I write from time to time about how to size up a real estate investment. We’ve discussed cap rate and gross rent multiplier and briefly IRR. In the multifamily market though it seems there are as many measures of a good investment as there are investors.

Recently we were talking with an investor who is out there beating the bushes and per usual the discussion of investment criteria came up. We wanted to know what makes a good investment… to him. He told us that he wants the property to pay itself off in 10 years, fair enough.

I got to thinking about what that means exactly. First I’m going to go ahead and assume that the down payment will be 25%. As I’ve mentioned previously we’re back to standard lending criteria, even conservative criteria, so forget the higher LTV stuff.

This investor isn’t so particular about the size of the property as much as he is the location. He’s enamored with a particular town close to Boston. He’ll by a duplex or a 3-family or a 6-family, really anything up to a million bucks or so. I’m going to go ahead and talk about commercial size multifamilies (5+ units).

First, I wonder about the idea of paying off an investment property. One of the beauties of real estate investment is leverage. Leverage is what allows you to control $4M in real estate with $1M in cash. The returns that you achieve in real estate are directly tied to your financing. Favorable financing terms can make or break an investment and, for the most part, when you you have a property with no leverage your return on equity is relatively low, but really thats an tangent.

So back to the 10 year rule. I suppose there are two ways to look at that. Either you want the property to throw off enough income that you can get into a note with a 10-year amortization or else you take the 25 (or 30) years but your net is equivalent, annually, to 10% of the purchase price. Well that sound like a 10 cap to me.

Example:

Property A is a 6-Unit in Malden

Income
• Each unit gets about $1000 so Potential Rental Income=$72,000

Financing

• Market rate 6.25%
• LTV 75%
• Total Expenses $23,000

Net: $49,000

A 10 cap on this property as you probably know would put the price of this property at $490,000. In case you’re wondering how to do that math, you take the net income of $49,000 and divide it by the cap rate, in this case “.10″, and we come up with $490,000. There’s one way to figure what you could pay.

It just so happens that if you got a 10 year note and you were able to get it at a DCR of 1, then with 25% down you could pay about the same for the property $485,000.

Truly this is all academic and what I guess I’m trying to say here is that whatever your goal is you can probably figure it in terms that will make sense to the rest of the investing community. In the above example the investor could simply say “I’ll buy anything at a 10 cap” and most folks in the business would (or should) know what you’re talking about.

Now to the Meat of the Matter
There are a lot of places you can get a 10 cap, but the better locations close to Boston aren’t among them. If you’re set on this kind of return you’re looking for a needle in a haystack. I’d go so far as to say that the only way you’re coming up with something like that is if you get into either

A) A value-add proposition where you are going to come in and really turn around a bad or deficient situation, or
B) You find some off-market deal where money isn’t the issue, time and discretion are.

Failing either of these scenarios you are very likely to pay quite a bit more for that property or else you won’t buy it because there are enough people out there walking around who will save you from it. The fact is that in the example above if the property is in good condition someone will probably pay well north of $500k more like something in the mid $600s, perhaps even more if its in the West End. I’d figure better parts of Malden in the high 8s to the high 6s and I have comps to prove it.

So what do you do? Well either you’re sidelined indefinitely sitting on the bench hoping to play, you go find another field, or you step up and swing knowing that the value of the investment over the long term is ensured because the fundamentals of the location, demographics, etc drive the desirability of the asset and will continue to.

Market prices are determined by the most that a buyer is willing to pay pitted against the least that a seller is willing to accept during one particular slice of time, and not by what you want to pay. Keep this in mind while you’re out there evaluating markets you want to invest in and plan to pay a dollar more than the next guy if you want to own the best properties.