When you are analyzing investment properties for purchase, it is critical that you know how to read a financial evaluation intelligently. This is not something taught in school, yet so important to your financial future. A wise man once said to me, “Trust, but verify.” I have learned that there are a lot of professionals in this industry who provide financial pro formas that lack a lot of the necessary information. Even if all of the information is provided to you, you must make sure that conservative numbers are used for variables like rent, maintenance and vacancy. In order to become a successful long-term investor, it’s very important that you read and understand the following:
First, make sure you are comparing “Apples to apples.” All too often I see first time investors compare and contrast properties without using the same tools to compare them. You must make sure you are on a level playing field. If you are constantly using different templates for your pro formas, then you are not comparing apples to apples.
I have stared at thousands of financial evaluators for residential investment property over the years, and it seems like no one can agree on what should be included in the calculations. For what it’s worth, here is my firm stance on what should be included and how it should be calculated.
I like to start with the address and a few pictures of the property if available. Next is a description of the property so you can find out more about it, like whether or not it’s rented, what the condition is like, and other information that numbers can’t always tell you. Make sure you have the specs like amount of bedrooms and bathrooms, square footage, and year built.
The next section is devoted to costs. It is here you list the sales price, down payment, closing costs and any estimated repair costs that all add up to your “Total out of pocket.” Knowing your total out of pocket cost is absolutely necessary. Without it, you cannot calculate your anticipated returns, i.e. how much money you stand to make.
The section after this is devoted to monthly expenses, which allow you to determine your monthly and/or annual cash flow. Here you list things like principal and interest (if you are using financing), property taxes, insurance, property management fees, anticipated maintenance costs, estimated vacancy factor, and any HOA fees. Underneath all of those expenses, create a line to tally everything up and call it “Total expenses.”
When it comes to maintenance and vacancy, it’s scary to see how many people do not add those expenses into calculating their net cash flow. Remember these words, “It’s not IF you will have maintenance and vacancy, it’s WHEN.” The actual amount for each expense varies, but to play it safe I recommend using 8% of your rental income for vacancy and 6% for maintenance. Those numbers will vary depending on age, condition, and location of property. If you purchase the right properties in the right areas, these should be pretty conservative numbers to use.
If you have everything above and a conservative rent estimate, you can do an analysis of your annual return, or cash on cash return. This is achieved by dividing the annual net cash flow by the total out of pocket cost to secure the property. Example: If your net (after all cost) cash flow is $200 per month or $2,400 for the year, and your total out of pocket cost was $24,000, your annual return is 10%. Calculating your Total R.O.I. (Return on Investment) is a more comprehensive formula that takes into account principal pay down, tax write offs, depreciation, and appreciation. For a comparative analysis, the brief formula described above works best.
One of the biggest mistakes you can make is overestimating the rent. If you are given a rent range, always take the low-end and you will be pleasantly surprised if it rents for more. Trust me when I say it is no fun the other way around.
There are additional financial benefits to owning rental income property. Depreciation allowance is one. Make sure to consult with your CPA for details. You are also allowed to write off any interest paid on the loan, travel to and from the property, property taxes and insurance, and any repairs and improvements to the property. Each of these cost savings can be factored into determining your total R.O.I.
By: Ross Nelson
Director of Operations of the Marshall Reddick Real Estate Network
For more information, visit the Marshall Reddick Real Estate Network website