The Basics Behind Analyzing A Rental Property (1-4 Units)
The starting point for any real estate investment is the analysis phase. Before you purchase any piece of real estate, you have to be comfortable with the financials and be realistic with your rental property analysis.
Each property that you purchase is a little business in itself and you need to make sure you take the time and treat it that way. There are far to many people, who understand that real estate can be very lucrative but do not have the education or knowledge to turn a profit. Real estate can be just as much a headache as it can be profitable, if you do not have a good understanding of the numbers going into a project.
The analysis of a rental property, especially when you are talking about rental property that ranges from 1 -4 units is fairly simple and once you get a good grasp of the concept, is easy to replicate. When you understand the concepts, you will be able to identify opportunities that others may not see. Whether a property is mismanaged, rents are under market value or the property is under priced. Being able to run an accurate analysis on a rental property will give you a leg up on your competition and allow you to acquire more properties that fit your specific profit return criteria.
The goal of this post is to help you learn some of the basics surrounding the analysis of a rental property and hopefully prevent you from buying a bad deal in the future.
How To Analyze A Rental Property
There are several factors that you can look at when you are analyzing a property but there are 2 primary factors that most focus on.
1) Cash Flow - This is the profit you have left over after operating expenses, vacancies and credit lose, debt service & capital expenditures.
2) Appreciation - This is the equity that is gained as the property increases in value.
Out of these 2 primary factors, Cash Flow is the main factor you will want to focus on during your analysis. Appreciation can be somewhat speculative and depending on your market, it can fluctuate drastically. Appreciation can also be very difficult to predict.
So, for your initial analysis on a rental property, you will want to make sure that there is enough Cash Flow left over after your bills are paid to begin taking a more detailed look into the secondary metrics associated with evaluating a rental property.
The Specifics Behind Cash Flow
Determining your Cash Flow seems like a fairly simple calculation (and it is), we just have to make sure that we account for all of the costs associated with getting to the final Cash Flow number. As well as accounting for the correct income & expense items, it is also just as important to have accurate figures plugged into your analysis.
In basic terms, Cash Flow is "Income - Expenses".
However, the income you bring in from a property can come from other places besides rent and the expenses include more than just your mortgage and can differ on each property depending on certain variables.
When it comes to analyzing the income for a rental property (on a 1-4 unit) , 99% of the time, your income will come from your rent. However, there are different ways to add revenue streams to increase your gross income on a property such as:
Coin Operated Laundry
Additional Services (House Keeping, Laundry)
Additional Pet Charges
These are just a few additional income streams that are possible, however the use of these will depend on several variables such as: building size & unit count, location, market and demographics.
The aspect of determining Cash Flow that we want you to focus more on are the expenses. When it comes to expenses, there will be expenses that you need to account for on every property and then there will be expenses that you can avoid or push on the tenant. Some of the expenses you will always account for on every rental property are:
Capital Expenditures (subjective topic - which we will touch on a little later)
These are expenses that you will not be able to avoid when running your numbers on your rental property.
Here are some expenses that you will be able to avoid or push on the tenant depending on the property and specific circumstances.
Now we understand what expenses we should expect to account for and what expenses do not always apply, let's take a look at where we can obtain the information to estimate these costs. As we stated before, it is very important that you are plugging in accurate numbers for your analysis, so that you can get accurate results. As the old saying goes "Garbage in is Garbage Out".
Taxes - Go to your local county's website or give them a call. They will be able to tell you the current taxes on the property (some adjustments may need to be made)
Insurance - Call your insurance broker and have him put together a quote for you on the property
Water - Call your local water authority or ask the owner of the property for his previous 4 bills
Sewer - Call your local water or sewer authority or ask the owner of the property for his previous 4 bills
Garbage - Call your local trash provider or ask the owner of property for his previous 4 bills
Gas - Call your local gas authority or ask the owner of the property for his previous 4 bills
Electricity - Call your local electrical authority or ask the owner of the property for his previous 4 bills
HOA Fees - Call the president, ask neighbors, the owner or call the hotline
Snow Removal - Call a local snow removal company for a quote
Lawn Care - Call a local lawn care company for a quote
Repairs - This will depend on the current condition of the property when you put it out to rent. If you have a fully renovated unit you will have a lower estimate for repairs but if you have a property in disrepair, you will have to budget more for repairs. (5% - 10% is a common estimate depending on condition of property)
Vacancy - This will depend on the market, how aggressively you price the unit as well as the demographics of the area. (3% - 10% is a common estimate depending on these variables). Turn over is one of the most expensive costs a landlord can occur.
Property Management - Call a couple local property management company's and get an estimate on their pricing. We like to always account for this number (even if you will be managing yourself) because if there comes a day when you are sick of personally managing the property, you will have to delegate this task to a Property Management company. We do this so we ensure we still have a positive Cash Flow when you decide to turn the property over to management.
Capital Expenditures - Your CapEx costs can be somewhat subjective but you need to put together a system to account for these costs. A capital expenditure is something you can capitalize over a period of time. It adds to or upgrades a properties physical asset. An example of Capital Expenditures are: new roof, appliances, flooring, furnaces, air conditioning system, electrical system, plumbing, foundation, extensive exterior paint, etc. These costs will not effect your Net Operating Income (which we will talk about later) but they are costs you should account for when projecting cash flow. We have found a good way to account for these costs to depreciate the life of the asset based on the cost of that item. For instance, if the previous owner put a brand new roof on the property and the replacement cost of the roof is $10,000 and you believe the life expectancy for this item to be 30 years. Then you would forecast an annual cost of $333.33 and $27.78 monthly. You would do this for each Capital Expenditure for the property.
Before we go into analyzing a property, let's talk about the last major expense: The Mortgage.
Now there are several different ways to acquire a property, but for the sake of this example, we will consider a traditional purchase.
Let's take a look at a hypothetical scenario:
148 Park Way is for sale at $200,000.
Down Payment = 20% = $40,000
Loan Amount = $160,000
Interest Rate = 5.2%
Term = 30 years
Mortgage Payment = $878.57
Now obviously, if you were to purchase the property in cash, you would have no mortgage payment thus increasing your Cash Flow. However, just because you have an increase in Cash Flow (when you buy a property in cash) does not mean that you have a better percentage return on your investment (ROI)
The Fun Part - Running The Numbers
Now that we have went over all of the details of the income and expense categories, it is not time for the fun stuff. Once we have all of the data that we need to run the analysis, we can determine all of the dollar figures and ratios we need to make an educated decision on the investment. Let's continue on with our scenario from above:
148 Park Way
Sale Price = $200,000
It is a 6 bedroom 2 bathroom duplex, where each side rents for $1,100 a month.
The first step in the process of the analysis will be to determine the Gross Scheduled Income (GSI) on the property.
Gross Scheduled Income - This is the annual income of the property if all rentable space were rented and collected.
$1,100 x 2 = $2,200 a month
$2,200 x 12 = $26,400 a year
Vacancy / Credit Loss - This property was recently renovated and is in a desirable area. For these reasons we project a vacancy & credit loss of 5% for the year.
$26,400 (GSI) * .05 (Vacancy) = $1,320 a year
Gross Operating Income - This is the actual income that you can expect from the property, taking into consideration vacancy & credit loss.
$26,400 (GSI) - $1,320 (Vacancy) = $25,080
Operating Expenses (annually)
School Taxes - $1,820
County / Town Taxes - $2,470
Insurance - $800
Repairs - $1,300 (5%)
Water - Paid for by tenant
Sewer - Paid for by tenant
Garbage - Paid for by tenant
Gas - Paid for by tenant
Electricity - Paid for by tenant
Snow Removal - $400
Lawn Care - $400
Property Management - $2,080 (8%)
Estimated Operating Expenses - $10,830
Net Operating Income - is simply the annual income generated by an income-producing property after taking into account all income collected from operations, and deducting all expenses incurred from operations
$25,080 (GOI) - $10,830 (Operating Expenses) = $14,250
Annual Debt Service - the total principal and interest required to be paid in a calendar year
$878.57 x 12 = $10,524.84
Capital Expenditures - A capital expenditure is something you can capitalize over a period of time. It adds to or upgrades a properties physical asset.
Capital Expenditures = $2,311.67
Estimated Cash Flow (Annually) - The net result of gross income minus expenses and debt service.
$14,250 (NOI) - $10,524.84 (Operating Expenses) - $2,311.67 (Capital Expenditures) = $1,413.49
Estimated Cash Flow (Monthly)
$1,413.49 / 12 = $117.79
Cash on Cash Return (ROI) - The net profit of an investment is divided by the amount of money invested, and the results are expressed as a percentage or ratio.
$1,413.49 (Annual Cash Flow) / $40,000 (Down Payment) + $4,800 (Closing Costs) = 3.15%
Cap Rate - shows the potential rate of return on the real estate investment if you were to buy the investment in all cash
$14,250 (NOI) / $200,000 (Fair Market Value - Purchase Price) = 7.125%
Gross Rent Multiplier - is the ratio of the price of a real estate investment to its annual rental income before accounting for expenses such as property taxes, insurance, and utilities; GRM is the number of years the property would take to pay for itself in gross received rent.
$200,000 (Selling Price) / $26,400 (Gross Scheduled Income) = 7.57
Debt Coverage Ratio - is a measure of the cash flow available to pay current debt obligations.
$14,250 (NOI) / $10,524.84 (Annual Debt Service) = 1.35%
Based on these calculations, you will have decide if the profit generated from this investment meets your profit requirements. Before you begin purchasing rental property, you should put together a plan. This plan should layout your goals and your profit expectations for each property that you purchase. By having these thresholds, you will have a target for each analysis that you run.
Hopefully this post, gave you a better understanding of the basics you need to work through when analyzing a rental property. As you can see, there is some work that goes into determining your final calculations and the numbers you need to know to determine if this investment meets your profit requirements. We wanted to give you this information to help avoid you buying a bad deal. After all bad deals can a lot of financial damage to you and your family. Remember for each property you analyze, do your home work and understand the numbers involved in the transaction.
HS Property Funds, LLC