I love Thin Mint Girl Scout cookies. Luckily for me, one of my coworkers brought in several boxes of the delicious cookies she ordered weeks earlier. When I was handed a box, I noticed that they appeared smaller than last year. It intrigued me so much that I did an Internet search and discovered that the boxes were indeed smaller. Due to the rising costs of floor, cocoa and transportation costs, the Girl Scouts decided to place less cookies in boxes or make certain kinds of cookies smaller. At $4 a box, raising the prices of the cookies in this economy was not a viable option. This got me thinking about value and what you really get for your money today.
I was talking with one of my clients who owns several properties and he said valuing properties was extremely difficult in this environment. A year ago, he could tell you if a deal made sense within five minutes, but today, it can take several days to figure out a real estate value. The variables have changed. When values decline, an investor is not able to use comparable sales as effectively as if values were increasing.
Comparable sales or comps look back 60 plus days on sales. If the market is declining, those sales are an ineffective measurement of the value of a property today. Unfortunately, with the tightening of the credit markets, it is not reasonable or advantageous to simply discount comps 5 percent to 15 percent. Today an investor must use all the tools in their arsenal to value a property correctly.
In the past, an investor had the benefit of the market on their side. If they made a mistake and bought too high, appreciation would allow their mistake to be offset and usually a profit could still be made. With values correcting and heading in a downward direction, it is no longer a viable option to pay a premium and let the market correct the mistake. Now an investor needs to understand what they are getting into when buying a real estate asset.
Even in good times when values are heading up, a smart investor knows he or she makes their money when they buy. An exit strategy is always in place before the close of escrow. For example, if an investor is looking for a 7 percent return on a property, they will do an analysis factoring in variables such as rental increases, expense decreases, etc., that they believe are realistic over “x” amount of time. That same investor may do a stress test to see how the numbers change if those same variables change. The stress test will show how the return on investment is affected if rents decline, expenses increase and capital improvements cost more than anticipated. The most important aspect of a stress test on a real estate investment is to measure the point where the investment is no longer financially viable.
It makes little sense to purchase a property without analyzing the risk of the asset. As obvious as that statement sounds, in today’s world many novice investors have found themselves in difficult situations unable to cover the monthly expenses associated with a property along with the debt service. And therein lies the risk with real estate — if the monthly mortgage payment and expenses exceed the monthly income, the property has a negative cash flow. An investor must plan and be prepared for a negative cash flow position. However, no investor can hold onto a property producing no positive income for an indefinite amount of time. Sooner or later, that property must become cash flow positive or the investor must have a clear exit, even if that means taking a loss.
Analyzing risk is an important aspect of real estate investing, but before an investor can do that, they must determine if the property is worth purchasing — does the property have value? When looking at real estate in a declining market, value must be determined by the investor. One real estate asset may have more intrinsic value over a twin property across the street because the first property is zoned differently or located in a different city. However, value is subjective and ever changing in a receding market. If the investor buys the property at a discount, they set a new lower comparable, further perpetuating a declining market. If the investor pays fair market value, they must be willing to hold onto the asset long enough to recover the cost, which they are going to lose.
Imagine going to the store, seeing a shirt you like and deciding to wait for a sale before purchasing it. A few moths later the shirt is on sale for 20 percent off its retail price. You decide to wait another month when you see the shirt marked down 40 percent off with an additional 10 percent off the marked down price. You decide you are going to wait another month. Once back at the store, you see the shirt is marked down 50 percent off with an additional 20 percent off at the register — you buy it. The shirt has an intrinsic value of “x” which you are willing to pay. Now imagine going back to the same store a month after purchasing and seeing the shirt you bought marked down 75 percent with an additional 30 percent off.
Now imagine buying a real estate asset before it was marked down or declined in value. This same asset is losing money each month and now is worth 40 percent less than was paid. You did not have an exit strategy or put the asset through a stress test so you do not know where it will end and how much money you will have to pour into the asset to cover the monthly payment. That is the feeling many investors have today and a feeling you can avoid if you take the proper precautions and understand what you are buying.
Just because a piece of real estate is listed as a “fire sale” item does not mean it is worth buying. Just like you would not buy a car on fire, you should not buy a property that is cheap for the sake of paying a low sales price. Unfortunately when you pay too much for real estate you do not even get a box of delicious Thin Mints to drown your sorrows.
Mike Heayn is a commercial loan consultant specializing in multi-family lending. He can be reached at (310) 428-1342, or at firstname.lastname@example.org.