If you’re looking to save $20,000, $50,000 or more on your next rental property purchase… keep reading.
New investors will often try to get a bargain by making an offer with a very low price.
While that technique can work sometimes, it does come with 2 main problems…
Problem #1) Sellers can be offended
If you haven’t built any sort of relationship with the seller (which most investors don’t do), and you’re offering a low price with no justification, often times the seller will be offended or they won’t take you or your offer seriously.
In either case, it can negatively affect communications with them or they may not want to talk to you at all, which obviously this makes it hard for you to buy their property!
Problem #2) Realtors won’t want to deal with you
If you’ve ever tried to make a very low offer on property with your realtor, you’ve probably noticed that they can be extremely hesitant to present it to the seller or listing agent.
Why? Because they know the seller or the listing agent may be offended or they won’t take the offer seriously (in other words, they aren’t taking YOU seriously).
Worse still, if your realtor does it enough times, their reputation with other agents may be tarnished because they don’t bring ‘serious’ offers to the table.
Realtors are trained to keep the deal together by smoothing ‘ruffled feathers’, keeping lines of communication open, etc., but that’s hard to do when one party has been offended.
So how do you negotiate a great price on a rental property?
By leveraging some easy math and
information provided by the seller or realtor
Stay with me on this and I’ll show you exactly what information to use and you’ll see why this is so powerful.
How Rental Properties Are Valued
Medium to large apartment buildings are typically valued based on the income they generate.
Even small rental properties such as duplexes and triplexes are often valued in the same way.
A good rule of thumb is…
- Lower income = lower purchase price/value
- Higher income = higher purchase price/value
Keep in mind that in some cases, small rentals can be valued almost like single family homes, so it can affect the above rule of thumb. That’s because small rentals are more affordable for investors, and some home buyers will even buy them as their principle residence and rent out other units for extra income.
The Formula Everyone Uses
Sellers and realtors use a formula called Cap Rate to determine the property value.
So what exactly is Cap Rate?
Here’s a plain English definition:
Cap Rate: If you paid all cash for a property, it’s the net income the property generates, expressed as a percentage of the purchase price
Essentially, it’s the following formula…
Cap Rate = Net Income / Price
(multiply result by 100 for a percentage)
Easy To Remember “Formula Triangle”
Notice there are 3 numbers used in the Cap Rate formula that are all inter-related:
- Net Operating Income (NOI)
- Cap Rate, and
Real estate formulas can be hard to remember. That’s why I recommend using the following pyramid to remember how they should be structured.
If you’ve never seen a formula triangle like this before, items that are side-by-side must be multiplied together, while stacked ones must be divided.
The following diagram shows the relationship between the above mentioned numbers:
Here are the formulas that can be derived from the triangle:
Cap Rate = NOI / Price
Net Operating Income = Cap Rate * Price
Price = NOI / Cap Rate
Take Advantage Of The Math
Why is the Cap Rate formula so important?
Since sellers and realtors use it to determine the property value…
And because the formula relies on correct income and expenses numbers for the net operating income…
If those numbers are wrong, you can use it to your advantage.
Here’s an example:
- Property is listed at $330,000
- Seller reports net operating income to be $20,000
- Therefore, seller/realtor proudly state the following cap rate:
Cap Rate = NOI / Price
= $20,000 / $330,000 = 6.06%
“Look at the GREAT return you’re getting!”, they say.
Well, there’s more to it than meets the eye.
Once you obtain all the income and expense documentation from the seller (you did ask for this in the offer, didn’t you?), you add everything up and discover the Net Operating Income is only $17,150. That’s a full $2,850 less per year than what was reported!
“Big deal”, you say. “It still cash flows and I want it”.
Actually, it IS a big deal.
Here’s a table that compares both sets of numbers, as well as the Cap Rate for each.
The 6.06% is now only 5.19%… almost 1% less than what was originally stated!
How can this happen? How can they get away with this?
The problem is that…
In real estate, there is no formal system in place to verify income and expenses for a property listing – you must do it yourself
So what happens is that many real estate sellers do it either:
- By accident by not adding up the numbers correctly, or
- On purpose by ‘adjusting’ the numbers (e.g. leaving off expenses) so they get a higher sale price
Easily Spot Wrong Numbers
It’s easy to see on any MLS listed property.
Total electricity costs = $6000 per year
How often do your electricity bills add up to exactly $6000?
The answer is… almost never. The property seller is guessing or estimating those amounts.
Important Rules of Thumb
Round numbers = estimated amounts (ie. $6000)
Odd numbers = accurate amounts (ie. $6429)
That’s why it’s critical to always verify the income and expense amounts for each deal you purchase. Otherwise, chances are you’ll be overpaying for the property.
Get A Discount Without Offending
Once you’ve verified the numbers, how do you use this information to keep more money in your pocket?
Here’s an easy 6-step system to follow, using the above example…
Use the formula triangle above to find the formula for Price
Price = Income / Cap Rate
Get the Cap Rate from the seller or realtor – e.g. 6.06%. There can be no disagreement here — THEY told you that number
Verify the actual Net Operating Income. There can be no disagreement here — it’s based on lease amounts and utility/expense statements
Calculate your new offer price based on Actual Net Operating Income (as verified by you) and the Reported Cap Rate (as given to you by the seller or realtor)
Price = Income / Cap Rate = $17,150 / 0.0606 = $283,000 (rounded down)
Confirm with the seller or realtor that the sale price is based on a Cap Rate of 6.06%. They will say ‘yes’
Show them the Actual Net Operating Income compared to the Reported amounts, and then reveal your new calculated offer price
This approach is much better than just giving very low offers, without any reason for a drop in price.
It will be very hard to a seller or realtor to argue against this new price because it’s based on:
- Actual Net Operating Income they can determine for themselves
- A Cap Rate value THEY provided to you!
The end result is that you have now purchased a property originally listed at $330,000 for only $283,000. That’s a savings of $47,000!
Even if you only convince the seller to drop their price by half that amount, it’s still well worth it to use this technique – you’ll save over $20,000
This example shows why as a real estate investor, you MUST understand the numbers.
If you don’t, you will likely overpay for properties and be at a disadvantage when competing with other investors in your marketplace.
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