Criteria for Investment

June 3, 2008 · 2 comments

A big decision that every investor needs to make is, “What are the specific criteria that I’m going to use to decide whether a particular investment is good enough to make?” Just because an investment is going to likely generate some profit doesn’t necessarily make it an investment worthy of your time. For example, would you invest $50,000 in a property that generates a profit of $10 per year? Of course not…you could get a better return on your investment by putting the $50,000 in a savings account (and with no risk whatsoever).

While some investors may not decide beforehand on their specific criteria, I think this is dangerous, as it requires the investor to make impartial assessments of the value of an investment while in the middle of evaluating that investment. Too often, once you put some effort into evaluating a deal, you start to look for reasons to make it work, because you don’t want to feel like you are doing all that due diligence for nothing. So investors that don’t have pre-defined criteria may tend to make up criteria on the spot that will help them justify the deal, even if it’s not a good one.

I don’t want that happening to me, so I spent some time thinking about my specific investment criteria, and writing them down as part of my business plan. Most of the criteria are defined in financial terms (minimum cap rate, minimum ROI values, and minimum cash flow), and are based on comparisons to other types of investments and their level or risk.


Criteria for Investment

The following is an outline of the minimum criteria — both financial and demographic – that must be met before a property will be considered for purchase. While these criteria are necessary to be met before an investment will be made, they are not sufficient; each property will be analyzed for all upside potential.

The criteria for long-term “fundamental” investments will differ from the criteria for short-term “value play” investments, and therefore each will be addressed separately. Each property analyzed by the company for potential investment will fall under one of the these categories, and will be analyzed based on that set of criteria.

“Fundamental” Investments

Any property being considered as a fundamental investment by the company must meet the following criteria; additionally, it must meet the criteria based on actual financial data, not pro-forma data or “after-improvement” financials:

  • Property must have a Capitalization Rate of greater than 8%
  • Property must have a Year 1 cash-on-cash return of greater than 8%, and subsequent year cash-on-cash returns of greater than 12%
  • Property must have a Year 1 total return of at least 18% (assuming 0% appreciation). Total return consists of cash-flow, equity accrual, appreciation, and tax benefits
  • Property must have a DSCR of at least 125%
  • Ideally, property must have a minimum cash flow of at least $6000/year, and at least $100/month per unit for larger properties (8+ units)

“Value Play” Investments

Any property being considered as a value play investment by the company will undergo three pro-forma analyses. The first pro-forma analysis will describe the current financial situation of the property using actual historical data; the second pro-forma analysis will describe the expected financial situation of the property after one year; and the third pro-forma analysis will describe the expected financial situation of the property at the earliest expected time of sale, using conservative market data and the company’s plan for improving the property.

The first pro-forma will be used to value the property and will be used to determine an offer price should the company decide to pursue the investment. The first pro-forma analysis (the current analysis) is less of a “pro-forma” and more of an income statement, as the line-items should be based on actual operational data, not pro-forma or anticipated income/expense data.

The second pro-forma will be used to identify the worst-case financial situation associated with the first-year ownership of the property; because the value play investment will likely be going through a transitional phase in year one – creating capital requirements, tenant turnover, loss of income, etc — the company must be prepared for all expenses and holding costs associated with that transitional period. In order for a property to be considered for purchase as a value play, the second pro-forma analysis (the one year analysis) must indicate that the property will be at least cash flow neutral (i.e., break-even) after year one.

The third pro-forma will be used to define the anticipated at-sale value of the property; the company will use this analysis to determine the return on investment that can be expected from the property. In order for a property to be considered for purchase as a value play, the third pro-forma analysis (the at-sale analysis) must meet the following criteria:

  • Property must meet a minimum annualized rate of return (total return) at the point of sale, with that annualized return relative to the time the property has been held. Specifically, the annualized ROR should at least meet the following criteria (investment returns increase each year due to the need to tie up capital for prolonged period of time):

         o 1-Year Hold: 30%

         o 2-Year Hold: 35%

         o 3-Year Hold: 40%

         o 4-Year Hold: 45%

         o 5-Year Hold: 50%

  • For analysis calculations, property must be assumed to have an “at sale” capitalization rate comparable to the average cap rate for recent sales of similar properties in the same area. This is regardless of the cap rate of the property at purchase
  • It should be assumed that a property will never have an improved vacancy rate higher than the local average (i.e., the company shouldn’t assume it can get the vacancy lower than the surrounding average)
  • It should be assumed that the average “Annual Operating Expense Increase” will never be lower than the average “Annual Revenue Increase”

2 responses to “Criteria for Investment”

  1. about2flip says:

    • Property must have a DSCR of at least 125%

    How did you calculate DSCR to be 125%. I have read that DSCR should be at 1.4. I am still learning multi-family.

    Thanks for your answer.

  2. J Scott says:

    This is generally going to be a requirement from your lender. Some lenders will look for a DSCR of 125%, while others will be more conservative and want to see a DSCR of at least 140%. Still others are going to be more relaxed about this requirement, and may only need to see 110%. Now that the credit market is getting tighter, I wouldn’t be surprised to see DSCR requirements continue moving up, so if you’re hearing 140%, that doesn’t surprise me.

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