Due Diligence and Property Analysis

Photo Credit: g.naharroWhen buying a Residential Income Property or any other income producing property, do not pay for a “Castle in the Sky”. Most income-producing properties should sell for a price based on their current net operating income (NOI) and thus, at their resulting CAP rate at the time of sale. However, some sellers and their brokers, wanting to maximize their return on investment (ROI), price their property by factoring in future increased revenues and improved management practices. It is the fiduciary duty of the seller’s broker to represent the seller’s interest at all times and attempt to get the highest possible price, therefore he may ask for “tomorrow’s” price today.

The investor will be wise to avoid this trap. Investing parameters, using VMM, does not allow paying today for “tomorrow’s” price. Ignoring this, buys a “Castle in the Sky”. In the world of real estate investments the true upside and profits come over time with steady increases in rents, market value appreciation, inflation, and improving market conditions. All this happens while the investment and debt service remain static and mortgage liability decreases, making an investment even more valuable, with better cash flow. An investor should not pay the seller up-front for this up side of the purchase.

Evaluation and Acquisition Process

  1. Interview and select a team of professionals such as a CPA/tax advisor, legal counsel, mortgage broker/lender, insurance broker, title company, and a property management firm.
  2. Verify all statements of the seller and his or her broker.
  3. Buying property is the profitable part of the transaction, not selling it. Be firm, within reason, and stick to the buying guidelines.
  4. Avoid properties with difficult location access, small bedrooms, small closets, a limited number of bathrooms, small kitchens and bad areas with high crime rates.
  5. Find the “story” behind the property’s sale. Why is it being sold? Is there a deferred maintenance issue? Is the rent too low? Is there a longtime ownership of the building? Is it a divorce or death case? Is it a damaged building? Is there bad management? Is it a bankruptcy case? Is it a rent controlled-building or area?
  6. Motivated sellers and mismanaged properties provide great opportunities to acquire properties. These sellers need to sell more than an investor needs to buy. Patience usually rewards “ready” investors as these opportunities often come when least expected.
  7. Never get emotionally involved with a property; remain rational and focused at all times.
  8. Get involved in every aspect of managing the business/investment.
  9. Concentrate on NOI, cash flow, and occupancy rate. Avoid properties with negative cash flow even when the appreciation potential is high. Residential Income Properties are only as valuable as the income they generate.
  10. Hire a professional inspector to examine every aspect of the property. Check crime statistics, disrepair issues, deferred maintenance, pool, roof, chimney soundness, and unfinished work in the property. Speak with the tenants if possible.
  11. Ask the seller for previous insurance claims since claims tend to affect subsequent insurance premiums.
  12. Get the current rent roll and operating expenses (P&L) year-to-date before submitting a purchase offer. (The last two or three years of operating statements will be helpful in obtaining a loan).
  13. Analyze the property with its actual income and its market income (pro-forma income). Deduct 8% for management fees, 8% for Vacancy and Collection and 8% for Repairs and Maintenance out of the operating statement (unless it’s already there). It doesn’t matter if the seller doesn’t use a management company or that his R&M is less than 5%. That is what the bank is going to do before approving the loan regardless of the seller’s statement.
  14. Take out depreciation, amortization, travel, and interest expense from the P&L, if they are there, and add them back in to the Net Operating income to get a true cash flow of the property. Again, this is what the lender will do to qualify the property.
  15. Write a purchase offer based on the desired CAP rate supported by actual rents and actual P&L and not on market rents, appreciation or some kind of future expectation.
  16. Write a purchase offer at current, or a bit below, market. Make sure the return on any out of pocket expenses, such as down payment, is at least as high as that of an interest bearing checking account.
  17. This is Residential Income Property, not a house. Therefore, low income (rents) along with high expenses results in low NOI and thus deserves a low purchase offer.
  18. Calculate the operating expense ratio relative to the income. 35% to 45% operating expense ratio is the norm. Use 45% of potential gross income to be safe.
  19. Make sure the Debt Service Coverage Ratio (DSCR) is no lower than 1.20.
  20. Since operating expenses tend to be far less on a per unit basis (particularly in large properties), the more units, the less the risk in cash flow and thus the more valuable the property.
  21. Rank properties as “A”, “B” and “C” with “A” being as best.
  22. A mortgage interest rate that is less than the capitalization rate will result in higher cash flow.
  23. Find an investment with a CAP rate close to or above the mortgage interest rate to avoid negative spread.
  24. GRM, Gross Rent Multiplier, represents the asking price of any income-producing property relative to all possible rent income. To find the GRM of any given property, divide its asking price by the Gross Scheduled Income (GSI).
  25. CAP rate, Capitalization Rate, is the return rate received on an investment if it were paid all in cash, without a mortgage.
  26. ROI is the annual return from out-of-pocket cash expenses that goes into the transaction such as down payment, attorney fees, appraisal fees, inspection fees, etc.
  27. Cost per unit is useful in determining the value compared with other buildings. This number is primarily rent driven and its underlying source is based on the property’s general condition, age, location, and unit size. Consider evaluating any given property by price per door (unit) or alternatively by price per square foot.
  28. Determining cash flow depends on rent collections, expenses, and the current and future mortgage rates.
  29. High business acumen will maximize the return. Perform due diligence and calculate numbers beforehand. Watch expenses carefully and make necessary adjustments to increase cash flow.
  30. Budget 10% of the property’s income to be set aside in an interest bearing account for emergency events and repairs.

The “Dissection” of Residential Income Property Analysis Line by Line:

The following is an example of basic Residential Income Property Analysis. It is dissected line-by-line for easy understanding outlining all required calculations. The most important elements in analyzing any property come down to three important factors which determine its viability.

NOI = Net Operating Income
CAP = Capitalization Rate
COC = Cash on Cash

In addition, there are other important elements to consider before submitting a purchase contract. But for now, let’s stick to these as a starting point for fundamental grasp of an analysis.

Property Assumptions:
Purchase Price $535,000
Down Payment 20% $107,000
Loan Term 30
Interest Rate 7%
Closing Costs $10,000
Gross Scheduled Income [GSI] $90,840
Vacancy Rate 10%
Pro forma Income Statement & Cash Flow:
Gross Scheduled Income [GSI] $90,840
Less Vacancy 10% $9,084
Total Actual Annual Income $81,756
Otder Income [Laundry, Late fees] $3,000
Gross Operating Income [GOI] $84,756
Annual Operating Expenses
Real Estate Taxes $5,686
Property Insurance $5,100
Advertising $417
Admin/Legal/Bank Charges $1,850
Property Management $6,780
Maintenance & Repair $16,750
Electricity $3,500
Water $3,740
Gas $2,001
Total Operating Expenses $45,824
Net Operating Income [NOI] $38,932
Annual Debt Service [Mortgage payments] $34,170
Before Tax Cash Flow[BTCF] $4,762

Capitalization Rate – CAP – 7.27%
Cash On Cash – COC – 4.07%
Gross Rent Multiplier – GRM – 5.88%
Net Income Multiplier – NIM – 13.74
Debt Coverage Ratio – DCR – 1.14
Expense Ratio – ER – 54% = $1,909 expenses per unit
Price Per Unit – $22,292

Breakdown & Summary Line by Line

  • Line 1 – Purchase price.
  • Line 2 – Down payment of 20%.
  • Line 3 – Loan term 30 years.
  • Line 4 – Interest rate.
  • Line 5 – Closing costs.
  • Line 6 – Gross Scheduled Income [GSI]. The maximum possible annual income generated by rent collections.
  • Line 7 – Actual number of days the property is vacant, and not collecting rent, expressed in percentage. Divide number of vacant days by 365.
  • Line 8 – Gross Scheduled Income [GSI] is the maximum possible annual income generated by collection of rents.
  • Line 9 – Vacancy rate in dollar amount. GSI, line 8, times vacancy rate, line 7.
  • Line 10 – Actual annual income collected after deducting vacancy rate. Line 8, less line 9.
  • Line 11 – Additional income generated by late fees, laundry fees, storage fees etc.
  • Line 12 – Gross Operating Income [GOI]. GSI, line 8, less vacancy rate, line 9, plus other income, line 11.
  • Line 13 – Annual real estate property taxes.
  • Line 14 – Annual property insurance.
  • Line 15 – Advertising.  
  • Line 16 – Day-to-day cost of operations.
  • Line 17 – Cost of professional property management company.
  • Line 18 – Cost of maintenance and repair.
  • Line 19 – Utility expense class.
  • Line 20 – Utility expense class.
  • Line 21 – Utility expense class.
  • Line 22 – The total sum of annual expenses of lines 13, 14, 15, 16, 17, 18, 19, 20, 21.
  • Line 23 – Net Operating Income [NOI] is the profit amount the property generates after deducting all expenses, excluding debt service [mortgage payments]. NOI is line 12, less line 22.
  • Line 24 – Annual Debt Service, is the annual mortgage payments that includes the principal and interest, or only interest in the case of interest only mortgage.
  • Line 25 – Before Tax Cash Flow [BTCF] is the positive cash flow the property generates on an annual basis. Line 23, less line 24.
  • Line 26 – Capitalization Rate is commonly referred to as the CAP rate. The CAP rate is NOI, line 23, divided by the purchase price of the property, line 1 and is expressed as a percentage. The higher the the CAP rate, the less expensive the property.
  • Line 27 – Cash-on-Cash [COC] is the return on investment [ROI]. It is [BTCF] line 25, divided by the sum of all of the out-of-pocket acquisition costs. In this case it is line 25, divided into the sum of down payment, line 2, plus closing costs, line 5.
  • Line 28 – Gross Rent Multiplier [GRM] is the purchase price of the property, line 1, divided by Gross Scheduled Income [GSI] lines 6 or 8. The lower the number the lower the purchase price.
  • Line 29 – Net Income Multiplier [NIM] is the purchase price of the property, line 1, divided by Net Operating Income [NOI] line 23. The lower the NIM the better.
  • Line 30 – Debt Coverage Ratio [DCR]. Net Operating Income, line 23, divided by Annual Debt Service, line 24. The higher the DCR the better. A DCR below 1.0 means the property generating a negative cash flow. A DCR above 1.25 is considered a good cash flowing property.
  • Line 31 – The Expense Ratio [ER]. Total Operating Expense, line 22, divided by Gross Operating Income [GOI], line 12, expressed as a percentage. A percentage below 35 considered good.
  • Line 32 – Price per Unit is purchase price, line 1, divided by number of units in the building. In this example it’s 24.

Photo Credit: g.naharro

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