You want to start your own real estate private equity firm but you don’t know how much it’ll cost

Here’s how to think about start-up costs: There are basically 2 ways to set up a real estate private equity firm

1. First way is to start a fund. This means you raise the money first and find the deals later

2. The second way is to operate deal-by-deal, which means you only raise money for specific deals as you need it

There are 3 main debt metrics in real estate:

1. Debt Service Coverage Ratio (DSCR)
2. Loan to Value (LTV)
3. Debt Yield

Here’s how to view each from both a buyer’s perspective & a lender’s perspective: // DSCR //

Definition: The DSCR is the ratio between the net operating income (NOI) from the property & the debt service associated with the loan

Formula: NOI / Debt Service

Example: A property has an NOI of $100k/yr & a debt service (inclusive of principal and interest) of $65k/yr. $100k / $65k = 1.67. So we would say the DSCR is 1.67x which is healthy - the property can easily service its debt

Buyer Perspective: This metric is probably the most helpful to understand how risky your deal is. It essentially asks the question: can the cashflow from the property satisfy the debt payments? If the answer is no & the DSCR is below 1x, you’ll need to come out of pocket to pay the loan, which is obviously a disaster. A deal like that inherently carries quite a bit of risk & you can lose more than just your initial investment

Lender Perspective: A traditional bank will likely not be interested in providing a loan unless the DSCR is at least 1.25x. Remember, the DSCR is inclusive of the principal payment, so even if you’re in an interest only period, the lender will calculate the DSCR as if the loan is amortizing. If you know the DSCR will be below 1.25x you will likely need to find a bridge, or hard money lender who specializes in transitional properties to give you a loan (or lower the leverage).

“How are real estate properties valued?”

There seems to be a lot of confusion around this topic when it’s actually really simple

The #1 myth you’ll hear is "Properties are sold based on their in-place income"

This is dead wrong. Let's walk through why this isn’t how it works: Easiest way to think about why this is false is by imagining a vacant 4 unit property. Vacant properties have no income. So if properties were actually sold based on the in-place cap rate, vacant properties would have a 0% cap rate and be sold for $0 dollars

That's obviously not the case. Vacant properties are generally worth more than $0 (there are some exceptions)

Why is this?

Because properties are sold based on the stabilized yield, not based on the in-place cap rate

Let's walk through an example. You have a vacant 4 unit property, how would you value it?

What's the relationship between cap rate, return on cost, and stabilized yield?

This is arguably the most important relationship in real estate and most people don’t understand it at all

It’s actually really simple

Let’s start with the basics: - The cap rate is the NOI divided by the purchase price. When you buy a deal, you buy it for an in-place cap rate

- The return on cost is the NOI increase of a specific action (usually a renovation) divided by the cost of that renovation

- The stabilized yield is the new NOI divided by all the costs in the deal

Stabilized yield is an extension of the cap rate through the duration of the deal by adding the NOI changes to the numerator and by adding the additional costs to the denominator of the formula

For example, if a property was purchased for $1MM and the NOI was $100k, the *cap rate* would be 10% ($100k NOI / $1MM PP)

If you executed a $100k renovation and that increased the rents and therefore the NOI by $20k, the *return on cost* of that specific renovation would be 20%

($20k NOI increase / $100k renovation cost)

Then you add the NOI increase to the numerator ($100k + $20k = $120k) and the cost increase to the denominator ($1MM + $100k = $1.1MM)

Which leads to the *stabilized yield* being 10.9% ($120k new NOI / $1.1MM total costs in the deal)

One of the biggest places beginners get tripped up is the property tour

They don’t know what to look for and they don’t know what anything costs

Here’s what to look for when touring a property so you can accurately price the renovation costs: Generally a renovation for a Class C 1-bed unit costs me $15k-$20k

Below are the items I focus on when touring to maximize rent and minimize cost

You should think about the property in the 3 categories outlined below
1. Bathroom (~$5k)
2. Kitchen (~$8k, grouping in all appliances & materials)
3. Floors/Paint/Other (~$2k)

Probably the most common question I get from younger guys is “How would you do it all again if you were my age?”

I’ll do you one better. Here’s an extremely realistic gameplan to get from ~$0 to $1MM in 5 yrs

I’m going to assume that you have a W2, are roughly 22 and have limited capital coming out of college

We’re going to get you from $0 to $1MM in just 3 deals // Deal 1 //

You’re broke and have no skills. Everyone was here at some point. You can either whine about it or you can get moving

Reason most people think making money is hard is that they focus on how hard the end goal is (making $1MM) instead of focusing on the first step of the process – gaining the knowledge necessary to start making money

This first deal doesn’t matter at all. The only reason it matters is to “get you in the game”. Once you buy a deal you start accruing market knowledge, you start accruing relationships (lender, investor, broker, etc) – you start to become “dangerous”

You obviously want it to be a good deal but it doesn’t need to be a *great* deal. Because the purpose isn’t to make money, it’s to gain knowledge/skills/relationships so you can make real money on future deals

So what does this mean in a practical sense?

Step 1: Figure out how much equity you either have yourself or can raise

I was literally dead broke for my first deal so was only able to put $2,500 of my own money in. I reached out to my entire network and was only able to gather ~$100k. That wasn’t enough to buy a triplex all cash in my market (which is what I was targeting)

So I reached out to friends who could possibly partner up in the deal. Meant splitting the profits but didn’t matter to me. Was going to do whatever it took. If I needed to take on 10 more partners, I would have. It wasn’t about the profit, it was about the skillset

I finally found a partner and using our combined networks, we were able to muster $200k, which allowed us to buy a triplex

I’m going to assume you can raise a similar amount, but if not, no problem. Whatever amount you can raise, you back into a deal of that size. If you truly can’t raise any money, start up a real estate social media account, share your thoughts/analysis, create a network and raise the money that way

Step 2: Finding the deal

- The market: You’re going to go into a market where deals sell for less than $150k/unit. Additionally, deals in the market should be selling for 6% cap rates at minimum otherwise you’re going to find it too difficult

- You’re going to search on Zillow/Redfin for duplexes, triplexes and quads (loopnet and crexi only really work for bigger properties)

- Open up excel. Make a list of every property listed in the market. Track the price per unit it’s listed for and note the price per unit it sells for. There should be 50+ properties on this list or you’re doing it wrong. Download any and all financial information that’s included in the listing. If there’s no information in the listing, call up the broker and get it from him. By the end of this process, you should know exactly what price per unit properties sell for in the market and exactly what cap rate they trade at. You’ll be looking to buy a property below the market price per unit and above the market cap rate (stabilized yield). Simple

- Market rents: Same thing. First use the mls/costar if you have access to it. If not, get comps from brokers (still have to vet them yourself). Worst case scenario, use Zillow/apartments.com for active comps. Put them all in excel, discard any outliers and take the average. You’ll still need to run the “market rent” for each new deal you look at as each property differs slightly, but this should get you close initially

- Expenses: Use the P&L information you now have. Line each individual P&L up next to each other in excel & for each individual line item, note the cost per unit, cost per square foot & the overall expense load as a percent of revenue. Now you’ve figured out both revenue & expenses. You now should be able to create a brand new P&L for new properties you look at from scratch

- Brokers: Every time you see a broker on a listing, you’re going to call him up, ask him a few questions about the deal, tell him your criteria & ask him to add you to his mailing list. You should start receiving “passive” deal flow to your inbox every morning. Should also set Zillow/redfin alerts for your criteria. You’ll probably have to look at over 100 deals before pulling the trigger

- Underwriting. You’re going to underwrite 3-5 deals a week minimum. You’re going to underwrite them based on their stabilized yield (if you don’t know what this is, search my tweets for it). You’re looking for a 200 bps+ spread between your stabilized yield & the market cap rate. The higher the stabilized yield, the better. The goal is to understand exactly what price per unit & stabilized yield you’d buy a property in this market for so you’re ready to pull the trigger when the time comes

Step 3: Pulling the trigger

Your “buy box” should already be established, only thing left to do is find a deal that fits it. You should be tracking the aggregation sites daily, have plenty of broker contacts at this point & have a lot of deal flow hitting your inbox

When you see a deal that fits your criteria, pull the trigger

Since this is your 1st deal, you may have a hard time getting a loan. Instead of whining about this (like most people do), you can:
1. Do the deal all cash
2. Use seller financing
3. Get a guarantor to hop on the loan

Doesn’t matter which one you use, just get the deal done. As quickly as possible

Deal 1 Summary: Depending on your access to capital, your first deal should be 1-5 units in the $200k to $500k range. The timeline should be quick (doesn’t take long to renovate 5 units or less) & the profit doesn’t matter as much so I’m not even going to bother listing it (obviously if you do raise money though, be honest about the return profile up front). The idea is to “get you in the game”

I own over $30 million of real estate

I bought my first deal with $2,500 of my own capital

If I had to start over in 2025…

Here’s how I’d find a market in just 4 steps: Step 1: Look for cities/towns under 250k population
Step 2: Vet supply
Step 3: Vet demand
Step 4: Make sure there are mispricings

HOW PRIVATE EQUITY FIRMS ANALYZE DEALS:

Most important metrics: 1. Stabilized cap rate (yield):

Since we focus on value add, the entry cap doesn’t matter, as long as we can service our debt

The stabilized yield matters because it shows the intrinsic cash flow of the deal

The stabilized yield is the stabilized (post-renovation) NOI divided by all the costs in the deal

Very simple calculation (see below for an example) but very important

We typically need to get to at least a 150 bp spread between the stabilized yield and the market cap rate for a deal to pencil (ex if market cap rate is 5%, need a minimum 6.5% stabilized yield)

For example, buy for an in-place 4 cap, increase revenue to get to a 6.5, sell for a 5 cap. If you buy for $10MM with an NOI of $400k, put in $2MM in renovations and bump the NOI to $780k, you stabilize at a 6.5 yield ($780k/$12MM)

Property is then worth $15.6MM ($780k/5% market cap), for a profit of $3.6MM

Speed matters as well (quicker the better for IRR)

Stabilized yield is a more important metric than IRR because it displays the intrinsic value of the cash flow

Whereas IRR is a bet on the state of the capital markets (debt financing available) at sale as well as cap rates at sale, which basically makes it a total guess

One of the biggest places beginners get tripped up is the property tour

They don’t know what to look for and they don’t know what anything costs

Here’s what to look for when touring a property so you can accurately price the renovation costs: Generally a renovation for a Class C 1-bed unit costs me $15k-$20k

Below are the items I focus on when touring to maximize rent and minimize cost

You should think about the property in the 3 categories outlined below
1. Bathroom (~$5k)
2. Kitchen (~$8k, grouping in all appliances & materials)
3. Floors/Paint/Other (~$2k)

One of the biggest mistakes I see beginners make is not understanding the market cap rate

If you don’t understand how the market values the property (the market cap rate), you’re going to lose money

Here’s why: Real estate properties are sold based on the value of the future cash flow

The cash flow is valued based on the cap rate (NOI / purchase price)

Higher the cap rate, the less valuable the cash flow stream (the property). Lower the cap rate, the more valuable the cash flow stream

You need to understand exactly how the market values the cash flow stream of the property you’re going to buy

Because you need to make sure that you’re not paying too much for it

If you pay too much for it (buy at too low of a cap rate), you lose money the day you buy it

Here’s an example:

Let’s say you’re looking to buy a real estate deal and want to use a community bank for the financing

These lenders will be looking to make sure you satisfy 5 main requirements in order to fund your deal: The 5 lender requirements are:

- within “the deal itself”
1. DSCR at or above 1.25x
2. LTV at or below 75%

- regarding “you as a borrower”
3. Net worth = loan amount
4. Liquidity = 10% of loan amount
5. Adequate experience (your “REO” schedule)

Let’s start off with what banks look for in the deal itself

Calculating property taxes in 3 simple steps:

1. Look up the property tax bill
2. Go to the county website
3. Call the assessor

Follow this step-by-step process and you'll never miscalculate property taxes again: 1. Look up the Property Tax Bill

First you're going to go on the county website (go on google and search "xx county property taxes"). From there, you input the property address and the tax bill should come up

The tax bill should show you the exact calculation. You then recalculate the property taxes based on the new purchase price

Generally it's assessed value * the mill rate (ex if you buy for $1MM and the mill rate is 25, your taxes would be $1MM*25/1000 = $25k). Sometimes it's appraised value * x% to get the assessed value, then assessed value * the mill rate.

Most of the time, the assessed/appraised value is the purchase price, but not every time, especially in non-disclosure states.

Some counties also recalculate property taxes every year, while other counties only do so every 5 years. Some states only recalculate at sale.

Almost every county calculates the property tax formula slightly differently, so the exact formula isn't important. What is important is that you follow the formula for that specific county to the "T".

There are 3 main debt metrics in real estate:

1. Debt Service Coverage Ratio (DSCR)
2. Loan to Value (LTV)
3. Debt Yield

Here’s how to view each from both a buyer’s perspective & a lender’s perspective: // DSCR //

Definition: The DSCR is the ratio between the net operating income (NOI) from the property & the debt service associated with the loan

Formula: NOI / Debt Service

Example: A property has an NOI of $100k/yr & a debt service (inclusive of principal and interest) of $65k/yr. $100k / $65k = 1.67. So we would say the DSCR is 1.67x which is healthy - the property can easily service its debt

Buyer Perspective: This metric is probably the most helpful to understand how risky your deal is. It essentially asks the question: can the cashflow from the property satisfy the debt payments? If the answer is no & the DSCR is below 1x, you’ll need to come out of pocket to pay the loan, which is obviously a disaster. A deal like that inherently carries quite a bit of risk & you can lose more than just your initial investment

Lender Perspective: A traditional bank will likely not be interested in providing a loan unless the DSCR is at least 1.25x. Remember, the DSCR is inclusive of the principal payment, so even if you’re in an interest only period, the lender will calculate the DSCR as if the loan is amortizing. If you know the DSCR will be below 1.25x you will likely need to find a bridge, or hard money lender who specializes in transitional properties to give you a loan (or lower the leverage).

1. Go to tertiary market
2. Find a product type that’s profitable to build
3. Check zoning code and figure out the zoning that allows for that product type
4. Reach out to every property zoned for that use but currently operating as a *different* use
5. Buy, profit

// THREAD // This takes the “off-market property” strategy one step further

The issue with most off-market strategies is that the owner actually has some idea of the value of the property

For example, most owners know approximately what a multifamily property should be worth in the area

That’s because of three reasons

1. They can base the value off the in-place cashflow
2. They can base the value off comps (and there’s always a ton of multifamily comps)
3. They can call up a broker to tell them what the value should be (and the broker will actually know)

Why you should almost always offer more concessions up front in exchange for higher rent:

// Thread // For those of you who don’t know, concessions are simply additional incentives to get tenants to lease a property

An easy example is offering free rent

Since concessions are a “one time expense” they aren’t typically “capped” (used in the NOI that’s divided by the cap rate to determine the sale price) at sale, but the top end rent figure always is

One high water market rent increases the value of the entire building

When your DSCR doesn't hit the bank’s threshold (usually a ~1.25x DSCR), most people think banks don't give you any option but to lower the LTV

But in reality, if you negotiate, you have 3 options: Option 1: Lower LTV
Option 2: Schedule an earnout once 1.25x DSCR is hit at implied ~75% LTV
Option 3: Fund reserves up front to artificially hit the 1.25x DSCR

Almost everyone goes with option 1, but it's actually the worst option by far

Let's go through them one by one

For this entire thread, let's assume you want 75% leverage, but the bank is pushing you towards 60% leverage because that's the leverage that supports a 1.25x DSCR at the projected Yr 1 NOI

One of the biggest places beginners get tripped up is the property tour

They don’t know what to look for and they don’t know what anything costs

Here’s what to look for when touring a property so you can accurately price the renovation costs: Generally a renovation for a Class C 1-bed unit costs me ~$15k

Below are the items I focus on when touring to maximize rent and minimize cost

You should think about the property in the 3 categories outlined below
1. Bathroom (~$5k)
2. Kitchen (~$8k, grouping in all appliances & materials)
3. Floors/Paint/Other (~$2k)

One of the biggest mistakes I see beginners make is not understanding the market cap rate

If you don’t understand how the market values the property (the market cap rate), you’re going to lose money

Here’s why: Real estate properties are sold based on the value of the future cash flow

The cash flow is valued based on the cap rate (NOI / purchase price)

Higher the cap rate, the less valuable the cash flow stream (the property). Lower the cap rate, the more valuable the cash flow stream

You need to understand exactly how the market values the cash flow stream of the property you’re going to buy

Because you need to make sure that you’re not paying too much for it

If you pay too much for it (buy at too low of a cap rate), you lose money the day you buy it

How to analyze real estate beyond the numbers:

Real estate isn't just numbers in excel

It’s living & breathing

Here’s what to look out for... First thing most investors do when they see a deal is open excel and look at the numbers

“What’s the cap rate?”

This is extremely stupid. You’re not buying numbers in excel, you’re buying real estate

If you buy solely based off numbers, you’re going to make a costly mistake

It’s actually pretty simple.

Over the last 3 years, a lot of inexperienced operators got in over their skis.

So you’re simply going to target them: 1. Position yourself in lower liquidity markets (markets where owners will have trouble selling an underperforming asset quickly – that likely means a discount for you as the buyer)
2. Look for properties with a loan maturity coming up in the next 6-12 months
3. Look for properties that’re owned by an inexperienced individual (not a private equity firm)
4. Look for properties with low in-place income that the owner is probably struggling with, banks in the area won’t have the appetite to lend on and most buyers will be too lazy to perform the work on (most buyers are looking for “easy” properties)

Here’s exactly how I analyze a real estate deal:

This deal is a perfect example of clear signs you can look out for

This 68-unit deal arrived in my inbox about a while ago with 5 massive red flags 1. The deal wasn’t listed on loopnet (came straight from a not-that-well-known broker). Means 90%+ of the market didn’t even see it
2. The location was not disclosed in the text of the initial email. Anytime there’s any sort of “effort barrier”, that further reduces the buyer pool
3. The link in the email directed you to an old listing. Another “barrier to entry” and also proof of an incompetent broker
4. The financials provided were horrible. Most notably, the broker underwrote essentially the same rent for the 1-bed and 2-bed units, which is obviously not true. This led to the broker’s proforma revenue being significantly lower than the actual market revenue, which presented an opportunity (most unsophisticated offers came in too low because they were relying on the broker’s numbers)
5. The asset was operating with higher-than-market vacancy with 5 evictions currently in motion (way too many). I know the market and this made it clear the owners were significantly mismanaging the asset

Basically there were clear signs of broker incompetence and owner mis-management. That means the deal is definitely worth looking into

Now let’s get into the deal itself