This one is not really a step in evaluating each deal, it’s a thing you learn more about every time you evaluate a deal. It is all about knowing what is happening in your market. Here are the most important things to know about your market.
The Capitalization Rate
The Cap Rate is a quick way to know what other investors in your area value the property you are looking at. It is a very quick way to put a value on a property given the information you already have with the Profit and Loss. That Net Operating Income line item along with the Cap Rate gives you what you need to arrive at this value. You just need to know the Cap Rate.
The best way to know is by reviewing a bunch of deals that have sold in your area. This could be done through your real estate agent, or by doing deals yourself. There is typically a going Cap Rate which is different for Class A, B, and C buildings and it will change over time. It’s very much like housing values in your area that change over time. It is driven by whatever the market will bear. In my area right now Class A buildings go for 6.1 to 6.5%, Bs are 6.5-6.9% and Cs are in the low 7% range. Remember that the Cap rate is the expected return before debt repayment. Lower class buildings have higher risk, and so the market demands a higher reward (the higher Cap Rate).
Once you know the Cap Rate for your property you can use the NOI to calculate a value. This is just a rough estimate. There are many other factors that will go into your valuation, but if the seller is asking way higher than what you get, it’s best to move on before you waste a bunch of time.
Start searching the internet for any desirable retail areas around your location. Apartment renters like to be near (but not too close to) superstores, schools, public transportation, malls, gas stations, air ports, arenas, beaches, and many more. There’s no way to mathematically rate the location, but I get a feel for it and give it a letter grade. I’m willing to pay more for better locations. There are also undesirable neighbors, like airports that are too close and make a lot of noise, or places that emit odors, like landfills. Watch out for these.
Another important thing about location is to look at the crime rate. Most areas can be found on an internet search. Another great way is to call the local police department and tell them you are thinking about buying and you plan to ‘fix the place up’. They will often give you general information about the crime down to your specific building. Helping you clean up the place helps them, too.
Look at information in your area on job, economic, and population growth. This might even differ between areas of the same city. More growth means more tenants. Better jobs means tenants can pay more.
Probably the high profile but least visible of all the things you need to know when evaluating a deal is the rent. Rents are hyper-local and come down to the neighborhood. The best way to know the rents is to have apartments already in your area. You’ll know how much you get for that 2 bedroom 1 bath apartment. If you don’t have that, then you will need to do some searching. The great thing is, landlords are happy to tell you!
First, get on the internet and go to Craigslist.com, Apartments.com, and Rentometer.com and search for apartment units similar to the ones you are trying to buy and are near. These sites will show you the prices right on the screen! Next, pose as a prospective tenant and call five or ten apartment buildings in your area. Ask them about the type of units and prices as if you were looking to rent. They will be happy to tell you.
Once you have the prices of the closest units in your area, you can take an average and put them into your spreadsheet. But we will talk about that later. Just remember that it is extremely important to know your area. Failing to learn any one of the above can cost you.