The due-diligence or inspection period is a very important time when purchasing a property. The period allows you to access to the property onsite and makes records available so you are able to verify the information and perception you have about the property you’re about to purchase.
Before purchasing a property, it’s critical that you take the necessary actions so that you can make an informed decision on whether the condition, operations and financial picture of the property are as you were made to believe.
Many sellers these days are waiting to trade their properties at–or above–the asking price. When demand is up, the asking price is typically influenced by an over-enthusiastic market environment. This is especially true in multifamily right now, because it’s in demand. When demand increases, so does the willingness to pay a higher price; it’s the law of supply and demand at play. In support of the highest possible sales price, a broker–with input from the seller–will put together a proforma income and expense statement to justify the asking price. A proforma is only as good as the assumptions used to create it.
The problem with most broker proformas:
The biggest problem with most broker proformas is that they typically do not take into consideration the total cost of acquiring, operating, maintaining, and selling the asset when the holding period ends; without this information, a true assessment of investment value will be difficult to achieve. The success of a real estate investment depends on 4 major things (1) it’s basis, (2) it’s financing, (3) it’s management, and (4) it’s cost at disposition. Because of these facts, the risk profile of real estate—as an asset class—is higher than a treasury bill, for example.
With a higher risk profile, a higher rate of return is justified for taking on the increased risk. Therefore, an internal rate of return of 14 or 15% before taxes is a reasonable expectation for properties like multifamily; unless you are reducing your returns in order to accommodate an equity partners’ required rate of return. An investment that offers a low return for higher risk is an investment not worth undertaking because of its inadequate compensation.
Games people play
Brokers will give you proformas without taking into account the true cost of ownership including acquisition and disposition costs. It is a half-ass approach, and half-baked idea, and yet brokers–along with some sellers–do this all of the time. In my own deals, I make it a point to explain why my offers are not where they want it to be. Typically, when I do this, they can see the logic. The reactions I get will vary depending on the character and personality of the person I am dealing with; for example, one broker’s voice suddenly went up an octave as he started talking really fast to get off the phone with me, and then never returned my phone calls or emails.
In another instance, a broker blatantly lied to me arguing that she had already received an LOI from an interested buyer at the “minimum price” the seller was supposedly willing to accept. When I withdrew my company’s interest, the truth came out. For this reason, we have had to incorporate a policy to only deal with decision-makers directly in order to avoid the greedy and costly games that some people will play in the middle of a deal to milk the most fees and commissions they can from it.
Real estate investment and development. WA Contractor Lic# WORLDWI852BM