All Forum Posts by: Chase McArthur

Your cap rate is going to be market dependent. Take a look at some comps in the area and see what their cap rates were. The only issue you will have with that is your property is vacant. I assume because its not in the best condition. Because of this comp cap rates won't really apply to that property.

You don't want to put an offer on the table that is determined by cap rate for a vacant building, especially one with long term vacancy. You should approach it from an "as-is" direction. The only thing you should concern yourself with as far as an investor is the potential up side to the property. As a contractor I'm sure you know your way around construction estimates. 

Look at what the property is in order to determine your purchase price, but look at the potential of the property to determine whether or not it would be a good investment.

Why has it been vacant for so long?

@Account Closed

I'm not saying that IRR is a bad metric, what I am saying is that the problem with utilizing an IRR calculation alone to determine a realistic rate of return is the fact that the IRR calculation builds in unrealistic reinvestment assumptions for interim cash flows.

The attractiveness of using the IRR formula comes from the fact that it seems to calculate a straightforward comparison. However, markets are nonlinear dynamical systems and scalable analytics must be utilized in order to quantify it.

XIRR has the same inherent problem of reinvested returns. The only difference between IRR and XIRR is the fact that IRR calculations are determined based off of a consistent cash flow where as XIRR calculations can be determined when there is inconsistent cash flow.

XIRR is nothing more than the aggregate of multiple CAGR's. There are inherent problems when attempting to analyze investment properties with a CAGR calculation. On the outset CAGR ignores volatility and simply assumes a linear growth rate within a dynamic system. And should you decide to exit before your investment horizon ends CAGR calculations become indeterminate (mathematically speaking). The reason being is that CAGR doesn't consider interim values, only beginning and end values (again linearity). This problem carries over into XIRR.

@Michinori Kaneko

All of this sounds ridiculously complicated, hence very intensive college course work. However, we live in a wonderfully technologically advanced world that enables 99% of the work to be done through algorithms. All I have to do is input the data and BOOM out comes the results. The most tedious task is initial data input, after that the rest is cake. 

All predictive analysis is is gazing into a crystal ball when you get down to it. It's educated guesses and strategic chaos. However, the economy is cyclical hence reasonably predictable. Once you have enough data you can start to easily correlate specific economic, political and social events with changes in the markets.

Like I said earlier, these types of analysis aren't done for your typical everyday mom and pop fix and flips. Deep dives are done when there is millions and tens of millions of dollars in play. Personally I wouldn't invest a dollar without running some form of detailed analysis, but this is second nature to me at this point.

As far as personal investments, I have found my analytics to be fairly accurate, as much as they can be anyway. You have to understand too, that analytics are constantly being updated, they are dynamic like the markets. It isn't a one and done kind of deal.

@Bill F.

I'm very sorry for such long winded responses but when it comes to analysis its anything but straightforward.

Oh sorry about that haha. Ok, I guess I was kind of vague, sorry about that too. IRR does take into account time value, but in order to get the actual dollar figure you have to run an NPV calculation as well. The IRR gives you the percentage return on the investment, where the NPV gives you the actual dollar amount that will be made. The two are used in conjuction because the IRR will be the discount rate that makes the NPV=0. Another way to put it is a good investment will show an IRR that is equal to or greater than the cost of capital. IRR can also help determine a break even point for your initial investment (your down payment and capital injection for improvements). The caveat to this in real estate is that the market value of properties are not necessarily determined by the cash flow that it generates. It is susceptible to the macro and micro economic factors as well as true market value, as you mentioned. However, this doesn't negate the advantages of calculating the DCF.

So this is where it gets a little hairy. There have been numerous journal papers in QF on the subject of calculating an accurate beta. The difficulty in calculating beta is due to a tremendous lack of data in real estate transactions. However, given the advent of the internet along with the growing popularity of REIT's it is becoming easier to determine a relatively significant beta. For example, with multifamily properties there are several ways to determine a relatively accurate benchmark using REIT returns to develop betas. In this case I took the weighted average of multiple REITS that were heavily invested in MF properties. For example, Equity Residential, Avalonbay, UDR, AIV, and Essex. Ycharts lists a 5 year beta for each of these REITS. Taking the weighted average over the span of those 5 years followed by calculating the weighted average of the prior calculations will give you a fairly accurate beta coefficient as a benchmark. Another option would be to calculate beta based of off the NCREIF and NAREIF rate of return and calculating the beta from those. This will give you an idea of the macroeconomic risk factors that can predict volatility risk. You can then run a diagnostic analysis on past market data to determine the volatility at a local level. This beta is calculated against a risk free return which is typically the 10 year T note.

This is the formula for calculating your ER. The return on the market could be the weighted average of returns from either the chosen REITS or indices. Warning brain melt down...here's the formula:

Essentially what you are doing with the CAPM is calculating your hurdle rate to use as your cost of equity in your WACC formula.

You know out of all the analysis I've done, not one person has ever asked me about Black Swans. That's an awesome question. Well, typically projections only run out to 10 years. Like any dynamic market the further you get away from year 1 the more unpredictable it becomes. As far as foreseeing an event, the only thing that I typically recommended was to reevaluate your position every 3-5 years. Go back through the data from your initial projections run another diagnostic analysis to determine what happened and when that created a deviation from projections. Then reevaluate the current market position and based off of your findings adjust as needed. Ultimately there is no way to accurately predict an even, hence the term, but there are measures you can take that will enable you to determine if now is a good time to pull the trigger on your exit strategy or hold fast. Luckily we learned A LOT from the 2008 crisis and because of that we are well positioned to see potential warning signs of things to come.

@Kimberly H.

Id be happy to show you some tricks. I'll do my best to not overwhelm you because analysis is a job in itself. And you are right the proforma is definately a sellers speculation...perfect market conditions, loyal tenants that never damage anything etc. Then you get that T12 and realize they have a 15% vacancy, and theyve spent 28% of their GPR on repairs and maintenance.

@Bill F.

So IRR on TMV is tricky. I assume you are talking about true market value. Because TMV is more about perspective. You have to be careful about over valueing the property you are analyzing. Sellers will typically over value their property, and buyers will typically under value them, based off of their definition of value or if they are trying to hit a particular return. Behavioral economics plays a major part in TMV. Often times we get emotionally over-optimistic about a particular property and we lose sight of the potential downside.

I'm not sure if youve ever heard of a Monte Carlo simulation, but what that does is take your projected numbers and runs them through a predetermined number of simulations, sometimes over 1 million different scenarios if you wanted it to. The Monte Carlo simulation takes all of your numbers and runs it through variable growth rates and will give you a terminal cap rate, a minimum, a median, and a maximum DCF value in order to reach your expected return rate. You can then cross-check your DCF calculation with a market analysis to determine whether or not you're DCF value is within a relative range of the market values. Your TMV will be subjectively determined based off of your assessment of the upside potential of the property. Depending on how thorough you wanted to be you could always run a diagnostic analysis and cross-check it with past market conditions and determine how a property will react to particular market fluctuations.

Does that make sense?

And yes by ER I mean expected return

@Bill F. @Michinori Kaneko

Both of you have valid points. However, for the sake of this discussion I will have to agree with Bill. The main reason being, as he stated, MIRR takes into account re-investment as well as capital expenditures. ROE depends on your ability to accurately define the equity in the property as well as takes a linear approach assuming that rent and appreciation will grow at a constant rate. Aside from that ROE/ROA are simply snapshots of any given period within a holding period. They cannot accurately predict returns over the entire investment horizon nor does it take into account reversionary cap rate. As stated earlier, they also do not account for the time-value of money, however, neither does IRR, at least not accurately. Both MIRR and IRR must be used in conjunction with other quantitative measures, like NPV, in order to calculate properly.

Secondly, IRR considers a re-investment of capital inflow at the properties IRR, not at the cost of capital. In this instance MIRR would be superior. However, both IRR and MIRR assume an unleveraged rate of return, most everyone knows that 95% of deals are leveraged. So what are we to do?

In the world of quantitative finance, IRR and MIRR work well when evaluating ROI's for potential investments. However, in the world of real estate there is difficulty in properly determining some very important metrics, especially when calculating returns. Without getting into too much detail, the most prevalent misconception lies in the concept of the discount rate. Most assume that a proper discount rate is simply the preferred return for investors. Well again, that's good for a back of the envelope calculation, but what happens when you leverage a deal with debt and investor capital? Well in order to calculate an accurate DCF you must figure the WACC. However, before you can do that you must calculate an ER, which is calculated by taking the average distribution of random cash inflows. You calculate your ER using the capital asset pricing model (CAPM). But before you can do that you have to accurately calculate the beta coefficient as well as a risk free return. Then there are other variables that have to be taken into account using various other calculations, but that's for another forum.

I hope this illustrates some of the mind blowing technicals that go into a professional analysis. If taken lightly, five years from now your investors are going to start asking you where all their money went. SO before you sink a dollar into an investment, you better have a relatively good idea where your money will be in the future.

@Kenny Kamdoum like most all of the posts have attested to, first network, network, network. Second build a team, a great team that will show your investors that their money is safe. Third, find the deals, this is where it gets tricky. As the properties get bigger the circle of investors gets smaller. As a CRE Investment Broker in multifamily I can see the transition from individual investors, to partnerships, to developers, to institutional investors. And the closer you get to the top it becomes apparent that everyone knows everyone else. Once you reach a certain threshold it will become impossible to find deals that other groups of investors dont already know about. The best way to find deals is through property managers. Often times they will know an impending sale before anyone. They are in constant communication with the owners and asset managers. So make them your best friends.

As for your team, everyone here has pretty much covered the bases. However, there is one person that is often times overlooked that will be a good investment, a good analyst. Someone that understands what investors are looking for. Someone that knows the numbers. Prior to my life as an agent I specialized in CRE investment underwriting. My job was to vet the deals that came across my desk. There are alot of variables that go into proper analysis. Hell, there are 4 different types of analysis that are done on deals. Sure, its possible to run a back of the envelope analysis but nothing thats comprehensive enough to entrust investors to sink millions of dollars into a deal. Since you're just starting out and this is what BP is for, I would be happy to help vet any deals that you come across. PM me and we can discuss it further if you'd like. That's also an open invitation to anyone who needs help running a proper and professional analysis.

@Lance Riggen Given the new details, the situation is a little more dynamic now. There are a few things that I would consider. How much deal volume have you done together? Is he bringing you deals, listing your flips or both? From what you tell us it seems that you have done several deals in the past and have no plans on stopping anytime soon. That being the case, if this agent has been with you through all your deals then I feel there should be some consideration on his part. Im in CRE so its a little different, but I have long time clients who get frequent flyer discounts. But then again, shaving a few bps off of commission on a $5M deal has a bit more of an impact. It's honestly something you should discuss with him. If I were your agent I would consider discounting my services in good faith that you would consider a slightly higher rate on a future deal when the spread is more favorable.

@Justin O'Malley forgive me for the book.

Looking at in from an analysts perspective, the margins are very thin but there's hope. Lets take a look:

Let's assume you buy below ask @ $122,000 (never pay asking) with 15% DP ($18,300 initial investment)

This puts you at 85% leverage w/ a debt of $103,700. Rates are higher for investment properties and lets assume your credit is perfect. We will go $103,700 @ 6.375%. That calculates to a P&I of $646. 

For CAPEX a safe bet would be to assume it at 1% of asking per annum. SO in this case lets say $130 to be safe. I wouldn't go into an investment without a reserve, for an older property especially. Things seem to always break after you buy them. But if your cash strapped then proceed at your own risk, the risk of eating up your returns.

Some of the repair costs can be assumed with your deposits if they are caused by your tenants. Otherwise we will just go with your original estimate of $100. But you need to consider turn over costs between tenants. 

You can safely assume, given the location of the property, that the vacancy will be kept at a minimum but again we will assume your original estimate of $80.

Management costs will be a toss up. Remember, with property managers, you get what you pay for. $100 it will be.

Insurance and tax @ $220.

This puts your expenses @ $630 + debt servicing $646 = $1276. Pretty close to your original estimate

There is, however, a major caveat when it comes to student housing. Your rents aren't necessarily dictated by the market. They are dictated by the student housing rates for the colleges nearby. You are looking at a 4 bedroom house. That's 4 students in one house who all get a nice fat housing check at the beginning of each semester. Aside from the obvious potential for damage this gives you a major advantage. Some student housing allowances can reach as high as $6k a semester. Because of this you are practically guaranteed rent along with a very hefty security deposit. Just a quick glance at Lakewood rents, a 4 bedroom 2 bath house, is averaging $2500 (apartments.com). 

Lets assume you could get $2100 a month. Now we are talking! That puts your monthly NOI @ $1470, that gives you a CAP @ 14.45%! After debt servicing you take home $824. However, if your estimate holds and you rent at market then it's a no brainer...pass.

When doing a predictive analysis you always assume the worst feasible scenario. If you still maintain a good IRR then the investment can seriously be considered. In this case if you can achieve the best scenario, then @ the five year mark (not counting inflation) you are looking at a 30.82% IRR...not including equity. The worst however, gives you an IRR of -28.47%...ouch.

This is a back of the envelope analysis off the top of my dome, so forgive me if there are a few discrepancies, a BS in applied mathematics ain't what it used to be. There are a great deal of variables that can have a drastic effect on your returns so just be careful. Message me if you want a serious hard numbers analysis and we can work it out. I was an RE investment analyst for 8 years so with more detail and some time I could give you a +/- 10%.