This is the time to double and triple-check your calculations because even a single mistake can be financially devastating. I’ve seen many people jump into a deal without the proper knowledge or experience and end up losing a substantial amount of money. Many of the mistakes made were avoidable if only the investor had followed some basic solutions prior to committing to the purchase. I would like to share those with you in order to help you avoid making some costly mistakes.
Solution #1: Be Conservative
When looking at investments, it pays to be conservative. One of the key metrics to look at is the cap rate. It's one of the best predictors of profitability and a property's return potential. A cap rate measure's a property's yield over a one-year period, making it easy to compare the cash flow of one property with another - excluding debt. The higher the cap rate, the lower the price of the property. The cap rate is calculated by dividing the net operating income (NOI) by the current market value of the property. As an example, if you have an NOI of $50,000, and the current market value of the property is $1,000,000, then the cap rate would be 5%.
One of the keys when evaluating a property is to have an exit cap greater than an in-place cap rate. An exit cap is the cap rate of property on the date you sell the property. It's calculated by dividing the expected net operating income (NOI) by the expected sale price and is expressed as a percentage. Ultimately the type of property, the demand at the time of sale, and the market's inventory will all affect the final price. Cap rates can change from 4% for Class A buildings in secondary markets, to 7% class C in the mid-west, with 5.5% being the average cap rate in the U.S. prior to the COVID-19 pandemic.
When doing your pro forma on a property, it’s best to plan on the conservative side. If you’re planning on buying a property with value-add improvements in mind, plug in lower premiums than the numbers you’re actually targeting. Premiums are the increase in rent, so if a current apartment rents for $1,000 and you plan on raising the rent to $1,200 after the value-add is completed, the premium would be $200. In plugging in the numbers, however, it makes sense to plug in a premium of $150. That way, if you can’t ultimately rent all the units for the projected premium, you won’t be finding yourself with a lower income than you projected. In a post-pandemic world, I’d highly suggest keeping rents flat for 12-24 months, since we assume it will be challenging to raise rents for a while.
The same approach goes for your expenses. Plug in higher expenses than what you anticipate, so if for your expenses come in below your expectations, your net operating income won’t be impacted. For example, if you project utility expenses at $3,000 per month, but the actual utility costs are $2,500, your projections will appear better than if you had plugged in the $3,000 amount.
Using a conservative approach when projecting vacancy rates on your pro forma is also a smart way to go. If you want to prepare yourself for the variables that happen with properties, assume a vacancy rate of at least 7% to 10%, even if the actual is much lower, and especially when you underwrite a deal during a recession. Having an overstated vacancy rate on a pro form could be a red flag about the property.
Solution #2: Hire a Mentor
If you’re new to real estate investing, you probably don't yet have enough knowledge or experience needed to analyze a deal and ensure you’re paying a fair price for the property. Hiring a mentor can solve your problem, as the mentor will have the experience and knowledge to look at a deal and determine whether the price is equitable or not.
The operative word here is “hire” - you’re not looking to barter your time in exchange for your mentor’s knowledge. The reason is simple: you want to work with someone who is not only at the top of his or her game, you want to work with someone who is willing to work with you. Not every successful real estate investor or syndicator is willing to exchange their knowledge for your time.
A mentor who is successful in real estate investing is going to cost - probably in the thousands of dollars. However, when you think about the potential income you’ll receive after learning from your mentor, the amount they charge is more than fair. Think of it as an investment in your future. Everyone pays thousands for college or an advanced degree, and having the opportunity to work with a successful mentor is certainly worth the money they will charge.
Just make sure that the mentor you choose is willing to give you one-on-one coaching. Hopefully, you’re at a point where you know the basics and can do a fair job of vetting a deal - before you hire your mentor. The one-on-one coaching is to learn the finer points of pricing the property, determining whether or not your asset is in a strong real estate market, and whether or not the projections made by the syndicator are valid.
You can find a mentor by going to meet-ups, real estate networking events in your area, getting referrals from other investors, listening to podcasts, or going on websites like we are now on Bigger Pockets. Some mentors offer “free training” as a way to get to know each other. Meet with your prospective mentor, and make sure that you’re completely comfortable with his or her approach. Trust your instincts, and make sure your investment philosophy is on par with your mentor’s. If he or she is comfortable with high-risk investments and you’re not, walk away.
Solution #3: Save Money for a Rainy Day
Even if you’re planning to purchase a newer property, you never know when things can go wrong. You may have some unexpected operational expenses, such as a plumbing problem or an electrical wiring problem, but the bigger problems come into play with capital expenditures.
For example, a new roof can cost in excess of $500,000 plus, depending on the size of the property. If you don’t put aside money for an unexpected capital expense, you’re going to be facing a cash-flow problem. Same with an HVAC system - they’re not inexpensive! Those unexpected expenses can wreak havoc with your monthly cash flow and can be devastating to your bottom line if you haven’t planned for them. Your 20% extra that’s raised as a cushion will help you get through those unplanned expenses.
Another thing to consider relates to raising capital from investors. I always tell my students that they need to raise a larger amount than what they think they’ll need. The reason is simple - some investors who originally committed to investing in your deal might back out or run into cash flow problems of their own, which would leave you with a shortfall that you might not be able to make up for on your own. I always try to get an amount that is 20% more than what is planned for, to cover any shortfalls from investors or larger loan requirements than I initially projected. Having that rainy-day fund is comforting.
The bottom line is that raising extra money for unexpected expenses is a solid practice. We always have at least 10% extra above budget across all of our properties, in case we need to use the cash to pay an unexpected expense.
