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Analysis
1.) Verify property income
Verify the rent roll. The rent roll is the rent paid by each tenant in the occupied units. Verify the number of vacancies.
2.) Find the Gross Rent Multiplier
On the gross rent multiplier analysis spreadsheet (I have included the spreadsheet at the end of this chapter) find a gross rent multiplier at 8, 7and 6. The gross rent multiplier is the Sales Price of the property divided by the Gross Yearly Rents
GRM = SP/GYR
As a rule of thumb, anything over 8 is difficult to cash flow from.
Run the operating budget using the cash flow analysis spreadsheet which is included at the end of this chapter. (8% vacancy estimated expenses. The taxes should be verified and you should obtain an insurance quote) If you verify expenses great. If not then formulate estimates for the rest - reserves, repairs/maintenance, yard work etc. Find cash flow from this.
4.) Find the Cap Rate Value
Price = NYOI / R
Divide the net yearly operating income that you found in your cash flow analysis (this number is the income minus all expenses except for the loan payment) by a reasonable cap rate value in your area. Your realtor should be able to provide a cap rate value which can be found for your area by solving for R in the above equation: divide NYOI by the price for recent sales. This metric and the gross rent multiplier value will give you a price target that you should not go over in your offer. Note: if the building is older, repairs and maintenance and reserve will be higher than previous figures in the owner’s budget. Utilities can also go up.
5.) Calculate the loan payment in cash on cash return.
Your cash on cash return will be your monthly net income (all expenses removed including the loan payment) multiplied by 12 and then divided by your cash put into the deal, typically your down payment.
Cash on Cash Return = (Net Monthly Income x 12) / Down Payment
So, for example, if you are cash flowing $250 a month from a rental property and you have a down payment of $20,000 in the deal, you would have a 15% cash on cash return.
$250 x 12 = $3,000
$3,000/$20,000 = 15%
This metric will help you decide between properties. For example, if you are evaluating two properties, one with a 15% cash on cash return and the other with a 25% cash on cash return, then all things being held equal, you would select the property with a 25% return.
Step Five: Tie Up the Property
Once you’ve identified a property you want to move toward getting off the market by issuing a letter of intent. This letter maps out the deal points, the price and leads to the price negotiation.
Purchase and sale agreement – this can be issued in addition or in lieu of the LOI but an attorney drafts this generally after the terms of the letter of intent have been sorted out. This document details the purchase price, down payment, initial deposit, escrow, time frames for contingencies, pro rated rents, taxes, insurance and security deposits. It also lays out the details for securing a title report, financing and due diligence, the time frames for pest control and physical and lead based paint inspections.
The main contingency that should be included is that the buyer must find financing suitable to his or her needs. This will serve as a catchall.
Step Six: Perform Due Diligence on the Property
Part One:
In this step, you uncover 100% of the details about a property and you generate an operating plan, a plan to improve the cash flow of the property. You perform a thorough walk-through of every unit and factor adjustments into the purchase price – either a detrimental discovery is fixed or the price is lowered.
For a thorough due Diligence Check list, see Rob McElroy’s book, “The ABCs of Real Estate Investing”, pages 134 through 137.
General areas covered:
- File audit
- Interior inspection
- Government agency reviews
- Service agreement review
- Exterior inspections
Part Two:
Obtain all books and records, including;
- 24 months of income and expenses.
- Service agreements.
- Current rent roll.
- Utility bills.
- Payroll info.
The property plan = the goal for the property
Develop a plan to increase the property cash flow and value.
For example, can you build a laundry facility and/or raise rents? Would it be beneficial to seek out new insurance quotes for a lower rate? How can you attract new, quality residents in a timely manner? What if you bid out the landscaping or hire a maintenance man?
Step Seven: Develop an Operating Budget
Fill in what you are finding out to be the real numbers in the cash flow analysis operating budget.
Use the standard income but also look for other income opportunities.
Expenses:
- Marketing
- Utilities
- Capital repairs
- Management costs
- Repairs and maintenance
- Property taxes
- Insurance
What are the true costs you are finding?
Step Eight: Confrontation Time, Bringing Your Findings to the Table
Again, for any detrimental items found, the sales price should be adjusted lower or the property findings should be fixed.
Confrontation items that should be addressed:
- Vacant units
- Future vacancies
- Bad tenant profiles
- High maintenance expenses
- Pest control issues
- Higher utility costs
- The property tax is higher
- Fire code violations
- Other violations
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