Much of the literature on commercial real estate (CRE) analysis tends to focus on the analysis required before a property is purchased. While this is incredibly important, it is only part of the story. The sales price is just as big a driver of returns as the purchase price. But, it tends to be overlooked.
Knowing when to sell a property is part art and part science, but there are three considerations that go into the decision: the original proforma, assessment of market conditions / potential for future returns, and the pool of available buyers. Each is discussed in detail below.
Prior to purchasing a property, a significant amount of time and resources goes into creating a “pro forma” financial projection of the property’s income, operating expenses, net operating income (NOI), and cash flow.
The output from the proforma is used to calculate key return metrics like capitalization rate (Cap Rate), internal rate of return (IRR), equity multiple, and cash on cash return. The value of these metrics helps to determine whether or not to proceed with the purchase. They also serve as a reference point for an investment’s actual performance during the term of the holding period.
If, during the term of the investment, an opportunity to sell the property presents itself, one of the first considerations is to see how the proposed sales price compares to the initial estimate in the proforma. It can go either way. For example, if the proforma for a class A multifamily property assumes a sales price of $5,000,000, but the offer is based on a market value of $4,000,000, a sale may not be in the best interest of investors and shareholders. Conversely, if the contemplated sales price is $6,000,000 and the proforma assumes a sales price of $5,000,000, there is a chance to outperform the original projections and a sale may be considered a lot more carefully.
With regard to the proforma, the main point is this. If the contemplated sales price compares favorably to the original pro forma projection, a sale may be given some consideration. If it doesn’t, it may be wise to continue holding the property until a more opportune time.
Market Conditions / Potential For Future Returns
Prior to making a purchase, commercial real estate investors spend a significant amount of time performing due diligence on the demographics, vacancy rates, interest rates, and occupancy of the property’s market. If market trends move in their favor, they may find themselves in possession of an asset whose valuation exceeds their original projections.
If this happens, one of the major questions that investors have to ask themselves is, “if I sell this property now, what is the potential return that I am missing if I continue to hold the asset?” For example, suppose that an investor requires a minimum 15% annual return on their apartment building. Because the market is hot, there is a new supply of apartments coming online that will act as future competition. An analysis of future cash flows estimates an annual return of 10%, which is clearly less than the 15% requirement. In such a case, it may make sense to sell because the potential for future returns is less than the requirement. Conversely, if the property owner concludes that rents will continue to rise and residents will continue leasing space, it may make more sense to hold on to the asset.
Pool of Available Buyers
Finally, the decision to sell also depends heavily on who the potential buyer could be. Each buyer has a different set of motivations that drives them to pursue various investment opportunities and it is important to understand what those are in a potential real estate transaction.
For example, a large, well funded institutional buyer like a Real Estate Investment Trust (REIT) with access to low cost capital may be willing to pay a significantly higher price than a local business owner or regional buyer. Or, if an individual is up against a deadline to put their 1031 Exchange Money to work, they may be willing to pay a premium versus an individual looking to make a long term investment for their own account.
With a potential sale on the horizon, it is always important to assess who the buyer is, what their interest is in the property, and what their motivations are for purchasing it. These factors are likely to influence the amount of money that they are willing to pay and therefore the potential return that can be obtained from a sale.
Summary and Conclusions
One of the challenging aspects of real estate investing is that there is no perfect equation to tell an investor when it is time to sell and for what price. However, there are several ways that a potential sale can be assessed. They include:
- Sales price relative to the original pro forma projection. If it is higher, there may be a good argument to sell.
- Current market conditions and their impact on future returns. If an assessment of conditions determines that it is better to sell now and lock in a profit versus selling into a less favorable future, it can make sense to sell.
- The potential buyer. If the buyer is well funded, they may be willing to pay a significantly higher price than an individual investor, business owner, or regional investor.
If these factors point to a profitable sale, then it may make sense. The sell/don’t sell analysis should be every bit as rigorous as the pre-purchase due diligence to ensure the best possible outcome for investors and shareholders.
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