Every real estate proforma has 100+ lines. I look at these three first. If these do not work, nothing else matters. If they do, then I keep reading.
1. Cap rate: This is the yield the asset generates on day one, before financing. It tells me whether I am being compensated for the risk I am taking. A low cap rate in a weak market is a red flag. A low cap rate in a supply-constrained, high-barrier market like Sacramento or San Diego is a different conversation entirely. Context matters. But it is always where I start.
2. Vacancy (at the asset and in the market, we talked about this in more detail last week): I want to know two things: how full is the property we are underwriting, and how full is everything around it? A 95% occupied building in a 20% vacant market is a problem waiting to happen. A 90% occupied building in a sub-3% vacancy market has a cushion. The market vacancy number tells me whether the fundamentals are on my side.
3. Replacement cost: What would it cost to build this from scratch today? If I can buy it at or below that number, I have a margin of safety built into the price. New supply cannot come in and undercut me because it cannot be built for what I paid. This one number changes how I think about downside risk entirely. In many markets that are infill and have high barriers to entry, you'll be paying more than replacement cost, the question is how much more compared to replacement cost and how does this compare to other recent sales in the market.
Everything else in the proforma matters. But if the yield is wrong, the market is weak, or I am overpaying relative to replacement cost - I stop reading.
We will be breaking down each of these three concepts in more detail in the coming weeks.
What is the first number you look at when evaluating a real estate deal?
Wednesday Real Estate 101: The three numbers I look at first in any proforma
