Why Numbers Sometimes Lie
By JD Esajian on April 6, 2015
One of the first things you should do when evaluating a new property is to run the numbers. Plug everything into your spreadsheet. If the numbers work, make an offer. This makes sense in theory, but may not always be the best thing to do. It is human nature to get influenced by a property you want. Instead of putting in realistic numbers, you bend them just to make the deal work. You may end up with a property that looks good on paper, but in a few years it is a burden on your portfolio. Numbers can give you an idea of whether or not to make an offer, but they don’t tell the whole story.
You can plug in any numbers into a spreadsheet to make a deal work. Minor changes in rental income and expenses can completely change the way you look at the property. Since you are in control of the numbers, you determine the bottom line. It is not easy to do, but you need to look at a property as if you were evaluating it for someone else. Once you take the emotion out of investing, you can make better decisions. It is important to look past the current condition, and consider which items will need updating in 12-36 months. If you look at a property in this way, it completely changes the value. Instead of planning for only minimal repairs, you may need money sooner. A great property can look completely different once you plan on doing work.
The most overlooked item on investment properties is future repairs. The roof may not need replacing after you buy by, but how much longer will it last? The same is the case with the appliances, mechanicals and everything else in the property. You may be able to get away with not spending money in the first year, but over time you will need to. This money needs to be available when you need it. If you don’t have reserves available, you will be in real trouble. It is not uncommon for many things to break down at once. This has to be accounted for in your initial evaluation of the property.
It is a common practice for investors to overestimate their after repair value. There are some properties that have a ceiling and nothing you do will get you the value you desire. You may think that your finishing touches will make the differences, but this is not the case. Buyers look at comparable sales and listings in an area. If the sales aren’t high enough, there is not much you can do to get your value up. Instead of looking at the highest comparable sale, you should look at the lowest. This is what buyers are going to do. If you work your way up from the bottom, you will get a much more realistic value. Use this number. If you still see value, you should make an offer. Investors get in trouble when they shoot for the moon on values that are not realistic. You may do great rehab work, but sometimes there is only so much that is within your power.
We are currently in a strong rental market . Many investors have bought property and decided to rent for the foreseeable future. This is a great approach, but numbers can be misleading in this area as well. Much like the housing market, last decade the rental market seems to have no ceiling. Landlords are naming their rental price and often getting it. The problem with this is that sooner or later demand will reduce leaving owners in a bind. Cash flow will be reduced and property values may not be high enough to sell. Small changes in rental properties can have a huge impact on the bottom line. A reduction in rent from $1500 to $1300 is an almost 15% drop. It is important to constantly stay on top of your rental market for any changes that would affect demand. Increased foreclosure and unemployment will make a dramatic impact from lease to lease. You can plug higher rental numbers in and make the property look good today but this may not always be the case.
Are you looking at your numbers with the best or worse case in mind? If you are like most investors, you have a positive outlook and think nothing bad will ever happen. The odds are that things will shift against the property at some point. It is always much better to plan for the worst and hope for the best. There is nothing wrong with considering the worst case on ever deal. There may be some deals you walk away from by being overly cautious. This is always much better than trying to deal with a property that is a money pit. You need to walk the line between cautious and keeping an eye towards the future. Making numbers work just to buy a property today should not be the end goal. The numbers should work when you decide to sell or for many years down the road.
You are directly in control of how you look at a property. You decide what numbers to plug in and what numbers to project. It is important to be honest with yourself and use realistic numbers. If you don’t lie when putting numbers in, you are left with honest answers on whether to pursue the property or not. You may not like what you hear all the time, but it is the best thing for your business. Numbers are always important, but they may not tell the whole story.