Evaluating Property Based on Cash Flow
There are many different ways and strategies for evaluating and using real estate as an investment, but perhaps the safest way to evaluate a property is to disregard its speculative future value and focus instead on the amount of cash flow it can produce relative to its cost.
The simplest formula that is used to compare properties based on their cash flow is a Gross Rent
Multiplier, or “GRM”, which is simply the Purchase Price divided by the total rents a property is likely to produce in a year, referred to as its Gross Scheduled Income or “GSI”. Another way to think of the GRM is to look at it as the number of years in rents that it would take to buy the property outright, not taking into account its expenses. Logically an investor would want to see this happen in the least number of years, all else being equal.
Here’s where the plot thickens: Before assuming you are getting an apples-to-apples comparison with regard to the Gross Rents, it is a worthwhile exercise to evaluate whether the stated rents are at, below, or above market rate. One method for doing this is to compare the rents per SF at a property, also taking into account unit sizes and other factors. It helps to pay attention to the relative price per SF of any properties you are comparing. And it is additionally useful to verify if the stated rents are in fact the actual rents being paid, or if they are “pro forma” figures. To paraphrase an attorney friend of mine, the term “pro forma” is Latin for “we made this up”.
While GRM is a good initial measure of comparing similar income properties, it doesn’t account for differences such as whether the property owner or the tenants pay the utilities, or how much the annual maintenance costs run. These factors are included in calculating a
property’s Cap rate, which divides its Net Operating Income, or “NOI” by its Purchase Price to arrive at a percentage return on rents after deducting its Operating Expenses (eg taxes, insurance, utilities and maintenance) compared to the total value of the property.
A property’s Cap Rate does not take into consideration loan payments, which are used for more advanced calculations such as its Leveraged Internal Rate of Return, or “IRR”, but those types of advanced calculations will generally play out proportionately once you get an
accurate Cap rate, so a cash-flow comparison between properties based on Cap Rate will generally suffice for an initial due diligence, and in Santa Cruz County, a Cap Rate of around 5% is enough to keep most investors happy on a medium-to-larger sized rental property.
Here’s where the plot thickens again: If you rely on Cap rate claims by Sellers or Listing Agents, you not only need to verify the stated income but also the stated expenses, which are commonly understated and not always intentionally. For instance, current property taxes will commonly be cited in a listing on a property that was purchased a long time ago, which is not valid for future projections since the tax rate adjusts upon sale based on the selling price. You can generally expect Operating Expenses (again, exclusive of Loan Payments) to run between 35% and 42% of a property’s Net Operating Income, so the a quick comparison of the ratio of the stated expenses to the stated income is an early indicator you can use to determine the likely reliability of the stated Cap Rate.
While there are many other factors to take into consideration before making a decision on any investment, these are good tools for at least comparing and contrasting cash flow performance between properties. Like any skill, you get better at evaluating investment property over time, and you can always tap an experienced professional for a free second opinion if you want to gain a clearer understanding of things and improve your chances of making good choices.