5 Step Basic Assessment Of Rental Property Viability

By on August 22, 2017

Even today with basic houses transacting on average in the hundreds of thousands of dollars each, a lot of investors still go in based on a hunch or just a “good feeling”.

No matter how many real estate crashes we’ve experienced in our lifetime and the ones we’ve only read about from history, people never seem to learn from their mistakes.

Part of this buying psychology is due to the higher tendency for real estate values to go up rather than down. So one would really have to be down on luck to buy a lemon and find little opportunity to exit before the losses stack up.

Yet the irony of real estate is that it might only take one bad deal for your to lose all the profits you’ve generated over the years… and then some.

This is why it boggles the mind that even to this day, a majority of investors in rental property don’t do enough analysis to evaluate the viability of their investments.

You don’t need to know quantum physics by hard or be slick with relativity theory to conduct a basic assessment on a rental property for prudence.

Here is a basic 5 step process to do just that.

1) Verify income

When a seller declares the current income of a house, you’d be a fool to take him by his words.

Since income is the key element in rental property success, it is critical that these numbers are verified so that you have a good idea of what you are exactly getting into.

For a start, there are 3 types of income to get accustomed to:

  1. Current income
  2. Potential income
  3. Future maximum income

Unless there are other sources of income, we will just refer income to rental.

Current income is the actual rental income that has been collected in the most recent 12 months.

Potential income is what the income could have been if it’s revenue generating potential was maximized in the last 12 months. If it is a multi-unit building in question, this would definitely take into account 100% occupancy.

Future maximum income is income that the property can potentially make in the markets today.

Landlords who are desperate to sell often try to value their properties based on the future maximum income. This is even when their current income is less than half of that.

You can’t really fault them for trying.

However, as the shrewd and pragmatic investor that you are, you should always start negotiation with the current income as the starting point… or lower. In other words, wholesale price.

But it is not uncommon for high profile property to close based on future potential income. It’s not difficult to find buyers willing to pay retail price for proven and easily marketable real estate.

And this is probably out of the league of what most of us are used to.

It would be easy enough if the rental property you are considering to buy is a single-family home.

It would be a little more complicated for multifamily property as you would inevitably have spreadsheets and tables thrown at your to decipher in the office.

Learn to differentiate between a pro forma income statement and an actual income statement.

Just be mindful and meticulous when going through these statements including the rent roll. And don’t be afraid to ask for clarification when in doubt.

2) Verify expenses

After income, the second most important variable is the expenses. You don’t need anyone to tell you that income minus expenses equals profits, do you?

This is why total expenses need to be verified.

Just as a seller would lean towards future income, he would lean towards lower expenses here.

And just like income, you should put your focus on actual expenses instead of projected ones.

Landlords who manage more complicated operations like those of a multifamily building will almost certainly have an expense table to refer to.

In many cases, the typical profit and loss statement will be lacking in details. This is why you need to review a more in-depth statement of expenses.

3) Net operating income (NOI)

Now that you have the actual income and expenses calculated, it is time to subtract the latter from the former.

The balance you are left with is the net operating income.

Compare this with what was disclosed by the seller initially.

Does it make sense? If not, why is that so? Have you made any mistakes in the equation?

Because the figure here is generated from activities that made up income and expenses, sometimes even a single variable in those two areas can grossly affect the NOI that you have ended up with.

The NOI is essential for the next step. This is why it has to be as accurate as possible.

4) Capitalization rate

There are a number real estate ratios that investors use when evaluating deals.

What you are more interested in here is the capitalization rate… which will give you an indication of it’s valuation.

This is a simple formula of NOI divided by purchase price.

With the final results after applying this equation, you will be able to work out a figure proposing what the property is actually valued at from your investor’s perspective.

As you can see. With simple mathematics, you should be able to tell why NOI in the previous step is a critical element in this whole assessment viability process.

If you use the numbers provided by a seller before your own calculation, and work out a capitalization rate of 7%, you need to ask yourself if this is what you are going after in this particular investment.

Now if the seller has absolutely no idea what he’s doing and provide figures that result in a capitalization rate of 20% due to a low selling price, you might want to consider closing the deal as soon as possible as he is most probably grossly undervaluing the property.

Or maybe… you have your numbers in a twist?

On the other hand, if you bring an industry capitalization rate into the picture and divide NOI with it, you would get the market price of the property in question.

Which leads to the question. Is the asking price higher or lower than the market value?

5) Returns after mortgage

The biggest expense that will be constantly chewing on your profits are the mortgage payments.

So it wouldn’t be fair at all to count your chickens before factoring in the mortgage expense.

Let’s say for example that a transaction price of $250,000 has been agreed. And you are taking up an 80% loan-to-value with 20% down payment. At a term of 20 years at 7%, we are looking at an annual expense of about $18,500.

If the NOI is $22,500, this would work out to $4,000 projected profit.

Taking into account the 20% down payment of $50,000, $4,000 divided by $50,000 would give us 8% cash-on-cash return.

Does 8% come close to your investment goals?

In closing this chapter, take note that this 5-step assessment process is a a very basic analysis system. When you get more involved in real estate investment, it is paramount that you will be using much more ratios and formulas to judge investment viability.

But for those who don’t do a lot of calculations before investing in rental property, this process is the very least that you should perform in order to get a general overview of how good a deal really is.



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