| This Is A Member-Only Page There are many different financial analysis tools available to help determine what price an investor can reasonably pay for a given income property, and what kind of return they are likely to receive on their investment. The more sophisticated the analysis, and the longer the projections into the future, the more assumptions must be made that can make such predictions invalid. The primary factors that will always affect return on investment is the NOI and the amount of leverage you are able to achieve.
If you are not yet familiar with the leverage concept, start you exploration of this phase of our approach to buying income producing real estate by spending a few minutes reviewing our page on Leverage.
Next, you may wish to become familiar with the various tools used to analyze a property's value as an investment vehicle and its likely financial performance over time. They are:
Also See: Financial Analyses of a Single family rental home in suburbia
The most conservative rental housing investment is almost always a single family home in a stable, suburban neighborhood. More than a third of the housing in America is rental property, and about 60% of that is single family housing, so there is always a market for that kind of property. Interestingly, more than half of the rental property held by Real Estate Partnerships is also single family housing. We have taken a typical example and run some numbers for you to work from to analyze a property in your own market. Check the numbers.
Capitalization Rate
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EXAMPLE: An investor is considering purchasing a property priced at $120,000. The property has an estimated net operating income of $12,600. Cap rate = $12,600 divided by $120,000. Cap rate = 10.5 percent.
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Cap rate calculation is highly subjective. Therefore investors must be certain to use realistic figures. The amount used for the total amount invested should include both the down payment and the borrowed money necessary to make the purchase.
A Cap Rate is often used to determine the value of income producing investments. Appraisers divide the NOI by the Cap Rate to estimate value. Net Operating Income, is gross income, less operating expenses like: taxes, insurance, maintenance and repair. Debt service is not deducted from the number. For example: if you have a property that rents for $1,000 per month. That produces $12,000 gross, less $2,000 taxes and insurance and $1,000 for maintenance and repair. You have an NOI of $9,000.
Capitalization rates crept up to 11.7% from 11.3% a year or so ago. Take that $9,000 and divide by the 11.7% rate. It would produce a value of $76,923 for your property, down from a value of $79,646 under the old rate.
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Cash on Cash Rate of Return The cash on cash rate of return method uses cash flow analysis to determine the value of property. It is calculated using the following formula:
Cash-on-Cash rate of return is Net Operating Income less Debt Service divided by Equity
EXAMPLE: A property's Net Operating Income is $100,000, with a Debt Service of $70,000, giving a Cash Return of $30,000.
The owner's Equity is $150,000.
Cash on Cash rate of return = $30,000 divided by $150,000 = 0.2 or 20%
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Debt Coverage Ratio.
The ratio between the annual Net Operating Income and the Annual Debt Service is the DCR. A property with a 1.2 Debt Coverage Ratio produces income before debt service that is 1.2 times as much as the debt service. The investment property generates 20% more net income than it needs to make its mortgage payments.
Most lenders require a Debt Coverage Ratio of at least 1.2 and usually desire 1.5 to finance an income property. This ratio is intended to predict our ability to meet mortgage payments. A presentation to a lender should always include the anticipated Debt Coverage Ratio extended to at lease five years.
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Fair Market Value
The most probable price a property should bring in a competitive and open market under all conditions requisite to a fair sale, the buyer and the seller each acting prudently, knowledgeably and assuming the price is not affected by undue stimulus. Implicit in this definition is the consummation of a sale as of a specified date and the passing of title from seller to buyer under conditions whereby:
- buyer and seller are typically motivated;
- both parties are well informed or well advised and each acting in what he considers his own best interest;
- a reasonable time is allowed in the open market;
- payment is made in terms of cash in U.S. dollars or in terms of financial arrangements comparable thereto;
- the price represents the normal consideration for the property sold unaffected by special or creative financing or sales concessions
*Granted by anyone associated with the sale. *adjustments to the comparables must be made for special or creative financing or sales concessions.
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Gross Rent Multiplier: The simplest way to obtain cursory estimates of the value of a property-the so-called "yardstick value"-is to calculate the gross rent multiplier (GRM). This method compares the property's sale price with its current gross annual rental income to determine whether the income will cover your new mortgage and operating expenses. The gross rent multiplier is calculated using the following formula: GRM = Sale price divided by the Gross annual rents The higher the gross rent multiplier, the more likely the property will yield a negative cash flow. Investors should not pay more than five to six times gross rent.
For Example: A property selling for $200,000 yields $16,700 in annual rent. The gross rent multiplier is calculated as follows: GRM = $200,000 divided by $16,700
GRM = 12
The property is selling for twelve times its annual rental. Investors should note that the gross rent multiplier does not take operating expenses into consideration; this can sometimes result in overvaluation. For example, buildings with common heat, electric or water have much higher expenses that those in which tenants are responsible for their own utilities; this dramatically lowers net operating income, but would not be reflected in the gross rent multiplier analysis. As noted above, GRM analysis should be used only to obtain a rough estimate of the property's value as it relates to income. The analysis is usually used to check sales information in a multi-listing service where only gross income and sales price are available on a comparable properties.
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Internal Rates of Return:
Internal rate of return (IRR) and financial market rate of return (FMRR) are sophisticated valuation methods used when properties have uneven and/or negative cash flows. They usually factor in tax ramifications and a sale of the property at some future date. The IRR uses discounted cash analysis to measure investment yield. The FMRR is a modified IRR that accounts for negative cash flows by using a safe estimated rate to save funds and earn interest in profitable years. Investors should note that IRR and FMRR are based on assumptions that may not be accurately predicted.
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Market Analyses:
A real estate appraisal term for determining what price the property is likely to bring in the local market at a certain point in time. The value is determined by comparing the subject property to similar properties that have recently sold, those that did not sell, and those that are currently being offered for sale. The best indicator of value for owner occupied housing.
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Price Per Square Foot:
Calculating price per square foot and price per unit is a good way to evaluate a property against comparable buildings in the area. Commercial buildings are usually leased at a annual square foot rate. So values are compared by calculating the price per square foot. Price per square foot is derived by dividing the building's cost by its square footage. The average cost per square foot of class A apartments during the second quarter of 1999 was $77.59, up 10.6 percent over 1996 and 20.8 percent over the same period of 1995, according to Coldwell Banker Commercial's National Sales Index.
Multifamily property asking prices in the second quarter of 1999 dropped 3% nationally to $57.67 a square foot from an average of $59.50 a year earlier. Midwest prices have declined 10.5% to $43.14, while the West edged up a little less than 1% to $70.46 per foot. That indicated a difference of 61.23% in the value of a comparable property in the Midwest, compared to the West.
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Price Per Unit:
Price per rentable unit is more commonly used on residential rental properties. Price per unit is derived by dividing the sale price by the number of units.
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Payback Rate:
The payback rate is an old-fashioned but widely used yardstick to calculate the owner's return. It simply measures how long it will take for an investor to earn back the investment. If the investor purchased a building for $1,000,000 in cash, and the property delivered an annual return of $100,000, at an 8% cost of funds, the payback period would be just under 14 years. The information presented above is a basic overview. We provide an entire e-course on the subject of Valuing Income Property in our CornerStone University. Also See: Financial Analyses of a Single family rental home in suburbia to top
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