So, you have found a property that you’re interested in. How you came across it could have been one of several ways. You may have received this listing from a wholesaler, or maybe you were driving around town, in an area or zip code that you have had your eye on for some time, and spotted it. We all have these areas we are looking at, and have just been waiting for the right opportunity. Either way, at first glance, it looks like this property is worth a closer examination.
The property is located in an up and coming area, but one of the challenges in neighborhoods like this is that prices can quickly outgrow realistic returns. Just because it’s in the right neighborhood doesn’t mean the property is going to make a good investment.
You’ve probably already pulled up the address in Zillow, and started to gather some comps to help you with your analysis. If you don’t already have Zillow saved on your phone, you should. It’s great for getting neighborhood information, such as recent sales, local schools, and other data points on the fly. Now that you’ve looked at some basic stats, you know that you should continue forward with a closer examination.
Capture the information you’ve already gathered in your notebook or iPad. Now it’s time to head back to your home or office and run some numbers.
Cash Flow Analysis
There are many different forms out there that people use to determine the cash flow of a potential property. You just want to find one that works best for you. If you like the one I’m going to show you here, just let me know and I can send it to you.
There isn’t really an exciting way to talk about a property’s cash flow statistics, this is where things are pretty black and white, but we are going to take a stab at it.
Here’s a screenshot of a Cash Flow Analyzer for rental properties.
This property analyzer is a tool that you use to plug in all of the relevant data to help you evaluate the potential returns. It’s a view on the potential cash flow of a property, and it helps you to determine whether the property will be a good investment.
On the sheet I use, the fields highlighted in yellow are the ones you enter the information into. The blue highlighted cells indicate fields that will automatically calculate based on the information you enter.
Here is the information you will need when filling it out: (the yellow cells)
Property Information: address, location (city), number of units, total monthly rent
Cost Information: property cost and down payment percentage
Mortgage Information: you will need to enter the interest rate and the loan term (in years). The balance, payment and amortized period will calculate automatically. If you use an analyzer that doesn’t automatically calculate the payment, you can use this Mortgage Calculator instead- CalcMort
Once you have completed filling out the all of your above info related to your acquisition costs, the next step is to enter some of the property related expenses. Make sure you capture all of the expenses you are likely to occur. Most people automatically enter property taxes and insurance, but some forget to include items like utilities, maintenance, or even lawn care. When you populate the following fields, make sure you enter them as an annual cost.
You’ll need to enter the following:
Real Estate Taxes: theses can be found on your county website. When you purchase the property, the tax value adjusts based on the purchase price.
Property Insurance: your insurance agent will provide you with an accurate number. As you can see in this example we are estimating costs at .25% of the purchase price. This will vary from area to area.
Repairs and Maintenance: go ahead and enter what you think you would need to cover each year’s annual maintenance. This shouldn’t include major capital improvements or rehab expenses, as those are capitalized. But carpet cleaning, drain clearing, and new locks are exepenses landlords are likely to incur on a regular basis, so make sure you factor for items like this.
Utilities: electric, water, and trash removal. Based on the size of the property, or complex, utility responsibility may vary. But if the expense is paid for by the landlord, make sure to include it here.
Lawn and Grounds Keeping: lawn care company and or snow removal costs.
Miscellaneous: unexpected expenses.
Here are some other optional expenses that you can factor in if it applies: personal property taxes, offsite management, payroll, expenses/benefits, taxes/worker’s compensation, accounting and legal, advertising, and supplies.
So now that we have filled out all of the yellow sections, let’s take a look at what populates for us, and how we get to the magic cash flow number.
Ratio Information: loan to value, return on cash and CAP rate (these numbers are all percentages) are calculated based on the property info you enter. Loan to value is just calculated based on the down payment percentage you entered at the top, so it’s nothing major. But the other two items, return on cash and CAP rate, are the two most important numbers on the whole sheet. These are the standardized returns that you can use to compare this investment against any other property you look at. The higher the number on either of these items, the better.
Total Operating Expenses is basically the sum of all expenses we just listed. Next, you have your Net Operating Income less the Annual Debt Service (your total mortgage payments). Then add back in your Principal Payments, minus Depreciation, and Taxable Net Income (Loss). Luckily all of these areas auto populate-and your magic number on Line 27 is your Cash Flow Below Taxes. In this example, our annual cash flow is estimated at $6,168.
There is also something here that may have caught your eye- notice that the Cash Flow before taxes is positive $6,168, but the Taxable Net Income shows as a loss? What this means is that the property will provide you with over $6,000 in cash flow each year, but actually show as a loss on your tax returns due to the effect of depreciation. You will make this profit tax free! Technically, it’s actually tax deferred, but by through the use of 1031 Exchanges, it can be deferred indefinitely. This is just one of the many benefits of investing in real estate versus other assets.
All of this may sound like a lot of info, and the first time you sit down to try this out it may seem clunky. After you do several (because who ever buys the first property they see?), it will get easier for you to grab these numbers and plug them into the Analyzer. Then you will know if you should take it or leave it.
If you like the Cash Flow Analysis tool I used, drop me a message and I can send you a copy to use. Let me know if you have any other questions on how to use this in the comments below.