In this lecture, we discuss some deal-specific considerations that affect your investment analysis.
- The first thing is the purchase price. Now purchase price really determines your profit or return potential. Because if you get the purchase price wrong, and for example if you overpay, there's going to be very little that you can do during the investment to really get what you could have gotten from the investment. So determining the right purchase price is critical because it can't be too high or you would miss out on returns but if you make it too low or offer too low you may never have gotten to acquire the property in the first place.
Now another consideration related to the purchase price that often affects an investment are what's called contingencies. These apply more often in commercial investments, for example if you're buying a warehouse where there was some industrial uses before and there is a huge risk of environmental contaminations that may involve some very very costly cleanups.
If that's the case and there aren't any other buyers that you're competing with, you may be able to negotiate a contingency in your purchase that says to the buyer hey I'm going to pay this price, but if there's something wrong in terms of environmentals and I have to spend money to clean it up, you agree to spend money to pay for that. And these contingencies could be done in such a way where a portion of the purchase price is held in escrow for a period of time, maybe up to a year or so, until those other issues are confirmed or verified to be addressed, or to be non issues.
So there are different ways where the purchase price could actually be adjusted. So contingencies are one of them, and that can impact or protect your returns. Now the other thing are some other special provisions that could be related to purchase price and one of the examples would be something like an earn out. And this is very common, or not that common but this applies more to operating assets or assets where you have operations. And earn outs are a way for a buyer who wants to buy an asset and wants to operate it and thinks they can do it better than the previous owner but wants to be able to get the asset without having to put as much cash up front.
And earn outs is a way to say to the seller hey let me pay for a portion of the purchase amount by giving you some ownership in the profits of the business after you sell it to me. And this can be a win win type of scenario where the buyer is able to get it without having to borrow as much money or put as much money into getting the asset and the seller they're confident that the buyer's able to execute and earn more profits from the property and get more out of it than they could.
Then they have the potential to earn more out of that sale over time than if they were just to take it as a one time transaction. So with respect to purchase prices there are actually quite a few things that could actually impact the ultimate purchase price. Things that would adjust it right whether they're contingencies or earn outs that would make it different from what you ultimately pay and it could impact your returns. The second deal related consideration is relating to rehab.
It's basically well deciding what exactly are you going to rehab or renovate? How much are you going to spend on it? How long is it going to take? And whether you're going to get financing around that? Because if you end up spending more than what you planned and if you end up taking much longer than what you planned in order to do the rehab, your returns for the investment are not going to be as good as you planned. It's going to be lower than what you planned both in terms of the cash multiple and the IRR which you're going to learn about later.
So how much you're going to spend how long it's going to take and exactly what you're going to do is going to impact your investment analysis. And that's part of the homework that you have to do as an investor before you really commit to buying it. You got to decide what exactly you're going to do with it. So for example when you're looking at a fix and flip investment, you don't just go buy it and then later decide what you're going to do to it, how much you're going to spend, and how long it's going to take. When you're looking at it you got to decide what it means.
That's part of your analysis. You're going to go to the property, you're going to take a tour, you're going to decide that the kitchen is fine but the bathroom needs to be renovated and it needs to be repainted outside. You can decide on those things and then get a quote on the costs around that and how long it would take so then you can factor all of that into your analysis so your analysis can give you as accurate a portrayal of what you're going to get out of that investment as possible.
The third thing is related to capitalization. And that really just is having to do with are you going to have investors? Are you going to take on some debt as well as equity investments, or are you doing it all by yourself. If it comes from investors or its coming from banks it's going to cost you, and what are you going to use it for right? So when we talked about the renovations, well there are other uses of the funds because maybe this is something where you're building brand new apartments and you need some funds to market the asset you got to pay for a bunch of things before you actually get enough tenants in the apartment So knowing what you need it for and exactly how you're going to spend it as well as where you're going to get it from, all of those will impact your investment analysis because where the investors are coming, and if there are investors coming in and how the banks are coming in will affect how and when you get your returns and that's part of what's called the distribution priority.
For example, if you're taking a lot of investments from investors you don't have a lot of money but you know how to put a deal together and you get investors to invest 90% of the costs of the investment, well guess what? They're going to have some priority on the profits that are coming in and you're going to have to return a certain amount of profits to them before you will see any kind of bonus for the hard work that you've put in. And that's what's called the distribution priority and the way that is usually handled is through something called the waterfall framework which we're going to discuss later in the course in great detail.
And then we're going to show you how to apply that for your investment analysis. The next thing related to deal considerations is not specifically part of the deal, but I put it here because it really does impact your investment analysis or specifically whether there is a good fit between the project and the investors involved, yourself included. Which is the return expectations. So if an investor is expecting to get high profits, really really high profits and really really high returns, then it wouldn't be a good fit for them to invest in a very safe investment where they're collecting five or seven percent returns.
So there's got to be a good fit between the investor and the type of investment. Because when your return expectations as an investor are very clear it does two things that allow you to be more efficient in evaluating investment opportunities. It will narrow down the choices or investments that you should be looking at, the types of investments, the type of assets. It also narrows down the markets that you should look into because it's easier to look at ones once you have a clear idea of what your expectations are.
If you're expecting really high returns you're going to have to look at riskier types of projects in more opportunistic or growth markets. But if you're looking for something very safe, and very low risk, then you can look at more income producing properties, properties that are brand new, properties that have tenants already there on long leases and in very core markets that aren't likely to have as much market risk as some of the newer markets.
And timing. Timing with respect to return expectations is when do you expect to get your money or profits back? So an investor that is looking to invest and want to get their money back within six months that wouldn't be a good fit for an investment where you really need to hold it for seven to 10 years to see the full returns where that project is really betting on some appreciation in the market. So when you expect your returns to come will also impact the return expectations, and ultimately what kind of projects you should look at.
In the next lecture we're going to talk about some other considerations that don't apply to all investments, but it may apply to some investments so I'm just going to highlight some of those for you and why you need to think about them in your investment analysis.
- Conducting market research
- The seven-stage investment process
- Due diligence: Validating and verifying your investment
- Financing and closing
- Exiting: Selling your investment
- Investment considerations and strategies
- Measuring returns
- How debt impacts your return
- Real estate analysis case studies