Think that cute little 3BR/2BA brick and siding foreclosure across town might be a good rental property? It
may be… Home prices are at a real low. The supply seems almost unlimited. Interest rates are the lowest
in years, and more and more people are looking for rentals every day.
Even today – with the stock market down over 52% from its record high in October 2007 - a home is still a
safe and highly leveraged asset with an ability to generate wealth which is second to none. But before you
cash out your mutual funds or dig up that coffee can full of cash in the backyard to become a real estate
investor, there are few things to consider.
Compare the Numbers - When you buy investment real estate, you’re not just buying bricks and mortar,
green shag carpet and pink bathroom tile at a great foreclosure price. You’re buying a “Money Machine.” It’s not the house, or duplex, or shopping center itself you’re buying. It’s what you can get out of it. The “Net Operating Income” is actually what’s for sale.
Real estate investors buy property based on “numbers” - not number of bedrooms, but financial analyses of a single property, or of that property in relation to others available. Don't base your purchase decisions on “price” alone. Unless you're paying all cash – which, normally, you shouldn't do – price is just a function ofthe loan terms.
The 3-legged Stool – The basis for considering the purchase of an investment property is like a 3-legged stool. The decision should be based on income, expenses, and financing. The key to your success in purchasing a “money machine” property is to combine these three legs – income, expense, and financing – into a package that makes financial sense. Unless the stool has all three of its legs, it can't stand. It will tip over, and you will fall off!
Leg 1 – Income - Pricing investment real estate is an art. There may not be a totally right or wrong
method. But, unfortunately, some investors don't have any method! An easy rule of thumb to forecast a
property's value is the Gross Multiplier. Many investors use this method alone tp determine what they
should pay for investment property based on it's potential income. The Gross Multiplier is the total rental
income you could realize from a building if it were 100% leased. It considers the monthly rental income in
relation to the sales price of the property. You might hear investors say, “I'll pay 7 times gross,” or “I'll only
pay 6 times gross.” But what if operating expenses turn out to be 8 times gross!?! The Gross Multiplier
method considers only one leg of the 3-legged stool. It does not take into account operating expense or
financing.
Leg 2 – Operating Expense – A primary concern in considering an investment property is what it will cost
to operate the property. What will it cost to fix the place up initially? What will annual repairs cost? Real
estate tax? Association dues? Property management costs? Insurance? Utilities? Advertising?
Supplies? Miscellaneous expenses? If the property has never been rented before, you need to develop
and estimate of these costs yourself. If the property is already a rental, ask the seller for their “Schedule E.” That's the form they've used to report their annual income and operating expense to the IRS. There's no reason an honest seller wouldn't want to show you their Schedule E.
Leg 3 – Financing – Interest rates are currently at an almost historic low. But financing of investment property should still be one of your most important calculations. In addition to using the Gross Multiplier formula, many investors figure the Capitalization Rate, or “Cap Rate.” The Cap Rate is the rate of return used to determine the value of the property's income stream. This can be very useful in comparing two or more properties you're considering purchasing. However, its primary benefit is its indication of the interest rate at which you should borrow.
To calculate the Cap Rate, you use the “net operating income” and the property price. Thus, this
calculation only considers two legs of the stool, ignoring financing. But since the method assumes that
you're paying cash for the property, the Cap Rate will stay the same whether your getting a 4%, 9% or 12%
rate on your loan. Therein, lies the key to this calculation. If the interest rate offered you is less than the
Cap Rate, the property is producing more than the mortgage money is costing you. If the interest rate is higher than the Cap Rate, don't even think about taking this loan. This indicates that the property is not producing enough to service the financing. Never risk borrowing more money than the property can support.
Finally, there's one way to determine the value of an investment property that considers all three legs of the stool at once... income, operating expense, and financing. It is the Cash-On-Cash formula, sometimes
called “equity dividend return.” In my opinion, it's the only one to use. The Cash-On-Cash calculation
considers your cash flow before tax versus the amount invested. It should always be used to tell you
whether to buy a property you're considering, whether to sell and investment you already own, or how one
property compares in value to others you're considering purchasing.
Notice that I have not mentioned appreciation. Anytime you buy real estate, you naturally hope that it will
appreciate in value. Historically, that has been true. But in the last couple of years, most property owners
have seen much of that appreciation of their property disappear. Therefore, my advice would be to never
buy investment real estate based on the hope that, over time, it will appreciate. If the only way you can
make money is for something to go up in value, that's not an investment; it's a speculation! When doing your analysis of property to consider what to invest in, always figure zero appreciation. That way, you'll know that the return on your investment is based on facts and figures, not speculation, and the investment will work for you even when the market goes stale.
