How to Find and Analyze a Cash Flowing Rental Property

Below is an excerpt from my upcoming third book My Happy Assets - Taking the Last Steps to Financial Independence.

If you like what you read, check out my first book, My Happy Assets at http://www.myhappyassets.com/ and the complete second book, Small Business Coffee Hour, Three Essential Ingredients for a Successful Business at http://www.smallbizcoffee.com/. Happy Reading!

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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

Real Estate Versus Stock Investing

Building a Small Business That Warren Buffett Would Love,available at Amazon.comorBarnesandNoble.com.

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Ten Advantages of Real Estate

Cash Flow

The chief thing here is that the property is self-maintaining as far as expenses go. It is a business model in itself – the income minus the outflow equals the cash flow. The expenses should first all be covered for the investment to make sense and secondly the property should generate a cash flow in order to add icing to the cake of property appreciation. When comparing real estate investing to stock investing, it is important to not only compare the national average real estate appreciation rate of 6% to the historic average stock market return of 10%, you must also factor in the cash flow received.

In addition, this is passive cash flow. Although you might have to handle tenant issues or arrange for repairs or do them yourself, your physical presence is not required 100% of the time in order to generate the income. In the stock universe you would have to generate this via dividends. Although this is not impossible to do, you must find healthy yields to match the cash flow return you would receive on a piece of real estate and monitor the stock for dividend cuts or “going out of business” drops.

Once your passive cash flow is equal to or greater than your expenses, you are financially free.

Control

In the stock universe you do not have much control over how the companies you own are managed – unless of course you are Warren Buffet who sits on the board of directors of some of the companies he owns. Sure you get a proxy vote but unless you own a large percentage of shares, this won’t amount to much. If you own Coke stock you could buy up all the Coke at your local super market in an attempt to ratchet up sales but I think we both would have to agree this would be futile.

In the real estate universe you can manipulate rents, you can screen tenants, you can landscape, you can throw a new coat of paint on the walls, you can physically drive up to the property. If rents drop in the area by $25 you can adjust accordingly to keep your vacancy rate low. If they go up, you can raise rents. In real estate you have much more control over the investment. In stocks, you can monitor and maintain control over the buy and sell decisions.

This also comments on the passivity of the investment. Without a property manager, the more control you exude over your piece of real estate and the less passive it becomes. Keep that in mind as well.

Appreciation

Real estate on average appreciates 6% nationally. Although this has not been the case recently, I use the long-term average for comparative purposes on stocks and property. Stocks appreciate by an average, long-term rate of 10% while real estate appreciates at 6%. Also, the beauty of real estate is that a tenant is paying down the mortgage and essentially buying the asset for you over time. The problem with the simple 10% versus 6% rate comparison, from a property investor’s point of view, is that it does not take leverage into consideration.

Leverage

If you put $20,000 down on a $100,000 property and it generates $3,000 a year in cash flow, what is your rate of return? It is $3,000/$20,000 or 15%.

If the property increases in value by 6%, how much have you gained?

Answer: $100,000 x 6% = $6,000.

How much of a rate of return is this over your initial investment?

Answer: $6,000/$20,000 = 30%

When you add this to your $3000 of cash flow, your true rate of return is $9,000/$20,000 or 45%.

If you took that money instead and invested it in a stock mutual fund, how much rate of return would you expect? Answer: 10% over the long haul.

Stocks 10%

Real Estate 45%

‘Nuff said.

Depreciation

This is one of those lovely phantom tax deductions you get to claim at the end of the year that will turn your rental money into 0% tax money – your earned income is taxed potentially at 50%, your portfolio income or dividend income is taxed at 15 – 20%, your passive or rental income can be taxed at 0%. This is how:

You get to depreciate residential real estate property over 27.5 years and commercial over 39 years. If you cash flow $20,000 out of your property but have depreciation of $25,000, you have a tax loss of $5,000 and no tax is paid on income. Sure, one could argue that the property is actually depreciating and generating a real repair cost, but repair costs are already factored in and come out of the cash flow.

The Depreciation Equation:

(Total Asset Value – Land Value) / Depreciable Years = Annual Depreciation

Refinance

If you increase the property value you can refinance it and withdraw the money tax free. Say you finance a $200,000 property and through a property improvement plan (you lower the vacancy rate, you increase rents based on a rent premium for ground floor apartments) the property is now worth $250,000. You can now refinance the property at $250,000 pay off the initial $200,000 and withdraw the $50,000 tax free.

Asset Protection

Two things here: insurance and incorporation. If a stock drops 50% in value, what protection do you have? Perhaps a stop loss order or a put option? If your investment property burns down, what protection do you have?

Answer: insurance

Also, the second form of protection is incorporation. Traditionally an LLC has been the most advantageous for property investors. By placing your property in this bucket you shield your personal assets should any one come after you with legal action.

1031 Exchanges

You can roll over property gains tax free by buying bigger properties using a 1031 exchange. The capital gains do not go away, they are still there. But, by using a 1031 exchange, you can continue to roll those gains into bigger and hopefully better properties tax free. If you finish and choose not to hold the last property or roll it, you will have tax consequences.

Hedge Against Inflation

Because real estate is a tangible asset, it will generally rise at the rate of inflation or higher. Historically inflation has been 4.1%. That means real estate, with its average, historical appreciation of 6% has beaten inflation by nearly 2%.

A Physical Asset

You can actually walk up to a piece of property. You can inspect it, you can visit the tenants, you can see cracks forming in the walls. With a stock, in a lot of respects, it exists out in the ether. Sure if you own Coke you can drink a Coke and you can go visit Coke headquarters in Atlanta, but the investment truly lives throughout the business model which you do not directly manage. A property on the other hand, can be managed directly by you.

To sum up, there are many advantages to real estate investing over stock investing and many analysts neglect to make a fair comparison between the two. Many merely compare the 6% appreciation in real estate to the 10% return in stocks. What they are chiefly leaving out are the benefits of passive cash flow, leverage and depreciation. Once these three factors alone are included in the mix, it is clear that real estate has some unique advantages over stocks. I do not wholeheartedly endorse real estate investing alone. I believe one must have a diversified investment strategy across different asset classes. It is not enough to have a bucket of mutual funds and claim diversification. It is important to have assets in stocks, real estate and business.

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The Short-A-Ralls of The Investing Universe: Covered Calls

Covered Calls

Covered Calls are like coveralls, the best kind of coveralls … short-a-ralls. Short-a-ralls are the best kind of coveralls, a hybrid between coveralls and shorts. You have not truly arrived until you own a pair of short-a-ralls. This goes for both male and female.

As you can see, we have moved along our Evolution of Stock Investing Chart … down through mutual funds, single stocks, ETFs, dividend yielders, royalty trusts and REITS. You can see on our little chart on the next page that we have arrived at covered call options, the best of them all, the short-a-ralls of the stock investing universe.

Looking through our chart you can see the rates of return you receive on each of the respective stock investing methods. On a $10,000 investments mutual funds should return on average $83 a month in cash flow. Of course this means withdrawing capital gains, suffering the tax consequences and potentially eating into principle when markets droop. You can see that the same amount of cash flow is generated on single stocks, ETFs and REITs, each with their own varying pros and cons. When you drop down to royalty trusts you see that the cash flow goes up about $20 a month. A little riskier perhaps but not terrible cash flow. If you do not like rental, dealing with tenants or property repairs, this is an excellent way to go to generate cash flow. Just make sure to educate yourself on the risks and technicalities of these investments.

But, if you drop down a little further where you run smack into covered calls. According to our chart, we can expect 50% yearly rate of returns on covered calls. A $10,000 investment will deliver $417 a month in cash flow. Sound too good to be true? Our rule is, if something sounds too good to be true then it is worth checking out. I will go into great detail on these short-a-ralls in chapter seven.

A Business Plan Outline - click to enlarge

An Invaluable Dividend Screen

Below is an excerpt from my upcoming third book My Happy Assets - Taking the Last Steps to Financial Independence.

If you like what you read, check out my first book, My Happy Assets at http://www.myhappyassets.com/ and the complete second book,Small Business Coffee Hour, Three Essential Ingredients for a Successful Business athttp://www.smallbizcoffee.com/. Happy Reading!

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If you are interested in generating cash flow from dividends, the screen below will help you identify stocks that are fertile with yield and ripe for investment.

Measure	Formula	What to Look For
Dividend Yield	Dividend per share divided by stock price	Yield at least equal to that of the S&P 500 and not out of line with that of the S&P industry yield. Use 8-20%(anything above is bad news)
Price to earnings ratio	Stock Price Divided by per-share earnings	P/E that is not excessive compared with company's historical P/E and with S&P industry P/E
Cash flow per share	Net income plus depreciation and amortization divided by number of shares outstanding	Should be at least three times dividend payment
Quick ratio	Current assets minus inventory divided by current liabilities	Should be at least 1.0
Payout ratio	Per-share dividends divided by per-share earnings	Should be higher than 50% but not exceed 100%
Dividend coverage ratio	Cash flow per share divided by dividends per share	Minimum should be 120%
Short-term debt coverage ratio	Operating income divided by short-term debt	Should be at least 2.0
Market Cap	This is the overall market capitalization of a company.	>= $1 billion. Traditionally, larger caps are steadier in their payouts.
ROE	Return on Equity	>= 10%
The Fundamental Grade	Stock Scouter	> = C
Institutional Ownership	What % of big funds own the company.	> = 30 %
Mean Recommendation	Buy, Hold or sell?	> = Hold from analysts
EPS Growth Next Year	How much will earnings grow?	> = 1

The Evolution of Stock Investing

Below is an excerpt from my upcoming third book My Happy Assets - Taking the Last Steps to Financial Independence.

If you like what you read, check out my first book, My Happy Assets at http://www.myhappyassets.com/ and the complete second book,Small Business Coffee Hour, Three Essential Ingredients for a Successful Business athttp://www.smallbizcoffee.com/. Happy Reading!

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(click for a larger image)

Let's Cover Your Assets

Okay John,” I said, “earlier I said there were four major classes of assets to invest in in the game of financial independence. What are they?”

“Let’s see … I believe rental property, dividend paying stocks, covered call options, and a business. Did I get those correct?”

“Yes, exactly right,” I said.

“Do I get a cookie or a gold star?”

“I also mentioned Buffett-style investing. Remember, Warren Buffett sees the retained earnings of a company as his cash flow in a sense. He uses Return on Equity to gauge his return in an investment. Warren takes a paycheck from his company at $100,000 a year. This allows him to pay his bills and in our world, creates his financial independence. He leaves the rest of the capital in the company to compound, mirroring the strategy of the companies he invests in … they leave the earnings in the company. Warren figures where else can he get a return of 25% a year except in a company that is generating 25% in earnings a year? His financial statements as it relates to cash flow looks like this:”

“Keep in mind that Buffett uses his income from his business as his personal cash flow to pay his bills. The rest he leaves in the business so his business can his assets. Our mission is to get you to the point of financial independence, the point that Buffett has reached with his income, and then you can make the same decision with the excess cash flow. You can reinvest your money to compound and grow a substantial net worth or use it for cash flow. Additionally, Buffett does it through a business that makes stock equity investments in other companies. You can choose to do it through the best asset class that suits you.