Go to any app on your phone and you can find a house or apartment for sale. It is exciting shopping for investments. However, it is no secret that we are in a hot market. How do we know if the prices sellers are asking are too high? It is not a simple answer, but the short answer is that it depends.
Compared To What?
When we conclude that a real estate asset is overpriced, what do we mean? Over priced compared to what? Last year’s cap rates? Current Income? Next Year’s Income? There are many things to consider when determining whether a real estate asset is overpriced. In a hot market, you are certain to pay a higher price for the same asset than you would have years prior. But that is only one perspective. There are multiple valuation metrics or rules of thumb:
- Price per unit
- Price per square foot
- Gross Rent Multiplier
- Cap Rate
Each of these metrics tell you different things. Looking a them alone can cause you to make a decision about a property that may not be entirely accurate.
What Do Investors Buy?
Here is the bottom line. At the end of the day, when you buy a real estate investment, whether it is a small multifamily or a large apartment, you are buying its cash flow streams. If the cash flow streams sufficiently cover debt obligation and secondarily provide you with the targeted cash on cash (CoC), average annual (AAR) and/or internal rate of returns (IRR), then you have made an investment that works for you.
Syndicated Investments
As syndicators, there is more to consider here. Because passive investors are involved and seek targeted returns (CoC, AAR, IRR), there is a larger hurdle of returns that the sponsor must be confident that the property can reasonably achieve. In a syndicated deal, much of that targeted return is made on the sale of the property, so there must be sufficient upside to net operating income in the investment. In other words, there must be plenty of room to grow the income from the property. If there is little upside to achieve targeted returns or targeted returns are low or insufficient, that is how to know if the asset is overpriced.
Today’s Hot Market
In today’s hot market, deal finders are seeing that they cannot be competitive on a deal by underwriting based on current income. In order to provide an offer that is competitive to sellers, they must underwrite more aggressively, based on potential income, which includes assumptions for rent growth, reduction to expenses, etc. In many ways in this market, competitiveness requires underwriting based on what the property could earn, versus what it currently earns. This is certainly something to keep in mind as you review investment opportunities, either as an active investor or potential passive investor.
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