comps is critical in today’s economy.
When evaluating a deal, you will want to request pricing guidance from the listing broker, but try not to get caught up in that number. The markets are changing and so are expectations.
Over the past 18 months, the “whisper price” was perceived as the minimum offer to make it into the next round in the selection process. This was a byproduct of low rates and healthy balance sheets ready for deployment, which increased the number of groups bidding on a single deal. This is no longer the case, so your first offer should be unbiased and reflect your opinion on what the asset is worth.
6. Cap Rates & Comps
There are two questions that should be answered to quickly identify whether the purchase price of the property is reasonable.
1 .How does the cap rate compare to recent sales in the submarket?
If similar vintage & quality assets are trading at a 5% cap rate but the property you’re evaluating is being marketed at 4%, you need to understand why. We’ve seen proven value-add deals trade for a premium, as well as properties with attractive assumable debt for investors searching for immediate yield, so be sure to vet the financials, rent roll, business plan, and market conditions prior to submitting an offer.
2. How does per unit price compare to recent sales?
If the average property in the submarket sold for $200k/unit over the past year, we would question properties being marketed for 10% more or less than recent sales. Carefully compare the location, vintage, construction, and rent structure since per unit sale comps alone can be deceiving. Just because a brand new, stabilized, mid-rise, Class A product traded for $300k/unit does not mean the Class B deal across the street should too.
7. Operational Efficiency
Operational efficiency cannot not be overlooked; it can add tremendous value to the property.
Expenses are the focal point for every group in an inflationary environment, from property managers, owner-operators, syndicators, and the largest REITs in the industry. The days of hiding inefficiencies behind double digit rent growth to offset the higher costs of operating multifamily apartments is behind us.
When evaluating a deal, dig into every general ledger line item to search for an opportunity to operate more efficiently. Whether that is top-line ancillary income opportunity, rebates from vendors, or variable expense discipline also referred to as “controllables”.
An under appreciated metric to understand is the relationship between resident satisfaction, retention, vacancy, turnover, and marketing because they are interrelated. When residents are satisfied, they tend to rent longer which reduces vacancy loss, hard turn costs, and customer acquisition costs however this simple topic is often overlooked and impacts your bottom line.
Some of the more important aspects to consider in terms of your operations include:
The Impact of Move Outs:
Here’s an example of the impact a single move-out can have to your bottom line. As you can see, a single resident move-out can equate to approximately one month of rent in operating costs.
Average rent/month: $1,200 ($40/day)
Turn time (days): 10
Vacancy loss: $40/day (rent) x 10 (turn time) = $400
Turn cost (physical): $500
Marketing cost: $300
$400 (vacancy)+$500 (turnover)+$300 (marketing per lease) = $1,200
Focusing on resident retention should be a priority at all times, but especially during economic downturns, when the effort to acquire new tenants could be more prolonged and more expensive.
The next category we look at is payroll since it accounts for the largest variable expense.
Once you understand the in-place staffing plan, determine how many employees you will operate with; base it upon your business plan and property needs.
Older vintage, value-add deals will require more staffing to field maintenance requests, fill work orders, and address deferred maintenance while newer stabilized deals will require less back-office staff.
When analyzing the expense load on the profit and loss statement, make sure to account for existing service contracts to determine current spending requirements, opportunity to negotiate new contracts, or eliminate unnecessary operating costs.
The cost of labor and materials continue to increase so look for opportunities to share resources or take some tasks in-house (contract painting, grounds, etc.).
Taxes & Insurance:
Taxes and insurance are important line items to analyze, especially with property values soaring and insurance rates increasing dramatically in many locations.
Higher valuations come with higher tax bills so consulting a local expert will reduce your risk of underestimating the largest expense line item in your pro forma.
We also recommend conservatively underwriting insurance by padding assumptions during the first pass of underwriting whether you are using an individual or blanket policy. Do research on the state or location you are in to ensure that you are aware of the premiums, flood zones, required coverage, and changing conditions.
Due to the perceived risk in Florida for example, some insurance companies are non-renewing policies or seeing 100% – 300% increases which poses risk to investors who do not account for these trends.
There are so many things to consider when evaluating deals in today’s economy, but if you break it down into steps you can take a measured approach to make sure you’re getting a strong deal and that the properties you’re looking at fit your business model.
Start by focusing on location, pricing, and operational efficiency and if the asset meets your criteria in those categories you can feel more comfortable moving forward with your evaluation.
Next, do your due diligence around the demographics, economic drivers, and accessibility of the location.
Research pricing trends and market cap rates in the same submarket. This is even more important during a volatile environment with interest rates on the move, keep your underwriting conservative and don’t buy a deal just to get a deal.
Finally, uncover opportunities to drive top line revenue, reduce controllable expenses, and operate more efficiently to generate superior risk-adjusted returns for your project.
Source: Blue Lake Capital