Property Investments: How to Evaluate
- February 25, 2020
- Posted by: Jim Pellerin
- Category: Buy, Rent and Hold
Property Investments: How to evaluate.
Hey everybody, Jim Pellerin here, Author of Seven Steps to Real Estate Riches and bringing you the truth about real estate investing.
Today, I want to talk a bit about how to evaluate your real estate investment and specifically a real estate investment from rental property investments – so a rental type real estate investment.
I mean there are many types of real estate investing that you can do but rentals are probably the most common and I’m going to go through a little bit on how to evaluate it.
A lot of people use basically two ways to evaluate rental property investments when it comes to looking at rentals.
First, they use something called Cap Rate, I’ll go through that; and secondly, they use something called gross rent multiplier (GRM).
Either people use them, or they don’t use them, but these are the two most common and let’s go through them.
Cap Rate for Rental Property Investments
So, what the Cap Rate is, is it represents a percent return that you’re going to get as if you had paid cash for your rental property investments.
What that means is they’re basically looking at how much money you have to put into this investment if you were to pay cash without any financing, and what kind of return you would get on it. Basically, it’s fully capitalized.
For example, let’s say you bought a piece of real estate worth $300,000 for cash, as I said, and it’s making you roughly $30,000 a year after all your expenses. If you take that thirty thousand and divide it by your cost of $300,000 you are basically getting a 10% return on your investment.
Just as if you were to buy stocks. If you bought stocks at $300,000 and it was paying you $30,000 a year. That’s a 10% return on your investment.
So that’s the Cap Rate. Now the key here is that $30,000 return is after expenses?
The Cap Rate uses what’s called your net operating income. Your net operating income purely defined is your rental income minus the operating expenses of the property. It’s really quite simple. They’ve taken out every expense that you have so it’s your income that you get after expenses – there’s no financing. It’s just rental income and that’s the return you’re getting on your investment. That’s the Cap Rate.
The problem with the Cap Rate is when you hear people talk about the Cap Rate of a particular property. I mean you’ll see it listed on MLS or in the various sites or newspapers or wherever and they’ll say a Cap Rate of 12 … right, and they’ll say that’s a really good Cap Rate.
Well, the problem with Cap Rates is they tend to have numbers in them that are over-exaggerated. Either the income is overstated, or the expenses are understated, under projected.
So, for example in that property that I mentioned earlier, if the gross income was $40,000 and you had expenses of $10,000, then your net operating income would be $30,000, just like I said earlier. And if you’re selling that property or if you’re buying that property for $300,000 and you paid cash for it, the Cap Rate would be 10%. Pretty straightforward … we just went through that, right.
But let’s say that the seller had exaggerated the income and it really wasn’t $40,000 and it was only $35,000. And let’s say that the expenses were under-exaggerated. So instead of them being $10,000, they were actually $15,000. Now your net operating income is only $20,000 because you take your $35,000 gross income minus your $15,000 operating expenses and now you only have $20,000 left.
So, $20,000 net operating income over that $300,000 that you would have paid for that house if you had bought it cash. Now your Cap Rate is only 6.67% and that’s quite a difference from the 10% that they had listed or the 12% or 13% or whatever they are advertising that the Cap Rate is.
Basically, the problem with Cap Rate is that the people indicating or stating the cap rate usually exaggerate one of the other or sometimes both. So, it’s best to do your own due diligence and to figure out your own Cap Rates or to figure out your own way of evaluating the property. There are various ways you can do that, and we’ll talk a bit about that.
Another problem with Cap Rate too is that you’ve got two variables. You’ve got your expenses and you’ve got your rental income, the various rents.
The higher the Cap Rate the better and a recommended minimum Cap Rate, if you’re looking at rental properties, is around 10%. That’s just an industry standard and it’ll fluctuate. But if you want to make a good return on investment that’s a good Cap Rate. And that should allow enough money left over so that you can finance it at a reasonable rate by putting 20% or 25% down.
Gross Rent Multiplier for Rental Property Investments
The other indicator or the other number that you can use is what’s called a gross rent multiplier (GRM). That number is based on the price, the $300,000 that we talked about earlier, divided by the actual rents.
In the previous example, if the rents were $40,000 and the purchase price was $300,000, the gross rent multiplier is 7.5. That’s $300,000 divided by $40,000. Or you can turn it to be the other way around you could say $40,000 times 7.5 and that gives you $300,000.
The lower the gross rent multiplier is, the better. And it’s just because you flip things around so instead of dividing, you’re multiplying. So, in this case, the lower the gross rent multiplier, the better. And a good rule of thumb is a gross rent multiplier or a GRM of 7 is a good number … you don’t want to have anything greater than a seven.
What that means is there should be enough protection or enough collateral or enough room in there for you to be able to pay for your expenses and for you to be able to pay for the financing if your GRM is 7.
So, if rents are $40,000 then the maximum purchase price you should be paying if your GRM is 7, is $280,000.
In our example earlier where you had rents of $40,000, you should not pay more than $280,000 for that house that’s listed at $300,000.
That gives you a good rough idea for a starting point. So, what you would do is you would make an offer based on that GRM and say … yeah, it looks good … I’ll make an offer of $280,000. And if people are interested and they come back when accepting your offer then you can go in and do your due diligence of checking rents in more detail, checking expenses, looking at rent rolls and various things.
Validate Rental Income
One of the things you can do too, prior to your offer to validate rental income, is to look at comparable rents in the neighborhood.
Look at buildings in the same type of condition, looking to see if they are 2-bedroom, 3-bedroom, 1- bedroom, whatever and see what the rents are going for in the neighborhood and use those as a better comparison.
And then what you do is you add a 5% vacancy rate and that should give you a good indicator of what the gross rental income should be for that property. Now keep in mind if it’s a multi-unit building and you’ve got 5, 6, 10 units or whatever, you have to look at how often these things are rented and what the rental has been and the occupancy has been over a period of time. So, you want to look at their rent roll
Another way to validate the rental income is to ask the owner for their tax filing for last year or for the previous year because most people don’t tend to exaggerate how much income they claimed when they filed the taxes. Now some people might say they did that because they are never going to claim all the income when they file taxes.
That’s another indicator of why you don’t want to buy that property, right?
So, the three steps to evaluate the rental income.
- I never use Cap Rates, so right away ignore the Cap Rate because there are too many opportunities for the current owner to exaggerate either over on the income or under on the expenses.
- I determined the income by using the comparison method looking at rentals in the area or by asking for the owner’s tax filing; and
- I multiply the rent income by 7 to determine the max purchase price. In that previous example we did, we had $40,000 gross income. The gross rent multiplier is 7 so I multiplied $40,000 by 7 and get $280,000 and that’s the offer I would have made on that property.
So that’s basically a quick and dirty way to do a quick evaluation before purchasing a property. As you get closer to finalizing the deal you will want to validate all those incomes. You will want to validate those expenses. You will want to look at the property. You want to do many other things, right?
Thanks very much
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