The key to hitting a home run in Real Estate investing is to buy a property with strong income potential for less than the market value of that income. This, actually very simple process, is usually the determining factor in a successful property investment strategy. In order to buy a property below the value of its current or potential revenue it is essential to make an accurate analysis of the both the property and its future earnings. This should be done at the very beginning as a way of screening potential investments. To do this accurately however, there are a few key indicators to keep an eye on.
Cash Flow
A strong and stable cash flow is the backbone of any good investment property, and can very easily be compared to other similar properties as an indicator of the properties’ relative performance. To calculate monthly cashflow simply subtract the properties’ mortgage from its total rents, it should go almost without saying that if this number is negative its best to walk away, at least for a novice investor.
Cash On Cash Return
Not a very important measurement technically speaking, the cash on cash return simply indicates how long it will take the property to pay of the down payment. The strength of the cash on cash return analysis is that it essentially compares properties’ prices to income levels as a ratio. To determine the cash on cash return for a property multiply the monthly cashflow by 12 which gives the properties’ annual cashflow, then divide your down payment by the annual cashflow.
Gross Income
One of the most basic and occasionally miscalculated indicators, the Gross income is simply the sum of all the properties’ income streams. Typically this will mean the total of all rental income, but other income such as laundry machines or storage should be included as well. The addition of some of these additional streams of income may turn a seemingly poor income property into a real money maker.
Effective Gross Income
A more realistic look at a properties gross income, the effective gross income factors in the vacancy rate. It is calculated by taking the gross income as an annual total and subtracting the percentage of vacancy. This is an important filter for taking a closer look at properties that seem too good to be true, often a property will have a very low vacancy rate because the rental rate is too low, or a very high rental rate and concordantly a fairly high vacancy rate. Ideally investment properties should find a balance between profitability and stable predictability.
Net Operating Income
Perhaps the first real glimpse at an investor’s potential income from a property, the net operating income is derived by subtracting the operating expenses from the effective gross income.
Capitalization Rate
The capitalization rate, often referred to as the CAP rate, looks at the properties net income in terms comparable to a more conventional investment such as CD’s or bonds. To determine the CAP rate for a property divide the total sales price by the net operating income. It is worth noting that the CAP rate looks at the property as if it were paid for in cash with absolutely no financing.
Debt Service
Debt service is essentially industry jargon for the monthly mortgage payment. It is important to compare apples to apples when dealing with debt service, however, the previous owners may have had extremely good or bad credit or purchased the property at a time when interest rates were either very high or very low, dramatically affecting the amount of their interest payment and the rate and terms of their loan. Also be sure to look at the number of loans on the property, as there may have been second or even third lines of credit taken against it. This is an important step for generally calculating a properties income potential, however, bear in mind that it is only an estimation at this stage.
Operating Expenses
The operating expenses are all of the properties other expenses aside from any mortgage payment or debt service. These usually include insurance and property taxes as well as landscaping, maintenance, repairs and management fees, and possibly others depending on the property. Always be sure to verify that the properties expenses actually are what a seller claims they are, this may require some digging but it is much easier than being stuck in a property that is losing money every month.
Vacancy
A vacancy is any unit that is either unoccupied or is occupied by a tenant who does not pay rent. Many owners would rather sell than try to deal with a difficult or unruly tenant who refuses to pay, whether the tenant can be evicted or not is an important consideration before moving forward on any such property.
Vacancy Rate
The number of vacancies per year divided by the number of units, for smaller one to four unit properties it is a good idea to calculate vacancy over at least 3 to 5 years to get an accurate measurement of it. While some degree of vacancy is natural, too much could be an indicator that the current rental rate is too high or even signal a change in the local Real Estate market.
In time crunching the numbers on a list of potential investment properties becomes fun and fairly easy to do, many seasoned investors can perform a quick analysis literally on the back of a napkin. Bear in mind too, that these are not the only indicators of a property’s value; there are many more sophisticated, technical ways to determine a properties true value, however for small properties these will serve as a good indicator of whether the property deserves a closer look or not.