Real Estate Investing ... Buy The Numbers
Have you ever wondered how a real estate agent who works with institutional investors actually goes about the process of evaluating potential purchases?
Well, that is one line of conversation that spiraled out of yesterday's article on Florida real estate investments (especially on Google+), so we will continue on the investment theme.
For people with a healthy background in mathematics, the process is fairly structured and simple. For those of you who prefer "the bigger picture" and do not really like the numbers side of the business, you might have to force your way through it (that's my nice way of saying "get over it" :) ).
But either way, whether you are a numbers person or not, the only way to ensure your rate of return is by analyzing the numbers, so let's explore how this is done.
Real Estate Investing ... Buy The Numbers
They say that numbers don't lie, only people lie.
Unfortunately for investors, people lie about numbers.
This is why experience in real estate investing is so important. I can look at the operating data of an investment and "smoke out a rat" pretty fast. In fact, I would say that besides my knowledge of the market, my ability to assess a proforma income statement is most likely the greatest value I bring to institutional investors.
The good news for our readers is that you can acquire this skill using the same learning process that I used.
It's something you might have heard about ...
That's right, take the time to analyze thousands of properties over the next few years, and people with numbers will not be able to lie to you either.
While this sounds like a mountain of work, I believe it is the only way to become an expert in real estate investing.
When a real estate investor is buying a property, she is doing so for the numbers (the rate of return). She is not doing it because she "likes the property," she is doing so because she likes what the property will do for her financial situation and goals.
Institutional investors do not buy real estate, they buy the numbers.
Real Estate Investing ... By The Numbers
The basic building blocks of real estate investment analysis is the real estate stack. If this term is foreign to you, follow this link to an article on the real estate stack.
Additionally, you can see a detailed application of the real estate stack using a real property by following this link.
The first goal for people wanting to learn how to analyze real estate investments should be to learn about about the stack and then create their own and run several properties though it for practice.
Every Sport Needs A Scoreboard
The biggest difference I find between the small local investor and the big institutional investor is the understanding that every investor should have a clearly defined goal. Institutional investors typically have a rate of return they need to achieve to deploy their capital, and they usually express this goal as an internal rate of return (IRR).
The IRR is the scoreboard that tells the investor whether they won or lost on an investment. Local investors can learn a lot from institutional investors in this light. If you do not have a goal, then how do you know what to buy?
For those of you who think "I'll know when I see it," you have some long years ahead of you. Think about this ...
The money you are investing is currently invested somewhere else right now. It could be in a savings account getting less than 1% rate of return, it could be in a CD getting twice that, or it could be in any other kind of investment as a stock/bond/annuity/etc/etc/etc. It could even be in real estate. It has to be somewhere, "doing" something. So when you invest in real estate, you immediately "lose" the return your money was generating before you deployed it into real estate.
You have to apply and risk/reward factor to what you could be doing outside of real estate before investing in a property. This is how you determine your target for an internal rate of return.
SUCCESSFUL INVESTMENT IS WARFARE!
There are fundamental concepts that apply to the real estate investment industry that have also been found true consistently on the battlefield throughout history.
Prudent investors could strengthen their positions by taking a lesson from our military history and doctrine.
This brief paper, assembled by a West Point-educated US Army combat veteran, attempts to explain how investors can alter their strategic plans by using the same analytical techniques as would be applied by our modern warriors.
The Skinny On Internal Rate Of Return (IRR)
The internal rate of return on an investment is the "rate of return" that makes the net present value of all cash flows (both positive and negative) from a particular investment equal to zero. OK, so what does that mean?
In a real estate investment, you spend money up front, then you might receive money (rent), and spend money (expenses), and then finally receive money (sale). So money does not just go out, and then come in. Money is always flowing. An internal rate of return measures this flow to evaluate how well moneys spent over time have been rewarded with moneys received over time.
The calculation is fairly complex, but thanks to spreadsheets (like Microsoft Excel), it is very easy to calculate an internal rate of return.
Real estate investors should establish a goal, expressed as a desired IRR, and buy all the real estate they determine can fulfill this goal. For example, you might say my minimum goal is an IRR of 142%. If you have billions to spend, you buy everything you find that exceeds an IRR of 14%. But if you only have tens of thousands of dollars, then you have the luxury of being selective. You find several properties that will satisfy your goal, and then you pick the one you think is the safest investment (or best return, or closest to your market area, or whatever your secondary goals require).
How To Deploy Your Capital In The Florida Real Estate Investments Market
There are many ways to get active in the market, but there is only two smart ways to do it (from what I have seen).
The mistake that most institutional investors make when they arrive in Florida is they reach out to the wrong people (Realtors and non-Realtors alike) and say "bring me properties." Then they have sales people trying to sell them properties. There is no trust. These new Florida investors get bogged down in analysis and they really do not have the local knowledge to accurately assess the reality of the proforma.
So they fudge. They build in a "no trust" factor and tell the sales people they are seeking a return that is higher than the market will bear. Sales people then have to "fluff" up the numbers to make the investments look better so that they can deliver the fudged goal of the investor. Remember, numbers do not lie, people lie.
Institutional investors need to be able to trust the information that they receive. They should either employ people to get to know the local market, or take the time to hire the real estate investment professionals who can demonstrate a reason to be trusted.
They should not ask for properties, they should ask for resumes and for interviews.
If you establish trust with somebody worthy of trust, you can buy all the real estate investments in Florida that you need.
Do not start with the property, start with a goal and a process to deliver long-term results.
If you would like to know more about institutional investing in Florida real estate, just drop me a note and we'll be in touch shortly.
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