HOW MUCH SHOULD WE OFFER?
Crafting Real Estate Offers In A Competitive Market
How can you make money today in a real estate market that is highly competitive?
Single family houses and multi-family apartments are seeing the effects of inflation and high demand. There is a housing shortage. Sellers of single family homes are getting multiple offers. In our local market there is less than one month supply. The average number of days on market is only 28. These are signs of a seller’s market.
Apartments are selling at low CAP rates, meaning prices are being driven up relative to their cash flow. The price gap between A and C class properties is being compressed. C class properties used to sell at an 8-10 CAP. Now they are selling around 5 in some markets.
Some owners are wondering if this is a good time to sell.
Some are asking what is left to invest in if they do sell.
HOW WE USED TO MAKE OFFERS
Recently Harland discussed how commercial properties are valued. You can read that blog here.
We used to make commercial offers based on the current cash flow and market cap rate.
Recall how Net Operating Income is determined:
NOI = Annual Operating Income less Operating Expenses
From there it was simple once you knew the market CAP rate:
Offer Price = NOI / CAP Rate
Using this formula today is likely to leave you with making offers at lower prices than other buyers in the market.
What do you do? How can you make a competitive offer that makes sense?
HOW WE MAKE OFFERS TODAY
Successful buyers in the market today are making offers based on potential they see in a property. What does that mean? How do you put a dollar value on potential?
Use pro-forma numbers. This does not mean taking the listing broker’s pro-forma numbers for granted. Ask some questions.
How do you expect the property to be operating after implementing changes to management? How much additional rent can be obtained by upgrading and renovating the property, then repositioning the property to serve the target market?
Reducing expenses can also improve pro-forma numbers. Maybe there is less expensive insurance available. Can repairs or landscaping expenses be reduced with contract services? Can utilities expenses be passed on to residents?
For the long-term stabilized value we use the projected NOI and anticipate a CAP rate at least as high as the current market.
Future Value = Stabilized NOI / Future CAP Rate
But we don’t offer the full Future Value price. Instead, we discount it for our time, efforts, and capital required to bring the value up to its potential.
Our Offer Price is somewhere between the value we determine based on current NOI and CAP rate and the Future Value based on Pro-Forma.
Sometimes we have to rely solely on pro-forma numbers. Like when a property will be converted from one use to another. Such as from a vacant hotel to an apartment building.
We are currently looking at hotel and motel properties that could be converted to apartments. There is no existing cash flow or NOI because the properties are vacant. We have to project a Future Value based on Pro-Forma numbers described above.
There are other questions to ask which affect the feasibility and profit potential. Can we purchase the property cheap enough, get the necessary zoning and legal approvals, get the renovations completed, make a profit for our investors, and get sufficiently compensated for our efforts? How long will it take? What will be the holding costs?
What is your planned exit strategy for the property? Hold for cash flow? Or sell it after adding value? Can you afford to hold it if the value is not as high as projections?
WHAT ABOUT THE SELLER?
When making an offer it’s not all about price. We need to find out the seller’s motivation. What is the seller’s urgency? Are there timing requirements?
When possible, it is best to meet the seller face to face. The seller’s broker will likely want to be present. This helps you, as the buyer, gauge the seller’s true motivation and objectives in selling.
What is the seller’s pain point? Why is he trying to sell? Is he focussing on investments somewhere else? Does he want free time to travel? Many mom and pop multi-family owners fall into this category. They are ready to retire and travel, leaving the landlording behind.
Is the seller concerned about tax consequences of realizing huge long term gains and having to recapture depreciation when selling?
It may be possible to structure a deal that reduces taxes for the seller and provides better financing terms for the buyer.
Is the seller trying to do a 1031 exchange into another property? That can add a sense of urgency.
Are there other properties that the seller also wants to sell?
The more that you can learn about the seller, the better prepared you can be to write an offer that appeals to the seller.
CRAFTING THE OFFER
With commercial properties we make our initial offer with a Letter of Intent, or LOI. It provides a written basis for negotiating, usually containing only one or two pages. It is more simple than a formal contract which is reviewed by our attorney.
The LOI states the price and terms of the offer being made. It is helpful to address the seller’s pain points in the terms. For example, if the seller is wanting a quick sale, you might include a shorter inspection period and close sooner rather than later.
For hotel and motel conversions we must also consider the amount of time and effort required to get zoning and architectural plans approved. This is part of our due diligence and can extend the inspection period and delay the closing date.
We frequently write and submit two LOIs. One offer gives the seller the price he wants along with terms that are favorable to us. This may include seller carryback financing. Another offer provides the seller with a quick sale but at a lower price.
Competitive markets require a fresh look at how we make offers. Cash and financed offers are coming in at higher prices than they used to. The potential value of the property at some future date needs to be considered. We also need to consider what the seller truly needs and craft an offer that addresses those needs while still providing the investor an opportunity to make decent profit.
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Mike is a retired aerospace engineer with a passion for real estate investing and teaching financial literacy. He lives with his wife in Daytona Beach, Florida.