Always Make Sure the Numbers Work When Buying Income Producing Real Estate

One of the cardinal rules of real estate investing is to make sure the “numbers” work.   Good real estate investors constantly harp on making sure the numbers are right before doing any deal.  What does that mean exactly?  Primarily it means two thing:  Analyzing of key numbers and positive cash flow.

The key numbers are rents, expenses, net operating income, cap rate, and cash on cash return.  There are other metrics that matter too, but these are the main items that will largely impact your investment.  In an ideal world, most of these will be provided for you with audited bank statements, but I wouldn’t count on it.  Often times, you will get partial and incomplete information, or sometimes no information as the owner hasn’t kept any records.  You then must do some detective work and educated guessing as to what numbers to assign to each item.

Rents are obviously key as they are the main and sometimes only revenue collected from the investment property.  To verify the rents, you must look at the leases to determine what the tenants are paying.  Do not just take a broker’s or seller’s word for it.  Income must be verified.  Another way to verify although less common, is to view a tenant’s estoppel certificate.  This certificate just states what rent a tenant pays and is read and signed by the tenant.  If this is combined with the lease verification, that should be enough tangible proof that the rents advertised are the rents that the tenants are paying.

The second important item to verify would the the operating expenses of the property.  You want to have a good idea of what the property taxes, insurance, management fees, maintenance, landscaping, and utilities are costing.  These will vary depending on the state and the type of property.  A commercial building such as an industrial warehouse where the tenant has signed a triple net lease, meaning that the tenant pays the property taxes, insurance, and maintenance for the building could have very little in the way of expenses.  On the opposite end of the spectrum, an apartment building where the landlord pays for all tenant utilities as well as other operating expenses could have an astronomical expense ratio.  You can get a pretty good idea about what the taxes, insurance and management fees are going to be, but maintenance is by far the most difficult to pin down.  If the owner provides financial statements with past maintenance expenses, they may or may not paint an accurate picture of the expenses going forward.  This is where an investor just has to have a “feel” for what a building will need.  A good rule of thumb is that older buildings will need much more maintenance sometimes up 15% of gross rents, and newer buildings will need much less such as 5% of gross rents.  This number is quite variable and very difficult to consistently estimate.

Net operating income or NOI is what you have after subtracting the expenses from the gross rents less vacancy.  Vacancy can be estimated by looking at the vacancy rate in your local market.  If your market is averaging 5% vacancy, it’s likely your property will as well.  So if you have $100,000 in gross potential rents less 5% vacancy, that gives you $95,000 in gross rental income minus $45,000 in expenses for a NOI of $50,000.  A good although imperfect rule of thumb is that the total expense ratio including vacancy will be somewhere around 50% of the gross potential income.  This mainly applies to multi-family as other properties would depend on lease terms.  This is obviously imprecise and much more detail is needed, but it is a good rule of thumb for comparison.  If you come across a rental property that is advertising a 20% expense ratio, you know that is not realistic.  Some can average 35%, but it’s extremely rare in my experience to go much below that number on a consistent basis.  After you have the NOI you can capitalize it by dividing it by the cap rate for similar properties in that particular market.  If properties are trading at a 7% cap rate, then that would give you a value of $714,285.  ($50,000/.07)  You would then compare that to the list price to see if it’s under or overpriced, or priced correctly.

Finally, most people will end up having to finance the property through a bank loan.  The main numbers for a bank loan are amortization period, term, and interest rate.  A longer amortization period is ideal for cash flow.  If your goal is for the property to produce robust cash flow immediately, it would be in your best interest to try and stretch the amortization period out as long as possible.  Twenty years is fairly common, but some loans can have 25 or 30 year amortization periods.  The term of the loan is very important.  The term limit is when the loan must be refinanced or paid off.  It is very risky to have a three or five year term.  If the economy tanks and your term is up and you must refinance, you may have a hard time finding a decent loan from a lender.  Either the interest rate is too high, or even worse you must sell the property to pay off the loan.  Ideally, you want a loan term that is ten years or longer.  As far as the interest rate goes, it’s common sense that you want a lower rate, just make sure the amortization period and the term are agreeable as well.

After those items are taken care of, you want to make sure the property cash flows.  That means the NOI from the property is greater than the debt service.  This is probably the main thing investors talk about when they say the numbers must work.  If you have a property that produces $100,000 in NOI but has $120,000 in debt service, you will be losing $20,000 per year unless you can get expenses down or rents up.  Fortunately, banks will somewhat protect you in that they will not loan on a property unless the NOI covers the debt around 1.25 times.  This is called the debt service coverage ratio.  Banks want to make sure there is some cushion in case NOI comes in smaller than expected.  In the above example, in order for the bank to loan on the property, they would need to see $150,000 in NOI or greater.  If the NOI was lower, the investor would have to put more money down and have a lower loan to value ratio.

You will also want to calculate the cash on cash return.  This is done by subtracting the debt service from the NOI and dividing by your down payment plus the costs of acquisition.  If NOI is $150,000 and debt service is $120,000 that leaves $30,000 in cash flow.  If the down payment was $500,000 and acquisition costs were $100,000, you would have a cash on cash return of 5%.  Keep in mind this would just be for year one.  Should rents and NOI rise in the future, this number will get higher and higher as the debt service remains fixed.

This was a basic rundown of the numbers needed to analyze whether or not an investment property makes sense.  If these numbers look good, it is likely that you have a decent investment.  If they don’t work, or require very optimistic assumptions to work out, tread carefully and rethink whether buying the property is a good idea.  For more advanced investors, there are more in depth numbers to study such as IRR, but these basic numbers should keep most investors out of trouble.

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