Three Ways to Think Like an Appraiser
This is a story that happens each year in our great country: A founder sells a portion of his startup company and make a nice cash pop. Now what? He decides to invest in real estate because real estate is a safe bet and tenants pay the note down for the owner. Mailbox money, what could go wrong? He asks his college buddy who sells commercial property to see if there are any “good deals” in his town. Our founder looks at three small retail centers that fall on his normal daily traffic route, then pulls the trigger. Boom! Within three months he is now the proud owner of a cash flowing asset. Was this a good buy? We will see.
I want to talk about three little tricks to help you think like an appraiser.
The methods of evaluation are:
1. Comparable Sales Approach
2. Income Approach
3. Cost to Replace
This does NOT substitute an appraisal, nor does it shortchange all the hard work and training put in by appraisers. I am not an appraiser, nor do I play one on the internet. But if you are a deal junkie like me, you need a quick “back of the envelope” formula to figure out it this deal is worth your time. I am going to give you three real life examples of deals I have done.
Deal #1
My lovely wife and I moved to Ann Arbor, MI in 2015. (Apparently, I did not pay much attention in geography class because I thought Ann Arbor was in Minnesota for a while. Now I know better.)We needed to buy a house, so we picked a neighborhood that was walkable to downtown. I looked at all the homes for sale and found one for 35% per square foot below the comparable sales on the street. Hmm…I figured there must be a problem.And sure enough, there was. One of the basement walls was bowing inward, crumbling, and leaking water. Now, I am Southern, and we don’t have basements, but I knew this was bad.
Problems are opportunities in real estate. Anold client of mine used to say,“It’s just time and money” and for the most part he was right. The question was how much time andmoney would it cost? I called the best basement guy in town, and he told he could fix it for $30,000. I bought the home for $200 per SF and invested another $40 per SF in fixing the basement and updating the interior. The appraisal came back at $256 per SF, and I invested $240 per SF, so I feltsafe. We caught a huge tail wind in the local market and ended up selling the home for $372 per SF. This was more luck than skill, but I feel safe we could have broken even, regardless of market conditions. By understanding the comparable sales down the street, we had confidence to move forward and buy our first home. This first successful investment led to my next deal.
Deal #2
My partner and I purchased a vacant 100,000 SF industrial property on forty acres. Ten acres were stabilized and heavily compacted with gravel. The building was nowhere near in perfect condition, but it was still very serviceable. Based on my knowledge of comparable sales in the area, Iknew it wouldcost $500,000 to stabilize 10 acres. Forty acres in this area costs $20,000 per acre. Quick math of $800,000 + $500,000 = $1,300,000. We put the deal under contract for $1,000,000 and held our breath until the appraise came in. I was shocked to see it appraised for well over our contract price. The property is now leased out and performing nicely. By understanding the replacement cost of the acreage and gravel laydown yard, we felt comfortable enough to move forward with the deal. Huge wins can happen when you buy a vacant property right, then lease it to a tenant. But what about buying a property with a tenant in place and receiving rent on day one?
Deal #3
We recently purchased a medical office building leased to a group of doctors. Based on conversations with local contractors, I knew the ballpark price to build new medical office space was $250+ per SF. We put the property under contract for $155 SF.The physician practice has six-year lease in place and all seven doctors personally guaranteed the lease. By understanding the cost to replace the building or constructing the same building brand-new next door, we had the confidence to move forward with the purchase.
Let’s check in on our new real estate investor.
Our proud owner is finding out there is a little more to real estate than meets the eye. The new smoothie shop that was one of the five tenants has already opened and closed its doors in less than one year—just one of the many business failures that happen each year in the US. Now he must wait six months for a new tenant, pay for new tenant finishes, and pay a leasing commission to the agent. Who is getting rich here, the owner or everyone else? The best way to increase cash flow and avoid problems to is understand the three ways to value real estate.
All three approaches are helpful. There is no “silver bullet” and I find it helpful to blend all three when determining the margin of safety.
