There are three broad categories of investment strategy that I advocate:
- bargain purchase
- increase value
- double-digit cap rate.
Bargain purchase is the purchase of real estate for at least 20% below current market value.
In the increase-value strategy, you buy a property for its current market value, but you select only properties with some unrealized potential. Then, immediately after purchase, you make whatever changes are necessary to increase the value of the property. In general, you must increase the value by at least 20% within six months in order for the strategy to be worthwhile.
Double-digit cap rate means that you buy the building on terms that it has a capitalization rate of 10% or more. The capitalization rate is the net operating income (rent minus operating expenses but before debt service) divided by the purchase price. In other words, it is the cash-on-cash rate of return you would get if you owned the property free and clear. In the absence of a bargain purchase, double-digit cap rates are very hard to find. They generally only occur temporarily in depressed markets or in small market niches.
The most common real estate investment strategy, however, is one which I condemn: buying properties which the investor believes will soon increase in value due to market-wide appreciation. This is, in fact, pure speculation. No one knows which areas will appreciate. Many billions have been made by investors pursuing this strategy, but they were simply lucky.-wrote John Reed
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