The Third Rule of Thumb and Determining if Your Offer is Realistic!

Now that you have an accepted offer, the real work begins. You don’t want to spend to much time evaluating your property until you know if the seller is going to accept your offer. Once your offer is under contract, then you need to make sure that the property is what you expected during your due diligence period.

Now that you are under contract, the seller will provide you with their financials. This is a great time to verify that all the numbers that you estimated are correct. You don’t want to buy a property only to find out that it won’t cash flow. If the numbers that the give you are less than you anticipated, then you may have to adjust your offer.

When you are evaluating the seller’s financials, the first thing that you want to do is to make sure that they haven’t padded their expenses. Sometimes, they are paying a friend or relative with free storage to manage the property. This can contribute to why they aren’t fully occupied, but it will also change the expenses that you will have compared to the current sellers.

When you are estimating the expenses for a property, you want to assume that they will be about 35% to 40% of the gross rents. If the property that you are looking at has expenses that are significantly less, you should do more research. You always want to get the financials on the property before you close. You need to know what expenses it has.

When you are making an offer prior to receiving the financials, you can use the average rental rates in the area and the average vacancy rate to determine your gross operating income. Once you have that, then you can subtract 40% of the gross rents to get your net operating income. If this doesn’t leave you with enough cash flow to make this opportunity work, then you need to lower your purchase price or move on.

If you get the financials and discover that the rents are much less than you estimated, or the costs are much higher than you anticipated, you may have to adjust. On the other hand, you also want to look at the upside potential of the property. Is there a way to improve the current property? Can you raise the rents? Can you improve the occupancy levels? If so, this will change the net operating income of the property which will push the value higher. If your goal is to come in and buy a property, get it up to its full potential and then sell it, you are looking for properties that are currently in distress. The key is to not pay to much for them.

If you find out that the current Net Operating income for a property is $260,000 but you know that with a few changes you can increase that to $300,000 that changes the value of the property quickly. In order for an investor to determine what a property is worth; they usually use the CAP rate. This is done by taking the net operating income and dividing it by the purchase price. So, if your buyer wants an 8% cap rate. If you divide $260,000 by 8% you get $3,250,000 as a value for the property. On the other hand, if you use $300,000 you get $3,750,000. That is a nice increase for simply raising rents and filling in your vacancy rate.

Make sure that you don’t pay too much for a property. You want to evaluate the financials carefully after your offer is accepted. If you need to adjust your offer, go back to the sellers, and explain why you are lowering your offer. Show them why anyone would offer the lower amount once they get the financials. As always, happy investing.