When you look at a property how do you know if it’s good? What do you look for? Investing in property is all about numbers. Don’t get emotionally attached to a nice looking property and that’s why you need to know how real estate investment analysis works. Remember its an investment not your home that you’re going to live in. You might be eager and say “show me the money” but wait before I show you the cash flow (not money!) let’s look at some numbers to analyse a residential real estate investment.
If you are not well-informed about how to analyse an investment then most likely someone will take you for a ride. You don’t want to be in that position.
Lets use an example seller pro forma to help us understand the numbers.
One Percent Rule
This is one of my favorite as you can quickly determine if the property is over priced. You need to know an estimated monthly rental amount for the property you are looking at for this calculation. Most often than not you can find this in a property pro forma that a seller provides.
One percent rule = (Monthly rental/Purchase Price) * 100
This should equate very close to 1% if not the property is over priced.
For our sample property this is = (1,325/137,000) * 100 = 0.96 (This is good as it’s close to 1%)
If the property is way under 1% then the seller is not going to simply agree to reducing his price. If there are good reasons you can find and negotiate with the seller then great if not walk away! If only I had known this rule before I would have saved a lot of time. This rule is about cash flow. If the property is not close to 1% then it most likely will not be cash flow positive. This rule determines quickly if the property will be able to make mortgage payment. There are other costs that need to be taken into consideration but this rule will quickly help you short list properties and save time.
Gross Rental Yield
In our example, Gross Rental Yield = (15,900 / 137,000) * 100 = 11.6%
Gross Rental Yield is simply the gross rent before expenses expressed as a ratio of the purchase price. The gross rental yield does not take expenses into account and hence a better ratio to use is net rental yield or net return which simply uses net income. In our example the net income is $8,758 and the net yield is 6.39%. Compare that to the Australian property market which at best produces 5% gross rental yield (not net!).
Gross Rent Multiplier (GRM)
In our example, GRM = 137,000 / 15,900 = 8.62
This simply means the property will take 8.6 years to pay itself off without considering any expenses or loan arrangements. This allows you to compare one property to another. The lower the GRM the better for the investor. The typical GRM could range between 4 & 9 and anything under 7 is great.
Cap Rate or Capitalization Rate
In our example, Cap Rate = 8,758 / 137,000 = 6.4%
Cap rate does not take into consideration the loan arrangements but it does consider property related expenses. Hence this is a better ratio than the GRM and allows investors to quickly compare properties and their returns.
Cash on Cash Return
In our example , Cash on Cash = (2,384 / 31,647) * 100= 7.53%
Cash on Cash is essentially what is your return on investment. For the money you put in, you will get 7.5% return before taking into consideration other benefits such as depreciation, mortgage pay down and property value appreciation. Please note the example pro forma above displays a typical 20% down payment for a local buyer and foreign buyer’s down payment will be higher.
This is another one of my favorite. Cash flow is simply the amount of money you get in your pocket after the property pays for itself. Positive is good (positive cash flow property) and negative is bad. Our example property brings in almost $200 cash flow per month or close to $2,400 per year. It is important to also note and validate the assumptions like vacancy, maintenance and property management rates. I have tried to keep the ratio’s to a minimum so that I don’t overwhelm you but there are more that you can learn overtime.
My 5-year-old daughter watches Sesame Street and there is a segment called ‘what’s the word on the street?’ In this segment they teach a new word every day. The last three words she learned were courteous, concentrate and absorb. Initially she had no idea what these words meant then slowly she started to learn and understand. In less than a week she started using these words in her daily routine. Real estate terms are a little like that, the more you practice the better you get at grasping the vocabulary!
- A pro forma like the one above is a good starting point but you have to do some research to confirm the numbers on it.
- A foreign buyer should never buy US property based on any website! You should first find advisers and a team to invest with. Why? Well I saw an apartment for $5,000. That’s right it was $5,000 and it was a foreclosed property. The tenant had trashed the property before leaving it for the bank. There was nothing inside the property no electric cabling, no sink, sorry I should say no bathroom or kitchen. Now do you think they are going to mention all this in the ad?
- A foreign buyer should also never try to find financing on their own. You need an adviser and a team. You will waste a lot of time if you try to do this on your own. You need someone on your team who can get the financing and knows the lender’s requirements.
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