Evaluating an Investment Property

by Jeff Fulmer

It's a great time to invest in real estate - property values are down and so are interest rates. But, how do you go about evaluating if a property is a sound and worthwhile investment? How can you compare one duplex in Sylvan Park to another one or determine if that condo for sale in Nashville would make a good rental?

Well, how much the seller is asking has absolutely nothing to do with the actual value of a property. What the previous owner paid for the property is equally irrelevant. To ascertain a rental property, it's important to review the four basic reasons for investing in real estate:

1. Income or cash flow
2. Principal reduction
3. Tax savings, primarily depreciation
4. Appreciation

It's a wonderful thing when all of these advantages come together to maximize your overall investment. However, principal reduction takes years to pay off, and now, so does appreciation. While there is a lot to be said for tax savings (see my previous blog entry, "What Everyone Should Know before Investing in Real Estate"), it is not a good reason to pick one property over another. The most important component to evaluate a property is the income or cash flow.

So, the next question to ask is how much money or income is the property producing? This is a harder question than it sounds because there are a variety of types of income: gross scheduled income (maximum rents), gross operating income (after vacancy rates), net operating income (after operating expenses), and cash flow (after debt service, but before taxes). You will need to answer all of those questions as accurately as you can before delving into the methods of valuation:

1. "Gross Multiplier" is the price you paid divided by the gross income. This will give you a quick, rough number 'times gross.' The problem with this method is it doesn't take into consideration the financing or operating expenses.

2. "Price Per Unit" is the total price divided by the number of units and is often used when looking at multi-unit buildings. There are people who say they won't pay X amount per unit, but if they are not looking at the 'income per unit,' it's not a very useful number.

3. "Price Per Square Foot" is the total price divided by the total square footage; yet another very popular means for evaluating all types of real estate. For example, the price per square foot for a home in a Franklin TN neighborhood may be $130 a square foot, but the home you are looking at may need to be gutted, or it may be much smaller than the average, driving up the price per square foot. Yes, it's a good number to know, but it doesn't take into consideration the size or quality of a property and, in the case of rental property, it doesn't include income or expenses.

4. "Cash on Cash" measures cash flow divided by the amount of cash invested. This percentage is probably the best method to evaluate a given property since it takes into account income, expenses, financing. What it doesn't do is translate easily into a price you should pay for a property and is best used to compare with other properties.

5. "Capitalization or Cap Rate" is net operating income divided by the total price. Like "cash on cash," cap rates are useful when comparing more than one property. Another way to look at cap rates is what you'd be earning if you paid cash for the property, since it doesn't take into consideration financing. In other words, your "cap rate" needs to be higher than the interest rate at which you are borrowing money.

Now, if you know the cap rates for similar properties in your market, you can work the formula backwards to determine the value of a property. Take the Net Operating Income and divide it by the average cap rate for your area, and you should get a realistic price.

6. "Float and Desire Method" (or Debt Capacity) is what you can afford to pay given a neutral cash flow. The formula is the net operating income divided by the interest rate of your loan divided by the loan to value (if you're putting down 20%, LTV would be 80%). By working the formula backwards (price X LTV = Amount of Loan; net operating Income divided by amount of the loan), you can also determine the highest interest rate you can afford to pay. *(These formulas assume an interest only loan). The point is that financing changes the value of a property.

It's recommended to look at most, if not all, of these methods when evaluating a specific property. Knowing all the numbers going in will minimize your risk and help you find the best property possible for your budget. If carefully selected, you will end up with an investment that will pay you back for the rest of your life.

For help in looking for the right property for you, contact Jeff Fulmer at 615-545-8611 or jeff@jefffulmer.com

HOME SALES INCREASE FOR SEVENTH CONSECUTIVE MONTH

*The following is the press release from the Greater Nashville Association of Realtors April Home Sales Report. If you would like to see the actual report with the comparison of sales for 2009 and 2008, click here. If you would more information about a house or condo in the greater Nashville area, feel free to visit my web-site at http://www.jefffulmer.com/.


There were 2,145 home closings reported for the month of April, according to figures provided by the Greater Nashville Association of REALTORS®. This represents an increase of 33.7 percent from the 1,604 closings reported for April 2009.

Year-to-date closings are up compared to last year with 6,337. That is an 18 percent increase compared to the 5,366 closings reported through April 2009.

“For the seventh consecutive month, home sales in Greater Nashville have increased,” said GNAR President Lucy Smith. “Stable prices for single family homes and condominiums paired with an increase in pending sales create a hopeful sign as we move into the summer selling season.”

“Many people may be wondering about the impact the recent flooding could have on the real estate market. Clearly, the damage and loss is significant in both downtown commercial and area residential property. There may be a brief impact, but there is likely to be continuing sales activity throughout Middle Tennessee. And, the exceptional job of response by both area volunteers and community leaders confirms that Greater Nashville will continue to attract companies and families. The true heart of this city has been revealed to people around the country and what they are seeing is very compelling,” Smith said.

There were 2,505 sales pending at the end of the month, compared to the 1,865 pending sales at this time last year. The average number of days on the market for a single-family home was 87 days.

The median residential price for a single-family home during April was $164,950 and for a condominium it was $143,950. This compares with last year’s median residential and condominium prices of $164,500 and $149,900, respectively.

Inventory at the end of April was 24,352, down slightly from 24,408 in 2009.

“Inventory remains stable, down only slightly from where it was a year ago,” Smith added. “Residential and condominium inventory levels are both up from where we were last year, with farm, land and lots down. The increase in home sales over the past several months proves people are continuing to make Middle Tennessee their home. Even with the expiration of the home-buyer tax credit, low mortgage rates and median prices make this an ideal time to purchase in Greater Nashville.”

Agent: Prices will rise as waters recede

Hammond looks to post-Katrina New Orleans for indicators
Print By J.R. Lind
05-05-2010 3:03 PM

Nashville real estate agent Grant Hammond thinks housing prices will head for higher ground as the Cumberland recedes.

Hammond blogs that the basic principles of supply-and-demand are in effect – and uses a post-Katrina New Orleans as an example.

As New Orleans recovered, rental prices jumped 39 percent and home prices in the suburbs surged. Some of the Big Easy's bedroom communities had home prices increase by as much as 23 percent in the months following the hurricane.

Of course, it's not an exact parallel. Devastation was widespread in New Orleans and many people left the city completely. Rebuilding was – and continues to be – a slow process. Hammond predicts home prices in the hardest hit areas of Nashville – Bellevue, Antioch and Pennington Bend - will drop sharply. But, he suspects, widespread out-moving may not be a problem.

"However, there are several large rental complexes very near those areas that may allow displaced residents to temporarily remain close to home. This is an important fact, since the further loss of consumer spending in those specific areas would magnify the loss in real estate prices through population attrition," he writes.


Hammond predicts a spike in sales in neighborhoods near Bellevue – specifically northern Brentwood, Franklin and West Meade.

"Eastern Bellevue, Green Hills, Hillwood and West End may see an increase in rental demand. Unquestionably, downtown Nashville itself as well as the Cool Springs area will experience higher than usual demand as displaced persons attempt to secure a rental or permanent residence closer to where they work," he said.

Hammond agrees with what a North Dakota agent told NashvillePost.com earlier this week: The flood could prove to be a boon to the Nashville real estate market.

"It is true that Nashville is in the beginning stages of scratching and clawing its way out of the national economic downtown. It is also true that jobs and general optimism had also begun to return to this area. For the supporting reasons above, I am predicting that the resulting economic impact from the flood will cause the Nashville real estate market to recover faster than if the flood had not occurred. The storm has caused the total inventory of homes to decrease more than the resulting demand. While this affect many only last 6-12 months, it may seamlessly blend into a recovering national recover," Hammond said.