We’re taught that we should never underwrite a commercial real estate deal based on future performance—but always on current performance.
This is great advice, but sometimes it doesn’t match reality.
Here’s an extreme example to make my point: What if you’re looking at an empty 10-unit apartment building?
Technically, the net operating income (NOI) is actually negative, and if we apply a cap rate to that, the seller would need to pay YOU to buy it.
But we all know that’s just silly.
Sometimes we have to break the rules because sometimes they just don’t work in ALL situations.
While many of us may not be looking for empty shell apartment buildings, most of us are looking for value-add opportunities.
Let’s suppose that you’re looking at a value-add deal. The rents are 20% below market and vacancies are 25%, but you determine that the market vacancies are 6%.
You believe that within 1-2 years, you could add significant value by stabilizing the asset.
Applying a cap rate to actual financials may not accurately value the building and/or may not make you competitive enough, but it may still allow you to make a good return.
So you may have to overpay.
That’s right. Overpay.
Now, hear me out before you shout and scream that this is not what’s taught in apartment building investing school.
It is true that you should value a building based on its actual net operating income. But sometimes, especially if it’s a value-add deal, you may have to pay a little bit more to be more competitive and get the deal.
But how much more? That is the question!
Here are some rules of thumb.
Rule #1: Don’t be too greedy or proud.
If you insist on paying no more than the prevailing cap rate on actual financials, even for value-add deals, then this “pride” or idealism might prevent you from ever getting into a deal.
In looking back on many of my negotiations and deals, one could argue that I could have done better, negotiated more, and given up less.
This may be true, but another thing could have happened: I may have lost the deal because I was pushing too hard because I was too greedy and wanted too much at the expense of others.
In my experience, creating win-win deals will get you more deals than beating down the other side and trying to squeeze out everything you can.
Don’t be too proud; get deals done instead!
Rule #2: Let your investment criteria tell you how much you can (over) pay.
If you’re looking for an investment with at least a 10% cash on cash return or an average annual return of 14%, then don’t do a deal with less return.
It’s potentially OK to over pay and maybe give up more upside than you should, but never compromise your minimum investment criteria.
Rule #3: Adjust what you are willing to (over) pay based on the risk.
The riskier the deal is, the higher your returns should be.
For example, let’s say you are, in fact, buying a shell of a building. Your “normal” target return of 14% may not be appropriate for this level of risk, but perhaps a 20% return is more reasonable.
The bottom line is, you can over pay to get into the deal, but only to the extent it still meets your minimum investment criteria, adjusted to the level of risk.
Rule #4: Overpay if you get terms.
If a seller is set on a certain (unreasonably) high price, I can sometimes give them what they want and be more competitive if he is willing to give me some terms.
If he agrees to hold a note for 3-5 years or lets me assume existing financing (if it’s favorable), then that may reduce my cost of capital (compared to equity investors, for example). This may boost my returns and allow me to increase my purchase price.
While it’s always more conservative to underwrite a deal base on actual performance, certain value-add deals allow us to overpay and STILL satisfy our investment criteria.
As long as you can meet your investment criteria, don’t be too proud or greedy to pay a little extra—otherwise, you may never get into a deal!