ThE ABc’S OF BUYING cASh FlOW REAl ESTATE lIkE BIllION-dOllAR PRIvATE EqUITY FUNdS- How much income does the property produce relative to price
(capitalization rate)? - How does the purchase price compare to local incomes?
I’ll expound on the relevance of each question.
Cost per square foot vs. Replacement cost: If it costs $15,000 to build
a car, including material costs and labor, and you are able to buy that ve-
hicle for $10,000, it’s obvious to see you achieved a legitimate discount.
Likewise, if you can buy a house for less money than it costs to build it
brand new, you may have a legitimate deal.
Considering the cost of land, entitlement, horizontal infrastructure
(power, water, sewer, roads, street lights, sidewalks, etc.), material costs
to go vertical, labor, marketing and selling costs, and the builder’s prof-
it, it’s hard to deliver a brand new single family home for less than $80
to $100 per square foot.
Due to an over-saturation of inventory, resale homes are available all
over the country for $40 to $70 per square foot (or less). If you buy a
home, at say $50 per square foot, and the replacement cost is $90 per
square foot, it’s just a matter of time before you see the gap close be-
tween your price and the price of new construction. For the most part,
this is inevitable as resale inventory is absorbed and financing becomes
more readily available, thereby bolstering home buyer demand.
Income approach to value: When you’re dealing in the entry-level
housing space, where many homes are purchased as investments, the
income approach to value helps us establish a price ceiling for property
values. If the income is high on a property, the price ceiling is softer
than if incomes are low.
Let’s look at an example (refer to Question #2 at the beginning of the
chapter):
Home A and B are both priced at $104k. Coincidentally, both rent
for $1,100 per month, but due to lower expenses (property taxes and
HOA dues), the net annual income on Home A is more than double
that of Home B. If both properties are in comparable risk neighbor-
hoods, Home A has more room for appreciation (a softer price ceil-
ing) than Home B due to the higher returns. All other variables the
same, Home B will have less buyers when it is sold again.