How do buyers measure their purchase? How do they know if they have a winner? Almost any measure requires the use of a timeline. Buying a deal for a $1 and selling it for $2 requires knowing when the dollar was invested and the hold time to determine yield. The dollar invested may have additional dollars added during the hold time. The timing of these additional dollars is also required to determine yield.
Everyone has a different measuring stick when it comes to defining a winning acquisition. Depending on what side of the coin you represent, just the fact that a deal closed means many people were paid for their good efforts; appraisers, mortgage bankers, legal professionals. That’s fine as they all represent pieces on the chess board of an acquisition.
Then there is the buyer. This person or entity has just signed on for an extended relationship with the asset. For many, their relationship with the asset ends on closing day; for the buyer their relationship is just beginning.
And you cannot just “figure” like the old farmer that “figured” if he sold a crop for double the costs then he must be making money. Costs include more than labor, material and overhead. There is cost of capital and opportunity cost to take into consideration.
A tried and true formula for measuring yield is to predetermine your risk premium. For some investors this baseline is cash the yield. This seldom plays out well as this is a comparison of apples to oranges (attempting to compare yield on a liquid asset versus an hard asset). The risk premium curve requires a comparison of like assets.
Here are some methods, some numerical, to measure a winning purchase. All require knowing the invested dollars and timeline to determine outcomes.
Land value. Too many people, when looking at income producing assets, fail to consider the land value as a stand-alone asset. Granted, the valuation of income property is predicated on income. However, land value can sometimes outstrip income production based on the highest and best use for the underlying land. Just a point to ponder. Consider the strawberry farms across the street from Disneyland. This from the Los Angeles Times, August 16, 1998:
The Walt Disney Company announces it has acquired an option to buy the last large development site in the resort district of Anaheim- a 52.5 acre strawberry farm that the Fujishige family has refused to sell for decades. Several real estate experts speculate the land will costs Disney from $65-78 million dollars.
Long-term value. We recognize real estate as a store of value. While prices do not always go up, they seldom go to zero. Real estate is also a hard asset, one that represents a physical plant that can produce income. This separates it from other stores of value like gold and diamonds…and we like income!
Occupancy and historic occupancy. A well occupied development is perceived to have good value. Historic occupancy is a factor in the decision-making process. More importantly is current market dynamics that convey going-forward market strength and occupancy potential.
Relative NOI. Relative here is just another word for guess. It’s ok to perform that back-of-the-envelope analysis for a minute, but this should give way to empirical number crunching long before an offer is on the table. When NOI is rising there is a presumption that value is rising. This form of thinking precludes performance of quality due diligence. Use actual, projected and forecast numbers. Yes, these are estimates, but estimates built on quality research.
Yield – IRR and cash-on-cash. Ah- now we have some hard and fast numbers to capture. . These two measures, while separate and distinct from each other, provide a number from which to compare other investments alternatives. To determine each of these read Frank Gallinelli’s book “What Every Real Estate Investor Needs to Know About Cash Flow… And 36 Other Key Financial Measures“.
Upside potential. Penciling upside potential has as many outcomes as the people doing the penciling. And “value” is calculated in so many different ways based on the experience and expertise of the person completing this determination. Here is a basic rule of thumb for determining upside potential:
- Compare cost per square foot (acquisition price) to current market price per square foot.
- Add costs to redevelop to the acquisition price.
- Compare total landing costs per square foot (acquisition price plus redevelopment expenses) to current market price.
- Determine percentage gain in value. If this number is less than 20%, depending redevelopment costs, the risk is out of line with the potential profit margin. A lower acquisition price is necessary to compensate for this risk.
The moral to this story is that there are several methods of determining value and gain on sale. As a buyer, your job is to select those methods that best represent an honest framework to capture the output yield for investors. There is no glory in producing inaccurate information as if the yield is sub-par one would think your objective is to not repeat this behavior and when you find a winning formula- repeat often. You have to study the details to be able to tell the difference.
This post is intended to spark your thinking on the topic. Please add your comments and suggestions. I am always willing to update articles with thoughts, suggestions and new ideas from our loyal readers.
This blog is intended to be informational only and does not provide legal, financial or accounting advice. Seek professional counsel. http://www.MultifamilyInsight.com