Center for Real Estate Studies ¨ Cal State Properties ¨ Cal State Investment LTD Partnership
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Comprehensive Property Analysis Strategies
THE INTERNAL RATE OF RETURN (IRR) TO AIM FOR
The IRR should reflect the degree of risk you’re willing to take. The riskier an investment, the higher the IRR. If you’re purchasing a building that has decreased in value only because of temporary market conditions, your degree of risk might be considered moderate. Conservative projections are computed using rental growth and vacancy rates, and they establish the lower limits of the IRR. IRR projections based on replacement costs determine the higher limits of the IRR. Analyzing both rates of return allows you to assess the risks versus rewards relationship of each investment.
REVENUE ASSUMPTIONS THAT MAKE SENSE
Revenue assumptions play an important part of your analysis. In addition to the information provided by consultants, check with local rental firms. They are on top of current trends and demand. Lease agreements should be verified to actual rents for each tenant. Use rental applications to develop tenant profiles. Obtain a signed estoppel from each tenant attesting to the rent paid, occupancy dates, and deposits. Rent raises don’t always occur on the first day of the month or in the first month of the year. A careful review of rental agreements will assist in making accurate cash flow projections. Ideally, try to stagger individual rent raises throughout the year. It is less disturbing to the entire complex.
Vacancies vary in seasonal locations like college towns and resort areas. Make provisions for these fluctuations in cash flow projections. Don’t assume income will be received evenly month-to-month and year-to-year. Projections based on research will result in a more accurate IRR.
ANALYZE EXPENSES CORRECTLY
When analyzing expenses, refer to the real estate investment inspection report. It should detail, by projected date the costs, repairs and replacements for each unit and the entire building. Using a comprehensive computer program will produce accurate operating budgets.
Mechanical equipment such as water heaters, dishwashers, garbage disposals, and pool equipment, for example, have estimated life spans. Major repairs and replacements on roofs, plumbing, decking, and cement should be detailed by estimated costs and the dates work is to be started and completed.
As with income, expenses do not occur evenly throughout the year. For example, in cold climates, utility bills are higher in the winter than in the summer. With grounds and pool maintenance, it is just the opposite.
Expense figures should be compared with those published by the IREM. All sizable discrepancies must be explained.
Do not make flat rate projections. Don’t apply inflation rates across the board. Projections should be made on an item-by-item basis using the best information available. For example, if the inflation rate of 5 percent is used in one year, don’t use it again unless it applies. Actuals should be used whenever possible.
USE THE FEEL-AND-TOUCH ANALYSIS
As part of the analysis, we at calstatecompanies believe that absolutely nothing beats the feel-and-touch approach. A physical inspection of the real estate investment and the neighborhood will confirm your consultant’s reports. Critical words like good, bad, best, worst, bright, dull, a lot, and a little are subjective. Make sure everyone’s singing from the same hymn book when praises to your real estate investment are being sung!
Ask yourself the following questions when evaluating the area as part of the physical inspection:
• Would you be willing to live or at least collect the rents in
• What’s the graffiti index?
• How does the landscaping of the other properties compare with the one
• Is there debris in the streets?
• Are there cars on blocks?
• Is it completely off the beaten path to major shopping and
• Is the community growing favorably in the direction of your real
• Are transportation lines readily available?
• Are schools and recreational facilities nearby?
• What is the ratio of renter- to owner-occupied buildings?
The greater the rental population, the more transient the area be-comes and the greater possibility of it being left unkempt. The physical test will give you that personal viewpoint necessary to complete the analysis.
Even in depressed markets you should look for properties in good locations. A cardinal rule is to buy the worst property in the best location, not the best property in the worst location. Buying the poorest real estate in a good location, at least gives you the opportunity to upgrade it. Whereas, upgrading an entire neighborhood could be difficult, if not impossible. When in doubt, a drive through will help. Contact your local real estate investment management company or real estate licensee for assistance.
ABOUT THE AUTHOR: Eugene E. Vollucci, is considered to be one of the foremost authorities on real estate taxation and investing and has authored books in these fields published by John Wiley & Sons of New York. He is the Director of the Center for RE Studies, a real estate research organization and President of calstatecompanies. To learn more about the Center, please visit our web site at http://www.calstatecompanies.com