Hey guys, Mo here –

First off, some BIG news. I am a minor GP for a strip mall in PHX. I can break down the deal & value-add business plan on a future email (with the blessings from my partners).

ALSO, we crossed 100 subscribers! Couldn’t have done it without Twitter and it’ll only get better in the future.

Today, let’s talk about a “good deal”. We hear that a lot in real estate from brokers.

“Hey man, I got a smoking deal for you.” or “it’s a great deal!”

What is a good deal?

What does it mean to “have a good deal” in real estate?

If you ask 100 different people the same question, you’ll probably have 100 different answers.

Ultimately, some of the factors that constitute a “good deal” in CRE come down to how the sponsor/owner does business and their risk profile.

Ex:

Syndication/private equity model:

Their goal is to buy an asset, renovate vacant units, and charge market rents for it. This is known as the “value add” model and they’ll eventually exit.

Syndicators may target the “lower middle market” or LMM. This is usually between 20-100 units. Syndicators raise equity from accredited investors, in chunks from $50-250k checks usually.

Real estate private equity (REPE for short) usually will employ the same strategies but at a larger scale. This is usually 150+ units and they’ll raise money from institutions. This could be life insurance companies, private equity offices, or pension companies.

“Forever hold” model:

If you follow @MosesKagan on Twitter, he’s one of the OG’s in Real Estate Twitter. He buys buildings in LA for a good cost basis and renovates them with high end finishes.

“Family offices” are just fancy finance terms for families that have generally $50-100mm of property that hold for generations.

A “smoking deal” is usually 20-30% below replacement cost for new construction.

In the last 15-20 years, the replacement cost has only gone up. The cost of construction materials, labor, and permitting process have been elongated and cities are notorious for denying housing projects.

The forever hold method is what most people want to do with real estate, but there’s a caveat where you have to reinvest into buildings to upgrade infrastructure every 40-50 years and address things as they break. These include roofs, HVAC, wiring, electrical, all the big ticket items that keep your units working as usual.

The Traditional “Sweet Spot”

Most REPE firms want to buy at stabilized cap rate + 200 bps or 2% above market cap rate.

EX – if you are looking at Class C buildings in Tier 2 markets (PHX/CBUS/INDY/ATL) – these historically have traded around 7.5-8.5% cap rates at stabilized values. Obviously, since real estate is cyclical, we tend to see them closer to the low 7’s.

The sweet spot for a good deal would be if you can buy it at a 9% going-in cap rate. Or when NOI is about 9% of purchase price.

Example:

Say you’re buying a 50 unit that’s making $300k in NOI in actuals. You know the rents can actually be pushed up closer to $400k via rent upgrades etc.

NOI is net operating income aka gross rents - gross expenses.

Free cash flow (FCF) is NOI - (debt service + capex).

The broker that’s listed it has it valued at closer to $4.0mm. At $300k NOI/$4mm purchase price = 7.5% cap rate on actuals.

This seems a little overvalued for me given actual financials. When you underwrite deals, your property taxes and insurance need to reflect the higher costs.

I’d need this to pencil at 9.5% for it to be a “smoking deal” or $300k/9.5% cap rate or I’d put an offer in around $3.2mm. The reason is that you’d probably need to invest some $ into renovating units and you need to bake that into your cost basis.

Assume 40/50 units are renovated so you’d need to factor in an extra $100k + closing costs (1% of deal) on top of purchase price to make the deal work.

So you’d need $3.2mm (purchase price) + $100k (capex) + $320k for closing costs. This would make your cost basis $3.62mm.

With current income ($300k), you’d be looking at buying this at a ~6.5% in-place cap rate.

$300k/$3.62mm = 6.49% cap rate.

After you stabilize it at $400k NOI/$3.62mm all-in costs, it comes out to an 11% stabilized cap – surpassing your 9.5% cap rate minimum.

At $400k NOI selling at a 7.5% cap rate, then it technically would be valued at $5.3mm after doing a lot of heavy lifting. Assuming, you’d want to do a 70% cash-out refi and leave no money in your deal, your cost basis would be max $3.7mm

The math:

$400k/7.5% = $5.3mm*

*Stabilized value

$5.3mm 70% (Loan to value) = $3.710mm*

*Cost basis you’d need to hit to refi all your equity out

If you offer $3.2mm purchase, the seller may give you a counter offer or to tell you to kick rocks because the offer was too low. You can readjust your numbers for a $3.3mm purchase price and your cost basis would go up and yields would go down.

Underwriting is both an art and a science because you need to look at what comps are trading for and if the math makes sense.

A lot of this is spreadsheet math and you need to make sure your assumptions are in line with the market comps.

Hope this example helps you crystalize what constitutes good deals and I can do a deal breakdown if you guys would like.

Thanks for reading!

-Mo