Reassess Everything

This thought is geared to Californians. I’ll keep this short so that you can get back to your egg nog. Each state treats property taxes a bit differently. In California, we have property tax based on Prop 13.

The Prop 13 highlight is that property taxes are 1% of assessed value and assessed value in California only changes when a property changes ownership. In many other states, the assessed value goes up every year. In California, it does not.

Why is this so important? Here are two reasons:

• If you are able to negotiate a good purchase price for your property that is less than the current assessed value, you can call the local tax assessor and convince him to lower your tax bill. I bought a house in 2012 for $160,000 that was assessed at $475,000. I called the assessor and convinced him that my purchase was fair market value. I save $3,000 a year in taxes from one 30 minute phone call.

• You can gift up to $1,000,000 worth of real estate to your children tax-free. This exclusion is based on ASSESSED value, not current value. If you hold a property in California for 50 years and it’s now worth $10,000,000, you can give it to your kids tax free for the assessed value of $50,000 (this is a real life example).

So, when you buy a property in California that you’re going to keep for a long time, make sure you get a great deal and that you call the assessors office for a reassessment.

What is Value Investing?

As a value investor you look at the operations, not the aesthetics. The value is in the cash flow and the company assets. If the ugly yellow house produces the same income as the pretty blue house, they have the same Intrinsic Value.

Intrinsic Value is calculated using the Net Operating Income (NOI) and a multiple that changes depending on your industry and market cycle. To determine the Intrinsic Value of mobile home parks in 2018, for example, you take the NOI and divide it by an 8% CAP rate (and add in the value of any other assets).

A good deal happens when you can buy a company for less than the Intrinsic Value. That’s value investing. Companies, stocks, bonds, and buildings all have an Intrinsic Value because they produce income..

Oil, gold, diamonds, apples, cars, paintings, and currencies do not produce income. These items have no Intrinsic Value, so it is difficult to determine their worth. Consequently, their value can go up and down depending on the press and popularity. The value of these items is determined by the supply and demand curve, by scarcity and emotion.

It is our belief that cash flow is a more reliable value indicator than supply and demand. We choose to invest in properties that produce income, when we are able to purchase for below the determined Intrinsic Value.

How Do I Determine Value?

Real Estate Valuation. The very first thing we do when a potential deal comes to Elkhorn Group is run an independent valuation. Some people call it “underwriting the deal”. There are three standard approaches to valuing a piece of investment real estate: comparable sales approach, replacement cost approach, and income approach.

• Comparable Sales. This is the easiest way to see property value. You search for recent sales of very similar properties and see what they sold for. Search Redfin, Zillow, Trulia, and LoopNet for recent sales in your target area. Look for properties that as are close to your target property as possible. Mark down the prices of recently closed transactions and the purchase price per sq. ft, per acre, per room, and so on. Multiply that number by your target property’s sq. ft., acreage, number of rooms and voila, your first valuation.

• Replacement Cost. This is another easy way to value property. find out the cost per sq ft to build in your area (call a local contractor) and the price per acre to purchase raw land (use the comparable sales method above). Multiply your target property’s square footage by the price to build and add the land value. That is the replacement value for your property. Your insurance company uses this method to determine your home value so you can use them to double check your answer. Now you have two ideas of what the property should be worth.

• Income approach. If you’re purchasing cash-flowing real estate, most people use the income approach to value the asset. This is by far the best method and the most complicated. Stay with me here.

CAP RATE - Each asset class (apartments, industrial land, single family homes, mobile home parks, self-storage) has a Cap Rate. The Cap rate is the percentage of the purchase price that the investor would like returned to them each year. This return is in form of Net Operating Income. Cap Rates differ across asset classes based on a number of factors, primarily risk and intensity of management. The higher the risk, the greater the return people are going to want for their money. Hotels are perceived as being more risky than apartment buildings, so investors demand a higher return from a hotel investment and thus, a higher Cap Rate.

Cap Rate (Percent Return)   X Purchase Price = Net Operating Income

or, alternatively

Purchase Price   = Net Operating Income   / Cap Rate

Cap Rate is measured as a percentage, the annual return on investment. Note: The Cap Rate does not take into account your bank loan. Your return on investment will change depending on your financing methods. If you purchase a property for $100,000 that has a NOI of $10,000 per year, you would call that a 10% cap rate (also known as a 10 Cap).

Okay, are you ready for the income valuation? Find the standard Cap Rate for your asset class by calling a local broker and asking her what the Cap Rates are in your area for industrial land, motels, or whatever type of asset you are valuing. Now you have one crucial element of the equation.

DETERMINING NOI - You have the Cap Rate. Once you find the NOI you can determine the maximum purchase price that you can pay for the property. NEVER rely on the numbers that the seller gives you for NOI. They will pad their income and reduce their expenses to make the property look better.

The best way to find NOI is to start with Gross Income. What is the property making each month in revenue? You should be able to find this number. Make sure that this number makes sense. Make sure that you end up with an annual number, and not the monthly number or year to date number.

Now find the standard expense ratio for the asset class. The expense ratio is a percentage of Gross Income that you can reasonably expect to pay in insurance, management, utilities, taxes, accounting, advertising, and so on. This number changes for each asset class but should be somewhere between 30-60% (I know that’s a big range). We usually use a conservative 50% when looking at mobile home parks.

Gross Income   - (Gross Income   X Expense Ratio)   = Net Operating Income

Or, more simply

Gross Income   X (1 - Expense Ratio)    = Net Operating Income

Take the Gross Income and multiply it by the Expense Ratio. This number represents your estimated annual expenses. Subtract the estimated expenses from the Gross Income to arrive at your Net Operating Income. Divide the NOI by your Cap Rate and there is the valuation! That’s how you find the maximum purchase price you should pay using the income approach.

These are very simple formulas yet it is hard for many people to grasp the Cap Rate. Assuming a stable NOI, the higher the Cap Rate, the lower the purchase price. The higher the Cap Rate, the higher the perceived risk. Capiche?!

Parting Thoughts: Real estate agents and Local Knowledge. The easiest way to make money in real estate is to purchase a property for less than the market value. That’s what we try to do in every single deal.

Call a few real estate agents and tell them about your deal and ask their opinion of the price and the area. Feel free to give them the address if you feel good about their character. You have it under contract (right? if the deal seems good, get it under contract), so you should be safe from people trying to steal your deal. Talk to the corner store owner, neighbors, anyone out on the street. People know a lot about their neighbors :).

On a separate but related note, keep in mind that values of fixed assets should be related to incomes in that area. One of my mentors, Ned Davis, has a market research company and says the following:

It is my view that the proper way to value assets is to relate them to income. Income is the anchor that truly determines the limits for valuation. The average family can afford a home some four times the amount of their income. In 2005-2006 new homes were selling for well over five times median income, and that simply represented the rubber band of valuation as far as it could be stretched. - Ned Davis Research

Thanks for reading. Will

The Union of Buyer and Seller

For every purchase there is a graph of all possible sale prices. On that scale is a range in which the buyer will buy and a range in which the seller will sell. Hopefully, there is a place where those two ranges overlap! That’s where the deal can happen.

As a buyer, you don’t NEED to know the range in which the seller will sell. At first, it’s better if you don’t know the seller’s range because you want to be able to evaluate where your range is independent of the seller’s asking price. Don’t let the asking price affect your own better judgement, especially if there is emotion involved!

What we want to find out is the range in which you, the buyer, will buy? Let’s figure that out.

In order to uncover your range, we want to value the purchase. Don’t look at the price tag!  (If you’re looking at real estate and want help figuring out the value, click here). Instead of looking at what the seller wants, think about what the item is worth to YOU? There is likely some emotion involved here, and timing. Perhaps you really need a pair of jeans RIGHT NOW for the party tonight and you want your butt to look good. Okay then, what is the most you would pay for these jeans and still feel happy about the sale? Figure that out, and you have your maximum price in the range. Note that number.

Okay so you have a maximum price, how do you now figure out what to offer the seller? There are two ways.

1. You can now look at the price tag and pay face value. If it’s at or below your maximum price and you don’t feel like negotiating, you can offer the asking price. I almost never do that, but you still can if you feel like it.

2. Look at the price tag and negotiate the price. What you’re trying to do here is find out the seller’s range. It helps to find something wrong with the item. If you bring up anything that’s wrong with the item, this let’s the seller lower the price without losing face. They know they priced the jeans to high, but if you ask for a discount without giving a reason, there is less chance they will give it to you. Ask, be nice, and get on their team. Both of you want the sale. Find the happy place (you can read about finding the happy place here).

They still might give you a discount for just asking, “can I get a discount?”. This is one of the easiest and laziest negotiation tools, but it works because most people CAN give you a discount. At Home Depot, they always give me a discount just for asking. It’s madening because I think they should give the discount to everyone. But they don’t.

The jeans don’t fit perfectly but I need a pair right now, can I get 50% off? These jeans are a bit discolored, aren’t they? Do you think you could sell them to me for half price? You can say almost anything and the jeans will get discounted. Shoot for the moon. Ask for 50% off. After asking for 50% off, 15% off won’t seem like a huge discount to the seller. NOTE: 15% off should be BELOW your maximum price. If you’re above your max price after 50% off, you still shouldn’t buy it.

Okay, that’s all for now. Please negotiate for things that are expensive. You can almost always get the price down and still be a good customer. Stick up for yourself and your hard earned money!

Negotiation Levers

There are powerful negotiation levers you can pull in your life. I pull them all the time in our business and I also pull them when I’m buying something off craigslist, ebay, or in a market / store where negotiation feels appropriate.

Lever One. Your wife / husband (imaginary or real). I discovered this lever right after I got married, buying a Toyota Prius off of Craigslist. The price on the ad seemed high (prices always seem high to me) and I said to the seller “I really want this car, but my wife will kill me if I pay $12,000 for it. Would you take $8,500?”

This phrase is a diamond hiding in plain sight. Right away the seller and I go from being on opposite teams to being on the same team. The team we are both on is called, “try to make this sale without making both of our wives (or husbands) angry that we bought (or sold) for too much (or too little).” Everyone who has been in a long term relationship can relate to this.

Lever Two. K.I.S.S. Bad negotiating will pit the buyer and the seller against each other. I don’t like that feeling. A phrase I use all the time is so straightforward and honest that the seller will never feel like you’re trying to pull the wool over their eyes. Just say, “What’s the lowest price you’ll accept and still be happy with the sale?” This is my “go to” line for smaller purchases. I thought it might translate well to real estate negotiations, but it doesn’t. When negotiating on a very large purchase, you need to be artful. This phrase is not artful, it’s just simple and useful.

Lever Three. Nothing. The last lever is one that everyone knows but most people don’t use. I don’t know why they don’t use it! It’s the most fun and the most easy, because you don’t say anything… … … … Try this when a seller says a price that you think is too high. Don’t respond AT ALL. Most likely they know it’s too high also and will negotiate themselves down without you saying a single word. The great thing about this is that you don’t seem like a squeaky wheel and you get to save your squeaky negotiation tactic to use AFTER they negotiate themselves down to normal price. CAPICHE?