CHAPTER 1

Do Your Homework: How to Gather the Data Needed to Make an Investment Decision

Before you delve into the basic calculations that underlie all real estate investments, you need to address a very fundamental issue: You can’t calculate anything and you can’t make projections unless you have the raw data with which to start. Information is a valuable commodity; you shouldn’t start off with any illusions that good information will fall into your lap without some effort on your part.

These guidelines are necessarily somewhat general. Data will be easier to find in some localities than in others, even within some transactions than in others. Still, if stock market debacles like Enron and WorldCom have taught us anything, it’s that investors need to know what’s really going on. You owe it to yourself to get the facts. The consequences of doing less can be unpleasant.

Property-Related Data

If you’re considering the purchase of an income property, you need to know as much as you can about its income and expenses. As we will emphasize throughout this book, you are not really buying a physical property so much as you are buying its income stream. The beauty is in the bottom line.

If you’re considering the purchase of an income property, the information you receive will probably come either directly from the seller or indirectly through the seller’s agent. In the next chapter, you’ll see in considerable detail how to analyze the basic income and expense numbers, but your first concern here is, “Are they accurate?” Here are some ways that can help you find out.

Ask to See the Leases

There are a lot of good reasons to do this. For one, if you buy the property, you are going to be subject to the terms of those leases, so it’s a very good idea to know what they say. More to the immediate point, however, is the question of the rental rates. Do the leases agree with the seller’s representations? How long does each lease run? Do tenants have options to renew and at what rates? The answers to these questions will have an important effect on your analysis of the current figures and on the forecasts you’ll make about the property’s future performance.

Look at the Property Tax Bill

That’s one way to confirm the accuracy of this expense; but also look to see if the current owner has received some sort of tax abatement (perhaps a development incentive) that may expire or may not apply at all to a new owner. Also, look for evidence of a “phase-in” of a new assessment. Some cities, in order to mitigate the impact that the periodic reassessment of property values can cause, will choose to implement a new assessment in phases. This can mean that the current taxes are accurate but that there is also the certainty of higher tax bills as the new assessment comes online.

Spot-Check Utility Bills

Most gas, electric, and water companies will give you usage information if you call. This is not the most efficient way to collect expense data on a property, but it can still serve a useful purpose. If what you find matches what the seller has told you, then you can have some reasonable hope that other representations will also be accurate. If, on the other hand, you discover discrepancies, you can ask for an explanation. Even if what you uncovered turns out to be an honest mistake, you’ve served notice that you are not to be trifled with when it comes to truth and accuracy.

Ask to See the Appropriate Sections of the Seller’s Tax Return

You’ll have to cover your ears when you try this, because the screaming can be painful. When the din subsides, point out that you don’t need to see anything unrelated to the property. If the owner holds the property as an individual, then the income and expense information probably appears on Schedule E, and he or she can show you just that form. The owner may own the property as a limited liability company (LLC) or some other form of partnership, in which case the property has its own tax return. It is quite unlikely that an owner will claim too much income or too little expense on a tax return, so this can be an illuminating source of information.

Recite the Representations About the Leases and the Schedule of Rent Income in the Offer to Purchase

Check with an attorney about the proper language, but put into the offer to purchase something along the lines of “The Seller warrants and represents that as of the date of this agreement, the leases are for [such and such amounts] and the expiration dates and renewal options are [whatever].” Then ask the lawyer about adding, “and that these warranties will survive the delivery of the deed.” The first part means the seller swears to tell nothing but the truth, and the second part means that he or she is not off the hook if you discover the lie after you complete the purchase. It’s amazing how many sellers get religion when faced with having their words immortalized in a contract.

Market-Related Data

Investigate Comparable Sales

If you were contemplating the purchase of a home, you would want to know how much other homes in the neighborhood had sold for. Sales of comparable properties don’t tell you as much about an investment property as they do about home sales, but they can sometimes provide a useful insight. There are some obvious problems with trying to use raw “comps” data that you typically get from a real estate agent. One problem is simply the lack of enough comparables to be meaningful. Let’s say that you’re looking at a 10,000 square foot shopping center. How many recent sales of centers the same size in the same market area are you likely to find? Probably not enough to provide a significant sample.

Your search might be a bit more productive if you look at some additional factors in regard to these comparables. Total square footage is one. You may find that three strip centers have sold in the last year, but each was a different size. You could examine the selling prices per square foot to see if you can discern a trend. You could also consider each property’s gross rent. Dividing the selling price by the gross rent gives you something called the gross rent multiplier (more on this in Part II, Calculation 5). Perhaps you’ll get lucky and see that these other three sales occurred at 7.1, 7.2, and 7.3 times each property’s gross rent.

Where do you find information like this? Public records from the tax assessor and city clerk will probably yield sale prices and property dimensions, but digging this out may be a chore. A growing number of Internet sites are dedicated to aggregating information about commercial properties sold and for sale. We could name some here, but we won’t because their Internet addresses will probably change before the ink dries on this page. Nonetheless, a web search should quickly point you to current sources. Also, check the websites of trade organizations like the Appraisal Institute (http://www.appraisalinstitute.org); they will almost certainly direct you to sources of data. Keep in mind, however, that you are not likely to find this kind of information online without having to pay for it.

If you’re dealing with a broker, he or she should be a great source of information. Even before computers made it easy to keep property records, good commercial brokers always accumulated data about every property they came in contact with. Ask for the information.

One final word on comparable sales data as they relate to income-producing real estate. Remember your mantra: You’re really buying the income stream. Comparable sales data are useful insofar as they give you a feel for your market. Data seldom tell you enough by themselves, however, to lead you to a decision about buying or selling.

Look for Lease Rates and Operating Expense Data

As you get into serious property analysis and projections, you need to know what tenants are willing to pay for space and how much owners are obliged to pay for operating expenses. Once again, you can ask the commercial broker to share that information. It would be a good idea to cozy up to a property manager as well (you may need his or her services later) because a manager will have firsthand knowledge of what it really costs to run a particular kind of property.

Find Out About Local Capitalization Rates

Unless you read this book from the back to the front, you may not know yet what a capitalization rate is. Suffice it to say for now that it’s one of several rate-of-return measurements that you will want to know. For the type of financial forecasting you’ll learn to perform, it’s very valuable to know what the typical capitalization rate is for a particular kind of property in a particular geographic area. Once again, your commercial broker is the first person to ask. This information is more difficult to find online, so despite our reluctance to name commercial websites, we will mention http://www.realtyrates.com as a current source of such data.

Armed with the confidence that you can dig up the data you need to perform a sensible property analysis, turn your sights now onto some real numbers.