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