How to find investment deals that "pencil out" today
I ran a poll on LinkedIn, asking real estate investors what part of the investing process was giving them the most trouble. Here’s how it broke down:

* Finding deals that pencil out: **77%**
* Raising equity and/or debt: 10%
* Economy/regulatory uncertainty: 10%
* Something else: 3%

While some investors are having trouble securing debt and/or equity to invest, and others are most affected by economic and regulatory uncertainty, the overwhelming answer is that it is challenging to find real estate investment deals that pencil out.

What is “pencil out”? And why is it so hard these days?

## What does “pencil out” mean?

This term came about in financial circles and is used commonly among investment bankers and real estate investors. TheFreeDictionary.com offers two definitions for “pencil out”:

&gt;verb: To calculate or estimate (projected profits and losses or other figures)  
&gt;  
&gt;verb: To appear likely to be of sufficient benefit to justify the projected costs

So for a project to “pencil” or “pencil out” means it *appears* *worthwhile based on initial underwriting*.

The word Pencil is used rather than Pen to imply that the numbers can be erased and recalculated. They are not final. This is why I say a project that pencils out appear worthwhile based on *initial* or *preliminary* underwriting. As you learn more, you change assumptions and allow your financial projections to update accordingly.

#### What metrics determine whether a project pencils out?

Real estate investors have several metrics they might focus on when determining if they like an investment deal. Some of the most common metrics are Cash Flow, Equity Multiple, Cash on Cash Return, and Internal Rate of Return. 

## So why is it so hard to find these deals that pencil out now?

#### High prices (low cap rates)

Real estate prices have risen fast in the last couple of years. That’s true on an absolute basis (dollars per square foot), and also on a cap rate basis. Cap rates measure the ratio between a property’s price or value, and that property’s income. So buying real estate *income* is more expensive.

All else equal, lower cap rates lower a property’s potential cash flow for an investor buying that asset. While price appreciation also drives investment returns, and it can be argued that lower cap rate properties are more likely to appreciate faster (*usually* true), many investors targeting Cash Flow and Cash on Cash Return metrics will have trouble making a low cap rate deal pencil.

#### Economic disruption

If tenants cannot, or do not, pay rent at a property, the whole model falls apart. Social and economic disruption to the economy can cause tenants to miss rent payments in a variety of ways, including:

* Residential tenant loses their job and cannot pay rent
* Business tenant goes bankrupt and cannot pay rent
* Local economy weakens and market rent decreases

All of these can affect the underwriting of a real estate investment deal.

#### Regulatory Uncertainty

Sometimes a property’s income can be affected by new and unforeseen regulations. During the height of the COVID pandemic, several states were changing the rules about how real estate investors can operate their properties. New rent control laws were passed in California, Oregon, and New York in recent years, impacting both new and existing investments. The [Center for Disease Control under President Trump](https://thehill.com/policy/finance/housing/514898-trump-eviction-ban-tests-limits-of-cdc-authority) banned the practice of evicting non-paying tenants under the banner of public health and safety. That mandate was later removed, but then [brought back again](https://apnews.com/article/eviction-ban-extended-biden-coronavirus-9e7c4dc97c49cbb42a1ecb55b06e3b4c) under President Biden’s administration. The Supreme Court stepped in to shut it down again, citing the CDC’s lack of authority to make such a decision. Various parties shoving this type of regulation each way at various levels of government leads to uncertainty.

Feel certain about how the rules of the game may further evolve in the coming years? If you do, you’re in rarefied air. Uncertainty makes it hard to confidently underwrite rent collections, rent increases, and expenses.

#### Inflation

The Federal Reserve, the President, and numerous news outlets were preaching that the recent rise in core [inflation is “transitory”](https://www.wsj.com/articles/fed-officials-see-transitory-inflation-lasting-quite-a-while-11632389401). Now that word isn't being used. Continued inflation can dramatically alter the expected metrics of real estate investments, for better or for worse. Stress testing for inflation in a real estate investment model can be a difficult situation for making bold and confident investment offers.

## How to find deals that pencil out

#### Apply disciplined underwriting

Full, disciplined underwriting means entering conservative estimates of key deal levers including rent and other income, expenses, and financing costs. Underwriting should be informed by market comps, trends, and up-to-date data that may affect the property’s performance.

While disciplined underwriting may actually whittle down the number of deals that pencil out for an investor, as they may underwrite too conservatively and lose the opportunity to a more aggressive investor, it’s actually the only way to really get *any* deals that truly pencil out. Aggressive investors that overpay for assets *never* have deals that pencil out.

#### Gain access to as many qualified deals as possible

Once you have your investment strategy and underwriting approach set, then think of it like a sieve. You pour sand through, let all the sand go, and hope to collect something interesting that doesn’t fall through the cracks. The more sand you pour through the sieve, the more chance you’ll collect something worthwhile.

So it is in real estate investing. You need to source, and underwrite, more deals in order to find the qualified ones. This can be done through listing portals, brokers, or through contacting sellers directly.

#### Work backwards toward a purchase price

Taking deals that might fit your investment model and “working backwards” toward the purchase price is a classic strategy. Two considerations need to be kept in mind here:

1. Your maximum purchase price — Start with underwriting the property’s income, then determine a fair value based on that income, and finally reduce that value based on your required investment return to reach the maximum price you are willing to pay.
2. Determine the seller’s —Discovering the minimum price that a seller will accept to sell the property is less than scientific. Since it would be against their interest to share that information, this enters the realm of negotiation, which is an art. However, there are several signals to consider, including the property’s Asking Price (if it is currently listed on the market), the seller’s motivation (are they retiring?), their broker’s guidance, your broker’s guidance, and the presence of competition.

Compare your maximum purchase price with the asking price, whisper price, or other best indication of the seller’s minimum acceptable price. The deal officially “pencils out” whenever your maximum purchase price is greater than the seller’s minimum acceptable sale price.

#### Work efficiently, make offers, keep moving

It would be wonderful to make an informed, fully underwritten offer on each and every interesting property within your target market. But there’s not enough time. Short-cuts are needed to work efficiently and put out enough offers to gain traction on deals done in today’s environment.

For value-add real estate investments, determining the precise pro forma NOI is the most intensive part of the deal analysis. Therefore, the biggest possible short-cut is to *delay* your full pro forma underwriting until you find whether the deal pencils in other ways. Take the current Net Operating Income at face value (or NOI + a growth factor), combine that with accurate financing assumptions, and see if the asking price is even within range of acceptable returns.

This doesn’t eliminate the need for a full, disciplined underwriting. If the deal doesn’t pencil at this stage though, it redirects your time and effort to other deals. Once you find deals that *could work,* head back to apply disciplined underwriting.

#### Get financing guidance

Let’s not skip too quickly over the phrase “**accurate financing assumptions**” above. In an age of low cap rates and varying financing structures available, good or bad financing assumptions can make or break the deal. Partner up with an expert in the debt capital markets that can help here.
[{"id": "hzc22rb", "text": "Amazing write up and thank you!", "replies": [], "depth": 1}, {"id": "hzc9tqz", "text": "Great post homie", "replies": [], "depth": 1}, {"id": "hzd6gk8", "text": "anyone that has trouble raising capital right now in reality actually has a problem finding deals that pencil. If you have a deal that pencils, you can raise capital in a heartbeat. There is so much money out there desperate to be deployed.", "replies": [{"id": "hzf76fu", "text": "The assumption your making is that all capital has the same requirements. If you can source capital with a reduced preferred return requirement, now all of a sudden deals that didn\u2019t pencil start to. It\u2019s as much about sourcing realistically priced capital as it about sourcing realistically priced properties.", "replies": [{"id": "hzfe8l5", "text": "^this is your mega funds (Blackstone, Starwood, etc) in a nutshell. Very easy to solve for a 9-10% irr and throw into a core-plus fund and collect fees. Not so much for the guy tying up deals and trying to raise equity from mom and pop investors looking for yield.", "replies": [], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "hzf6nuu", "text": "This is great. So concise with some great nuggets. Thinking of acquisitions as buying real estate income is the absolute most boiled down way to explain what investment real estate is.", "replies": [], "depth": 1}, {"id": "hzf7ypu", "text": "Great post, thank you ! saved for future reference.", "replies": [], "depth": 1}, {"id": "hzi190d", "text": "Just lower your exit cap and it will pencil, simple.", "replies": [], "depth": 1}]