 Think that cute little 3BR/2BA brick and siding bungalow across town might be a great rental property? It might be! But when you buy investment real estate, you're not just buying bricks and mortar, green shag and pink tile at a great fixer-uppoer price. You're buying a "Money Machine." It's not the house, or duplex, or shopping center itself. It's what you can get out of it! The "Net Operating Income" is actually what's for sale.
Here are a few tips to make sure you don't just buy that house because it's a great price and you think someone might want to rent it: Compare the Numbers - 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 decision on "price" alone. Unless you're paying all cash - which, normally, you shouldn't do - price is just a function of the loan terms. As interest rates go up, the value of the property goes down. NOTE: This is especially important to consider if you're selling investment property. When selling, you must have assumable financing! Otherwise, you're at the mercy of what rate the buyer can get for financing. 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 the property is to combune these three legs - income, expenses 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! Consider this: Operating Expense - A primary concern in considering an investment property is what it will cost you to operate the property. What will it cost to fix the place up initially? What will annual repairs cost? Real estate tax? Association dues? Management costs? Insurance? Utilities? Advertising? Supplies? Miscellaneous expenses? If the property has never been rented before, you need to develop an 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. (In fact, I will not list a rental property unless the seller provides a copy of the Schedule E for my file!) Operating Expense is the first leg of the stool. Gross Multiplier - Pricing investment real estate is an art. There's may not be a totally right or wrong method. But, unfortunately, some investors don't have any method! The Gross Multiplier is an easy rule of thimb to forecast a propertt's value. Many people use this method to determine what they should pay for investment property. 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. many investors say, "I pay 7 times gross," or "I only pay 6 times gross." But what if your operating expense turn out to be 8 time gross!?! This method considers only one leg of our 3-legged stool. It does not take into account operating expense or financing. 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. To calculate the Cap Rate, you use the "net operating income" and the property price. However, the method assumes you are paying cash. So it only considers two legs of the stool, and ignores the third, financing. With 9% financing or 12% financing, the Cap Rate will stay the same. The primary benefit of the Cap Rate is its indication of the interest rate at which you should borrow. If the interest rate offered you is less than the Cap Rate, the property is producing more than the money is costing you. If the interest rate is higher than the Cap Rate, don't even think about it! This indicates that the property is not producing enough to service the financing. Never risk borrowing more money than the property can support. Cash-On-Cash - Sometimes called "equity dividend return," for my money, this is the only way to determine the value of an investment property. It considers all three legs of the stool... income, operating expense, and financing. The Cash-On-Cash formula 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 an investment property you already own, or how one property compares in value to others you're considering. And there's one last thing we haven't mentioned... Appreciation - Anytime you buy real estate, you naturally hope that it will appreciate in value. And for the past several years, appreciation in the market has certainly been good. But you should 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! In fact, when doing investment analyses for my clients, I figure zero appreciation. Thay way, they will know that the return on their investment is based on facts and figures, not speculation. The investment will work for them even if the market goes stale. One final note: In 2004, investors lowered the pre-tax yields they require to go into real estate - whether it's a single house, and office building or a large shopping center. The required return is at its lowest level since Real Estate Research Corp. started tracking figures in 1979. Behind the drop, RERC says, is the fact that investment real estate poses a low risk factor relative to other investments! |