There are four main factors that indicate whether or not a rental property is a good deal: the income it produces, the location, the available financing and the fair market value of the property relative to the purchase price. In this article, we will look at how to analyze a rental property in one of these areasevaluating a properties income-- to know if you are really getting a great deal. Step One: Analyzing Cash Flow Cash Flow Analysis: After obtaining some simple information from the seller, you can organize and analyze that information to determine the amount of positive or negative cash flow a prospective property will produce. Make sure to use annual numbers rather than monthly when completing your cash flow analysis. Let us review the Property Cash Flow Analysis: o Gross Income: In this section of the Cash Flow Analysis, an investor adds the scheduled or expected rents and all other expected income to determine the Gross Scheduled Income (GSI). He then subtracts the vacancy allowance or expected vacancy, taken from the current vacancy rate for the area, to arrive at the Gross Effective Income (GEI). o Expenses: Here, the investor determines the total Operating Expenses (OE) by adding all the expenses involved in the operation of the property not including any debt service. o Net Operating Income: The Net Operating Income (NOI) is the difference between the Gross Effective Income and the Operating Expenses o Debt Service: Debt Service (DS) is the total principal and interest payments for all the mortgages or loans used to acquire the property. o Cash Flow: The propertys Cash Flow or Net Income (NI) is the Net Operating Income less the total Debt Service (DS). This can be a positive or negative number. Step Two: Verifying The Numbers Sometimes to get a higher purchase price, a seller will inflate the amount of income a property produces or simply fail to mention all of the expenses actually required to maintain the property. Often the seller will be completely honest with the information he supplies, yet some important figures are inadvertently left out. For example, this could happen if the seller manages the property himself and does not include a property management fee in the numbers he gives you. The seller may not have kept up with necessary repairs and maintenance on the property, in which case the expenses he supplies may not be sufficient for you to adequately maintain the property. Unfortunately, if the buyer bases his offer on incorrect information, he could lose a lot of money. As the buyer, you must protect yourself from this by verifying all of the information you receive on a property. You must take the information you get from the seller lightly until you have verified its accuracy. There are a number of ways to verify a property's income and expenses: Property Operating Statements: These statements are often referred to as Profit and Loss or Income and Expense statements. A good investor will keep records of all the income and expenses produced by his property on a monthly and annual basis. You can compare the information provided by these statements with the information that the seller initially provided. It is a good idea to get the propertys Operating Statements for at least the past three full years as well as year-to-date. Be wary of falsified information. Many sellers and realtors will falsely advertise a propertys Operating Statements by providing a prospective buyer with a Pro-forma. A Pro-forma does not take its numbers from what the property actually produced, but instead gives their estimate of what the property should produce. The net income shown by these estimates are almost always drastically higher than what the property is actually producing. The seller or realtor will attempt to justify the estimated numbers over the actual numbers by suggesting that the current rents are low, or if some minor repairs are done the propertys value would increase. No matter what their reasons are, your offer should be derived from the numbers that the property is currently producing. If you are able to increase its value through rent increases, repairs or whatever it may be, the benefit should be yoursnot the sellers. Schedule Es: A Schedule E is the federal tax form that reports real estate income and expenses. The propertys gain or loss as shown on this form is then added to the owners other income to determine his federal income tax obligation. Schedule Es will provide the most accurate accounting of a propertys income and expenses. This is because if the seller has left out expenses that he has paid on his property, then his tax obligation will be higher. Because no one wants to pay more in taxes, they do not forget to include any of the applicable expenses. A seller may confess that he added in more expenses or recorded less income than there really was in order to lower his tax obligation. No matter what is claimed, you need only go by what is established on the Schedule E. If the seller lied on his tax returns, then a lower purchase price for his property may be the consequence. Dont take any risks by going on someones word alone. o There are expenses that are sometimes not included on the Schedule E that you must add when analyzing a propertys income: property management, yard maintenance, and snow removal. There are also some expenses on the Schedule E that you can exclude: depreciation, interest, meals and entertainment, and travel. In reviewing the Schedule Es, request copies of at least the past three years. Beware of continued drastic declines in rental income over these years. This could indicate an unfavorable change in the market or the areas economy. If there is such a decline, try to determine its cause so that you can more wisely proceed with or terminate the analysis process. o Not all investors use a 1040 Form Schedule E to report their real estate income. If they own their property in a corporation then they will not use this form. If this is the case, you still want to analyze the same information that would be reported on a Schedule E. You can do this by requesting from the seller copies of all tax returns relating to the property and gathering the information from them. Utility Companies: By calling the utility companies, you can find out the propertys exact utility expense history. County Tax Assessors Office: The Assessors office has on record all property tax obligations, as well as any unpaid property taxes. Lease Agreements: By reviewing the current leases, you will know the exact amount of rent that the property currently generates. Market Rents: Even though a property may be currently receiving a certain amount in rents, it is still possible that these rents are not fair market rents. If a property is rented abnormally higher than the fair market rates, a new buyer will struggle to get them rented for the same amount when the current leases expire. Familiarize yourself with current market rents so that you can make the appropriate adjustments to your offer. Insurance Company: Insurance rates will vary from client to client and company to company. Because of this, you cannot assume that your insurance rate for a property will be exactly the same as the current owners; however, they are usually fairly close. Call around and price rates from different companies to find the best one for you. Make sure to compare similar plans. If the coverage being offered is not the same, then the rates will be different. You need to compare rates for the same coverage. Make sure that the company you choose not only has competitive rates, but is also a well-known, reputable company. I recommend that you use all of these methods to verify a property's income and expenses. You do not need to obtain and review this information prior to "tying the property up." You can use a separate addendum to request this information and make the purchase and earnest money agreement contingent upon your approval of it. You will need to state the amount of time you will have to review this information and to back out with all earnest monies returned to you if the information is not satisfactory to you. If it is not, you can either back out entirely or renegotiate the purchase price. I hope this information proves helpful, I know this system really works! Good luck, and happy investing! |
