Deal or No Deal: 10 Minute Process To Quickly Screen Properties
Use napkin math to quickly screen properties before sinking time into underwriting.
A regular feature I will be doing is underwriting a random property. This article will focus on my initial screening process before spending significant time with a full underwriting. In part two of this article, I dive deeper into my underwriting process.
Many terms in this article are basic real estate lingo. If you aren’t familiar with the terms, you should spend a few days on Google learning the basics.
My Proprietary Process (That I Stole From Others)
When coming across a property that piques my interest, I have three steps to minimize downstream wasted effort:
Does this generally meet my screening criteria? Yes, go to 2.
Does this pass the sniff test a.k.a. back of the napkin math? Yes, go to 3.
Step 1: Weeding Out The Garbage
Time To Complete: 1-3 minutes
Before I put pen to paper and potentially waste my time underwriting a property, I make sure the property generally meets my screening criteria in this priority order:
In a market I know well (i.e. I know what market rents are without researching)
Large enough for non-recourse lending (typically loan value greater than $1 million)
Doesn’t require a ton of day 1 capital expense (I’m at the stage of my real estate career where I want to minimize risk)
Some forced appreciation possible (net operating income (NOI) increase I can “control”)
You need to spend time thinking about what type of properties you are going to focus on to develop your own screening criteria. As a less experienced investor, taking a shotgun approach with real estate asset classes and a bunch of different markets probably won’t work.
Pro Tip: Have your screening criteria drafted in a format that is easily consumed by a broker. A good practice is to include this criteria in early broker communication so they are aware of what you are looking for with future deal flow.
Step 2: Napkin Math
Time to complete: 2-15 minutes
Assuming my screening criteria is generally met, I will do quick back-of-the-napkin math to determine if this is a property worth pursuing. You should be able to do this without having to research any information. If you have to research the info to perform this step, you need to stop and spend time learning about the market you are potentially buying in - economy, crime, supply, cap rates, etc.
Pro Tip: Use a real piece of paper for napkin math. Napkins tear easily when you write on them.
What I need for information at this point:
Unit breakdown of the property
Ballpark market cap rate for the property
I don’t care what the actual rents or expenses are for the property at this stage. I know the market rents and I know the expense ratio for multi-family is going to fall somewhere between 30-40% for most buildings.
The napkin math is:
Determine gross potential rent: Market rent per month for each unit multiplied by number of units multiplied by 12 months
Determine potential actual rent: Multiply step 1 number by 0.94 (6% vacancy/credit loss.)
Determine potential net operating income (NOI) range: Multiply step 2 number by 0.60 and 0.70 (Potential actual rent minus 30-40% expense ratio)
Determine estimated value range: Divide step 3 numbers by the market cap rate (Property value = NOI/cap rate). This range can be a significant spread depending on the size of the property and cap rate. Choosing a cap rate is a bit of an art as each property even on the same street is unique, so using a range for the cap rate can also be useful at this step.
Also, keep in mind that the value range you are calculating is assuming every unit is at market rate. This will never happen, so your value range will likely always be skewed a bit high.
Compare selling price to estimated value range.
If list price is less than value range: Potential great deal.
If the list price is within the value range: Possible good to OK deal.
If the list price is greater than value range: Probably not a good deal.
Here’s an example using numbers for a property I acquired recently:
Gross potential rent: $1000/unit market rent x 63 units x 12 months = $756,000
Potential actual rent: $756,000 x 94% = $710,640
30% expense ratio: $710,640 x 70% = $497,448
40% expense ratio: $710,640 x 60% = $426,384
Estimated value range
High: $497,448 NOI / 9.0% market cap rate = $5,527,200
Low: $426,384 NOI / 9.0% market cap rate = $4,737,600
Selling list price: $4,950,000
The list price was at the low end of my value estimate range, so this was a potential good/great deal. I went to contract at $4.35MM based on in-place financials and closed at $4.23MM. This property has turned out to be a great deal.
At this point in my process, I typically have about 10-15 minutes of time invested. If my napkin math looks good, I will call the broker to discuss more details of the property. If I still like the property after the call, I will proceed to step 3 of a full underwriting in order to submit an offer. I will cover this in my next article.
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