They say that you make your money on the purchase.
Essentially, on day 1, it's already determined if you will make or lose money. That's why rental property analysis is the most important part.
Property analysis is easy and hard at the same time. You'll see why in a moment, but first let's break it down.
Really, there are only 3 steps to investment analysis:
Pretty simple, right?
Well, that's the easy part. The hard part is figuring out the litany of things that can and will throw off your numbers and send you down a path toward a bad deal. Remember, you win or lose upon purchase, so get it right up front.
It can be very hard to calculate what a property should sell for; There are a lot of reasons why values can fluctuate significantly between two similar properties.
Market value is price at which a property can be sold. You can't predict what someone else will pay - there are a lot of crazy people out there, but you can make a fair estimate of what a reasonable person would pay.
So, I’ll go over a few methods which you can use to estimate the value of a property
I’m covering this method first because it’s by far the easiest way to get a rough idea of the investment property’s market value. The Gross Rent Multiplier is a really rough measure of an investment property, using only the gross rents, while ignoring any expenses.
Simply take the sale price (or asking price) and divide it by the gross rents (total rent before an expenses).
Asking Price / Gross Rents = GRM
If the asking price for a property is $250,000 and it has gross rents of $40,000 per year, the GRM is 6.25. Read all about the Gross Rent Multiplier.
When you are searching for properties, you should research a number of recent sales in your market area. You can fairly easily calculate the GRM for these properties as the rent and sale price is generally available online. By making a spreadsheet you can calculate all the GRM’s and hopefully find a range or approximate average.
Once you do, you can reverse the calculation and use it to estimate value. Let's say you found that a GRM of 8 is average in your location. Use the new formula to calculate your potential investment
Basically, it’s easy and it can save you a lot of time.
If you are going to use the gross rent multiplier while searching for properties, I would use it as a filter, but not a deciding factor. By filtering out low GRM properties, you are probably saving yourself a lot of time and energy analyzing properties that would just be a waste of time anyhow.
Also, most properties don’t list detailed expenses when you are first looking at them. It is impossible to accurately evaluate a rental property without knowing the expenses (look at my 3 steps above). So GRM gives you a way to estimate price without having all the pieces you need.
It is a quick and dirty calculation to give you a rough starting point. It is not meant as an accurate measure of actual market value.
You may have noticed the GRM calculation doesn’t take into account any expenses at all. All of its downfalls are related to this. Because properties can fluctuate widely with their expenses, the GRM will also fluctuate like crazy. You may see one property with a GRM of 6 and another with a Rent Multiplier of 15.
It is unlikely that one property is a steal and the other one a bad buy, so the difference is most likely due to high expenses. Don’t forget, older properties tend to have higher expenses and sell for a lower price, so you may expect to see the multiple change based upon this as well.
The Comparative Market Analysis method, or CMA, is when you compare the potential property to recent sales in the area. You should adjust the value based upon differences in the target property and recent sales in order to arrive at an accurate value.
Learn everything you ever wanted to know about Comparative Market Analysis.
If you are looking at a single family home that is 1500 square feet with 3 beds and 2 bathrooms, you may be able to find 3 or 4 properties that have a similar square footage with the same number of beds and baths. Since the properties are so similar and geographically nearby, the CMA can quickly determine the accurate price.
Unfortunately, the more differences the properties have, the more the Comparative Market Analysis method falls apart. It may be easy to compare a 3/2 1500 sf home to a 3/2 1700 sf home, but is it possible to compare a 3/2 1500 sf home built in 2005 to a 5/1, 2800 sf 1880's colonial on 3 acres of land with original woodwork. Sometimes it's impossible to truly compare properties.
Comparative Market Analysis works well on most properties 4 units and under that actually have comparable sales in their area. If it's 5 units or more, or there is a significant lack of comparable sales, other methods should be used for analysis.
The best thing you can do is get accurate expense information from the current owner, BEFORE you make an offer.
You should compare the expenses they give you to your own pro-forma. Essentially, compare the accurate information they give you to your assumptions about income and expenses. You can do this by checking out a rental income worksheet.
You can use the income and expense worksheet I have on the page linked, or you can create your own rental property analysis spreadsheet to carry around with you. Either way, you should have assumptions about expenses to compare to the current expenses on the property.
It's important to have a list of assumptions on expenses when analyzing any rental property. It's important because many owners either inflate their expenses to get tax write-offs, or they hide their expenses to sell their property for more money. Always assume every seller is hiding something from you, and come armed with your own assumptions on expenses.
The 50% rule is a great place to start. Though any "rule of thumb" has it's drawbacks, the 50% rule is actually a pretty safe number to run with. Basically, it assumes that 50% of your rents will go toward expenses.
Obviously this won't work when rents are really high or low, or the property is very old or brand new. It's normal to expect your expenses to fluctuate, but it's a place to start. Once you have some experience and a few properties under your belt, you can calculate your own expense ratio and use that.
It is amazingly important to conduct your due diligence before purchase. It is quite likely that the current owner is hiding deferred maintenance, necessary repairs, or even bad tenants from you. The biggest thing that can blow up your numbers is getting them wrong in the first place. Check out this article on conducting due diligence to avoid these problems in the first place.
This is the part we are all looking for, right? Knowing your return is the most important thing…but I’ll throw you a curve ball – There are different types of return you can calculate. I’ll cover two major ways to calculate return.
This is actually a kind of interesting because it has different meanings in different fields. As it relates to rental property, Cash on Cash return is the Cash you get back each year compared to the cash you put down on the property.
This is actually quite simple: (Net Operating Income – Debt Service)/Cash Invested.
Let’s say you put $50,000 down on a $200,000 house (assume that includes all closing costs) and it has a yearly Gross Rents of $20,000. Now let’s say the following are your expenses
So calculating your cash on cash return: $4,200/$50,000 = -.084= -8.4%
Your cash on cash return is negative 8.4%, not very good!
ROI and Cash on Cash are very similar, except one main difference. Cash on Cash is strictly cash in vs cash out. ROI includes only actual expenses, not principal payments. Remember, a principal payment is essentially putting cash from one pocket into another (your bank account into the equity of the property). Your new list of expenses looks like this:
So calculating your cash on cash return: $1,800/$50,000 = .036 = 3.6% return on investment.
3.6% still isn’t very good in real estate, but when you sell the property, you should get that principal back, which is why it’s not counted as an expense for ROI.
Though ROI is extremely important and a more accurate way to calculate your return, cash on cash return is the most prevalent way to calculate returns in real estate.
Well, it doesn’t matter if you are earning 20% per year ROI, if your Cash return is negative, you will eventually run out of money and you won’t have any money to pay the bills!
A high ROI but low CoC property definitely has a place in a portfolio, but will probably be shorter term with the intent to sell, and you will need good cash-flowing properties in the portfolio to pick up the slack from the low cash generated from this investment.
You found a great deal, but will the bank finance it?
Banks are pretty boring about how they lend. If you don't meet their ratios they simply won't lend. Learn a bit about the secret sauce and you'll figure out how to get financing.
In layman terms, the debt coverage ratio is how much net rent you have each month above what the bank is going to charge for a mortgage.
DCR (or DSCR) = net rent/Debt Service
So if you have a net monthly rent of $1,200 and a monthly mortgage payment of $1,000, your debt coverage ratio is 1.2.
Banks are very simple in the way they make investment decisions and this ratio is a simple number, so banks love it.
Essentially, if you have a good cushion of net rent each month above the mortgage amount, the bank feels comfortable you will pay them. Often, banks use a DCR or 1.2-1.3, though every bank has a different requirement.
Debt Coverage Ratios are a terrible way to analyze a deal, but it is essential to know it and calculate it. It doesn’t matter how much money you will earn, if you don’t have monthly rents at a certain threshold, they simply won’t lend.
Everything that has numbers can be manipulated. It is important to know these numbers before you apply for financing because you can easily manipulate them.
If you find the debt coverage ratio on your deal is too low, but it’s a killer deal you don’t want to pass up, find ways to raise the ratio. You can do this by finding ways to increase rent or cut expenses. Electricity isn’t sub-metered? Done. Landlord pays the water? Just fix the lease…
Now the debt ratios work and the bank will lend.