Someone once said, ‘never judge a book by its cover’. Sound advice as I’m sure most of us have experienced at some point in our lives when we thought something would be a dud and instead turned out great: a party, a class, a date, or even a property. That’s great, but how can you tell if a property will be a good book or a bad book which looks just like its cover?
Basically, just like a book, you have to invest some time looking inside… An excellent example of this will be at the end of this article! In the case of commercial real estate, there are a number of aspects to look at when judging a property. First there is the condition. On the surface, the property might look tired and worn.
However, once you get inside you find that the bones of the building – the framing, foundation, electrical and plumbing systems, etc. – are all 100%. When you look carefully outside, perhaps the roof is actually fine with at least 10+ years left and while it could use paint, the siding itself is in good shape. Furthermore, things like landscaping and parking lots are easy fixes. If you had only driven by the property without taking the time to get out of your car and really look, you would have kept driving when actually the property itself physically was just fine.
Second, there are the numbers! The first thing many investors look at is the NOI and nothing else. That’s pretty short sighted! NOI is not the ‘end of the story’. Many times, the NOI only points to a deeper story that needs to be told about the operations of the property. For example, are the expenses in line with market norms. An easy starting place on that front is the management fee. Is the percentage reasonable. We’ve seen many cases where a property is what we call ‘over managed’ and that fee can be literally double market norms.
Next you can look at Repair/Turnover and Tenant expenses. Again, are they normal for the area. Another example would be overall utility costs. Are they much higher than the market and if so, why? On several occasions in recent years our clients have uncovered water leaks in particular which have driven Water/Sewer costs 50% or higher than what they should be.
Last and most importantly, how do the rents look relative to competitors. This is where having really good property managers and leasing agents comes in. Rents are the single largest source of cash flow gain available to most buyers and the one most often overlooked.
Third, what about the area. Do you see an address on a particular street which causes you to turn away? As with the first area of condition, perhaps you need to actually drive out to the location and see where it really lies. Many times you might have prejudged a property based on the street without realizing the actual address could be miles from the rough part of that street and actually in a pretty nice area surrounded by other nicer properties. Don’t be like others who look away without being willing to invest a little time. You never know what you may find.
All of that leads to a classic situation on a property for which we secured the financing here in Portland. The property was marketed as a very low cap rate deal. That alone turned a lot of investors away. However, when our client ran the listing by me, I quickly realized something was very wrong with the numbers. The property expenses were not only out of market norms, they were barely on the same planet! For example, this was a 33-unit apartment project for which management placed an onsite management person who not only received their unit free, but a salary on top essentially making that a $50,000/year job – on a 33-unit property! Virtually every other category was off as well.
By the time my client and I created a market projection with the help of his management team, we realized this was actually a close
to 6% cap rate property. Moreover, rents were at least 20% or more under market which builds in NOI build up over the next 24-36 months. The trick of course was working with the right lender and getting the help of the listing and selling agents. In the end, my client concluded this may be the best purchase he’s made. All of that on a property completely overlooked by other investors for 6 months.
The moral of the story from everything above is again, don’t judge a book by its cover. Invest a little time, read through a few chapters, and you never know. You may find the gem everyone else overlooked. Feel free to reach out if you would like any additional info on this transaction. Happy to share all the other details we uncovered making this property a home run.
