How We Assess Value

[Matthew Irish-Jones]

Decided to put this out here for anyone interested. There are always tons of people asking me about numbers, returns, cash on cash, CAP rates and what neighborhoods are best to invest relative to WNY. We work with a lot of out of state investors so they are using online data to determine whether something is a good investment or not. I have always considered these paper returns. Full disclosure I own some high risk properties with great paper returns. Sometimes the actual returns are great for a year or two if I am lucky, and sometimes they go South for a year or two... high return = high risk, know your risk tolerance.

We have set the following criteria for assessing value in order of importance.  This is our system for assessing value and we do our best to guide clients using the below criteria which I thought may be helpful for fellow investors trying to figure out how best to spend their hard earned money. 

1. Location -   For the most part you are buying a permanent location when you buy a property, chose wisely.  This seems obvious but its fairly complex.  The best locations are the most sought after and therefor have the highest price... for a reason!  They represent low risk, high chance of appreciation and predictability.  If you are not considering location with your purchase you are doing it wrong.  If you are an out of town or out of state investor, you are better served getting a great location and a lower return than the opposite.  

There are micro markets within every location, streets with good sides and bad, etc... this is where a savvy agent or local PM can help.  Know  your area.  If you are buying in a C/D class area you should be buying the best house on the best street.  Having the best asset and the highest rent in a C/D class area is not a bad thing if you market your property properly, its a good thing, you will get the best of the best applicants. 

2. Asset - After you pick the right location, you need to pick the right asset.  Once again there are paper returns on crap assets that will make you look like a genius for 2 years or maybe 3.  When you buy an $80,000 house with low taxes and two tenants paying $900 each for a total rent roll of $1800 you are getting rich each month.  

Then...your tenants move out and you need to renovate each unit + a roof + hot water tanks, furnaces, your plumbing is galvanized, electric is knob and tube and your house needs to be rewired and now you have a $180,000 house with rehab paid out of pocket when you could have just leveraged a $180,000 house with 20-25% down.  If you find yourself screaming at vendors their quotes are too high... you may have bought a crap asset.  

Your asset condition is imperative to understand. You should run your CapEx at the 5, 10,15, and 20 year mark. There are averages for every category in every industry, averages are your enemy. We use them for basic analysis to decide if we want to further evaluate the property. We do not use averages to make a buying decision.

You should not use averages either.  You should deduce your yearly average from your actual line item expenses.  For example: 

$15,000 Upper Unit renovation needed when tenant moves out 

$20,000 Lower Unit renovation needed at some point in next 10 years

$4000 for two furnaces

$2400 for two hot water tanks

Etc...

Total: $41,400 / 10 years = $4140 per year.   You should use this figure to adjust your % of rent number, not the other way around.

There is also an intuitive sense of asset condition that needs to take place.  If you see poor workmanship, improper plumbing lines being run, sloppy flooring with gaps, etc.. these things are all going to cost money to fix or re-due.  Last point on asset..  if you want to use % returns on assets the only time they have some relevance is to understand total overhead costs of vendors on your properties does not change.  A $20,00 roof on a $400,000 asset is 5% a $20,000 roof on an $80,000 asset is 25%.  You do not get a cheaper roof quote because you have a cheaper property, as a % of total value, and as a % of rent, you will pay a significantly higher %.

3. Numbers - cash on cash, CAP rates, IRR, ROI, cash flow, price per square foot, etc... are all helpful tools in determining returns. It is important to understand with so many variables in a calculation there is as much art as their is science in assessing returns. Highly intelligent people usually have the hardest time grasping this concept. If the math checks out, and its a 15 CAP, why the hell am I telling someone not to buy the property?

With all of these tools what is most important to understand is the margin of error in your calculated returns.  In my humble opinion your margin of error goes up astronomically when you get the first 2 points wrong, are given bad advice, or do not properly analyze the risk.  

You only get returns when everything works.  The highest demand locations for investments are in part in high demand because of the predictability of returns.  D class investing comes with wild speculation and tenant pools that have a high probability of not paying rent or damaging the apartment.  

If you can get a great location and a great asset and a 4% cash on cash return vs a poor location and a poor asset and a 25% return... take the easy money.  4% returns with debt paydown, appreciation, and extremely low % risk for a default on payments, low turnover cost and an asset with everything brand new is going to save you time, headaches, and most importantly limit your risk.  

Numbers and returns are important to understand but, they are third on our list.  Numbers can be deceiving, especially for an investor looking for turn key services or someone looking to be a passive investor.  

For the newbie investors, risk should scare you more than anyone.  Generally speaking newer investors are jumping into a double without as many reserves as a large portfolio investor.  If you make an error you are paying the mortgage for your investment property out of pocket and its no longer an investment, its a nightmare.

Once you have properly assessed the value of a purchase you are ready to make an offer... next comes being able to execute but, you can't get to execution until you figure out how to properly assess value.