How to Analyze A Residential Rental Property
When it comes to investing in real estate for the purpose of buying and holding, you will have to understand how to analyze the property to ensure that the numbers work. Before you purchase a rental property, you must have a good understanding of the financials and ensure that the returns meet your specific criteria. There are several other factors that you will be looking at when it comes to purchasing a property, but for the sake of this article, we are only going to be discussing the financial analysis of the property.
Each property that you purchase needs to be looked at as a little business, so you need to make sure you put in the necessary due diligence to treat it that way. As a whole, people understand that real estate can be very lucrative but they do not have the knowledge or education to take action on the process. The process for analyzing and purchasing a rental property is not rocket science and once you understand the basics, you will be able to easily determine if you should look into the property further or move on to the next.
We hope that this post will give you enough information to educate you on how the process works and math surrounding an analysis of a rental property.
Analyzing A Rental Property
When it comes to analyzing a rental property there are several variables that we will calculate to determine if the subject property meets our criteria for purchase. Two of the most common factors are:
1) Cash Flow - The main reason that you should be purchasing rental property, is the cash flow that it generates. Your cash flow is the profit left over after operating expenses, debt service and capital expenditures are paid.
2) Appreciation - Real estate as a whole has consistently appreciated throughout the years. Each specific market carries its own appreciation rate based on supply and demand and interest in living in the area. You appreciation is the equity that is gained as the property increases in value throughout the years.
You should not purchase a rental property based off of the appreciation factor but almost treat it as an added bonus on top of the cash flow that is generated from the property on a monthly basis. Appreciation can be very difficult to predict and can fluctuate drastically over the period of ownership of the building.
As a real estate investor, you need to create a specific buying criteria, so when you are finished with your financial analysis you have a way to measure the subject property against a baseline. If the property meets your cash flow requirements, you can continue to further analyse the property to ensure that the subject property meets the criteria for the secondary metrics on the property.
Cash Flow Analysis
As we previously discussed, the analysis for your rental property is fairly simple to calculate and there are several tools online to make it even easier. When running our numbers, we just want to make sure that we account for all of the expenses on the property and try to ensure accurate figures so we can properly forecast the income stream the property generates.
In the most basic definition, Cash flow is Income - Expenses
So let's further elaborate on the income and expenses associated with a rental property. For the majority of rental properties, the primary and only income source will be through the collection of rents. However there are additional ways to add additional revenue streams to your property, thus increasing your NOI and the cash flow generated on the property. Some of the most common additional revenue streams are:
Coin Operated Laundry
Rent from Garages/Sheds
Additional Pet Charges
You should always try and get creative with your subject property to see if there are any additional ways to generate revenue from the building. In order for some of the additional revenue streams to make sense, it will depend on unit count, location, market and demographics.
When it comes to the rental income generated from the property, when putting together your analysis, you will want have an accurate idea of what each unit in the property will rent for. You can do this by running your own rent analysis on the property or you can utilize an agent/property manager to help determining these forecasted figures.
The next aspect of your cash flow analysis will be to accurately determine the operating expenses associated with the property. For the majority of the rental properties that you analyze, there will be certain expenses that are consistent with each of the properties that you analyze. These expenses are:
Capital Expenditures (These costs will not effect your NOI but should be accounted for in Cash Flow Analysis)
These are expenses that you can expect on every rental property that you analyse. Here are a list of other expenses that you may have to pay depending on the current setup of the property and market conditions.
Not only do you need to know the different types of expenses that we can expect when analyzing a rental property, we also have to ensure that the numbers we plug in for these expenses are accurate so we can derive at an accurate cash flow number.
Taxes - All tax information is typically held on the local county website. If this information is not made public, you can always call the county office and request the tax information on a specific property. You can also request the tax information from the seller of the property.
Insurance - If you are getting in this business, it is important to begin building a relationship with an insurance company/broker to assist you with your property insurance needs on your rental properties. When forecasting an insurance number for your analysis, you can call your insurance broker and have him assemble a quote for you on the subject property.
Water - Depending on the if the property is separately metered or not, will determine if the owner pays the water bill or it can be pushed on to the tenant. To get an accurate number for the water expense on the property, you can call your local water authority or ask the owner of the property for his previous 4 water bills on the subject property.
Sewer - Same goes for the sewer bill, give the local sewer authority a call or you can ask the owner of the property for his previous 4 bills.
Garbage - If a garbage service is extra in your area, you can call your local trash provider or you can ask the property owner for his previous 4 bills.
Gas - The gas bill on the property can be accurately determined by contacting your local gas provider or asking the property owner for his previous 4 bills.
Electricity - To determine an accurate figure for your electrical expense, you can contact your local electricity provider or ask the owner of the property for his previous 4 bills.
HOA Fees - Some properties that you may look at will be in a homeowner association. These associations have monthly fees that you must pay. To determine these fees, you can contact the president, ask the neighbors or call the hotline for the association.
Snow Removal - Some of us live in an area where it snows often. Sometimes, you will be able to push this task on the tenant but for multi unit properties, most likely it will be your responsibility to remove the snow. Just call a snow removal company to get a quote on a cost for a yearly contract.
Lawn Care - Similar to snow removal, if the property is a single family home, you may be able to push this cost on to the tenant. Other wise, you will be responsible for the lawn care of the property. You can call a local lawn care company to get a quote on a contract to cut the lawn.
Repairs - The repairs that you estimate for a subject rental property will depend on the current overall condition of the property. If you have a property that has just been completely renovated, as a rule of thumb, you should forecast around 3-5% of the gross income of the property. If you have a property that is older and is in disrepair, you will forecast around 8-10% of the gross income of the property.
Vacancy/Credit Loss - Every property will go through a period of turn over and vacancy, no matter how good of a landlord you think you are. How vacant your units will be, will depend on the market you are investing in, how aggressively your price the unit as well as the demographics of the subject property.
Property Management - Regardless if you initially intend on utilizing a property management company or not, we suggest that you run your numbers with property management in place if for any reason you would like to delegate management down the road. The typical property management fee will be around 8-10% of the gross rents the building generates.
Capital Expenditures - Your CapEx costs can be somewhat subjective but you need to put together a system to account for these costs. A capital expenditure is something you can capitalize over a period of time. It adds to or upgrades a properties physical asset. An example of Capital Expenditures are: new roof, appliances, flooring, furnaces, air conditioning system, electrical system, plumbing, foundation, extensive exterior paint, etc. These costs will not effect your Net Operating Income (which we will talk about later) but they are costs you should account for when projecting cash flow. We have found a good way to account for these costs to depreciate the life of the asset based on the cost of that item. For instance, if the previous owner put a brand new roof on the property and the replacement cost of the roof is $10,000 and you believe the life expectancy for this item to be 30 years. Then you would forecast an annual cost of $333.33 and $27.78 monthly. You would do this for each Capital Expenditure for the property.
Debt Service - If you plan on leveraging your property through the use of debt, you will need to account for the monthly cost of this debt. Here is a hypothetical scenario of forecasting the debt service on a property. A standard rental property loan will be on a 30 year term with 25% down and current interest rates are in the low to mid 5's depending on your current personal financial situation. There are also several tools available on the web that will help you get to this debt payment number as well.
123 Main Street
Purchase Price = $200,000
Down Payment = 25% = $50,000
Loan Amount = $150,000
Interest Rate = 5.25%
Mortgage Payment (Interest & Principal) = $828
As stated, if you were to purchase this property in cash, you would not have a mortgage payment on the property, thus increasing your cash flow. Even though your cash flow will increase, since you are not using leverage, your actually Cash on Cash return will decrease.
Now that we have a good idea of income and expenses that we can expect on a subject property, it is now time to work through an analysis and review all of the important metrics to determine if we will purchase a subject property or not. Once we have all of the data, we can make an educated decision as to if this is going to be a good investment or not.
123 Main Street
Purchase Price = $200,000
The property is a 6 bedroom 2 bathroom duplex, each unit will rent for $1,100 a piece.
Gross Scheduled Income - The annual income of the property if all units were rented and monies collected.
$1,100 x 2 = $2,200 a month
$2,200 x 12 = $26,400 a year
Vacancy & Credit Loss - The subject property has recently been renovated and is in a desirable part of town. The vacancy and credit loss for the subject property will be projected at 5%.
$26,400 (GSI) x .05 (Vacancy & Credit Loss) = $1,320 per year
Gross Operating Income - This is the total income you can expect from the property after taking into consideration the vacancy and credit loss from the property.
$26,400 (GSI) - $1,320 (Vacancy & Credit Loss) = $25,080
Annual Operating Expenses - The costs associated with the operation and maintenance of the subject property.
School Taxes - $2,000
County/Town Taxes - $2,360
Insurance - $700
Repairs - $1,300 (5%)
Water - $1,200
Sewer - Paid by tenant
Garbage - Paid by tenant
Gas - Paid by tenant
Electricity - Paid by tenant
Snow Removal - $400
Lawn Care - $400
Property Management - $2,080 (8%)
Estimated Annual Operating Expenses = $10,440
Net Operating Income - The annual income generated by an income producing property after accounting for all income collected from operations and deducting expenses, excluding cap ex and debt service.
$25,080 (GOI) - $10,440 (Operating Expenses) = $14,640
Annual Debt Service - The total interest & principal required to be paid in a calendar year.
$828 x 12 = $9,936
Capital Expenditures - A capital expenditure is a renovation that adds to or upgrades a properties physical asset. There are repairs outside of your standard maintenance requests when managing a property.
Capital Expenditures = $2,311.67
Estimated Annual Cash Flow - The net result of gross income minus expenses, debt service and capital expenditures.
$14,640 (NOI) - $10,440 (Operating Expenses) - $828 (Debt Service) - $2,311.67 (Capital Expenditures) = $1,060.33
Estimated Monthly Cash Flow
$1,060.33 (Annual Cash Flow) / 12 = $88.36
Cash on Cash Return - The net profit of the subject property divided by the amount of capital invested.
$1,060.33 (Annual Cash Flow) / $50,000 (Down Payment) + $4,200 (Closing Costs) = 1.79%
Cap Rate - The potential return on a real estate investment if you were to buy the investment in all cash.
$14,640 (NOI) / $200,000 (Purchase Price) = 7.32%
Gross Rent Multiplier - The ratio of the price of a real estate investment to it's annual rental income before accounting for expenses such as property taxes, insurance and utilities. The GRM is the number of years the property would take to pay for itself in gross received rent.
$200,000 (Selling Price) / $26,400 (Gross Scheduled Income) = 7.57
Debt Coverage Ratio - The amount of cash flow available to pay current rent obligations. Lenders need at least a DCR of 1.25 to consider lending on the product.
$14,060 (NOI) / $9,936 (Annual Debt Service) = 1.41%
Once we have gathered all of the data, completed our analysis and finalized our calculations, we will have to decide if this specific property is producing enough income for us to invest in the property. This is where you will utilize the criteria that you put in place. You will see if the financials from the subject property meet the requirements that you put together. If they do, you will begin looking into the secondary metrics to finalize your decision as to if you will purchase the property or not.
Our hope is that this post gave you some insight into the variables involved in properly analyzing a rental property as well as some of the calculations you will have to consider to determine if this property is worth your time and money. Once you get a few analysis under your belt, the process of analyzing a rental property will become fairly easy. Be very diligent when it comes to your analysis so that you can avoid buying a bad deal. For each property that you analyze, have a firm understanding of the numbers and produce accurate calculations to get a good understanding of the performance of the property.