Property Analysis or "Is this a good deal?"
This question has been asked so many times that I have decided to write up a crash course in analyzing financial statements. You don't need to be a financial wiz to invest in real estate, but you really need to understand a few basic concepts. We even have a tool on this website that will do analysis for you and I will show how you can use this tool to make a decision.
Fortunately we have a sample property report that has already been created. So if you would like to follow along at home you can print out the report and view each page in detail and follow along with the discussion.
The first page of the report (Property Summary) tells you what the basic facts are that you used to create this report. This well tell you where the property is, what kind of financing you will use to buy the property, what kind of profit you can earn, the cash flow you will receive, and the assumptions about your local real estate market. Everything that you put into the web input form will be here and this is a good way to remember which property you were evaluating.
A lot of people won't do analysis because "I don't know what to expect" or "I don't know what is reasonable". Then ask someone who does! There are knowledgable people on this website and there are also knowledgable people at your local REI club. The truth is that no one knows for 100% fact what will happen in the future so you just need some educated guesses. The key thing is that you want to use the SAME estimates if you are comparing similar properties.
At this point I want to stop and go off on a minor rant:
CASH FLOW IS NOT THE SAME THING AS NET INCOME
CASH FLOW IS NOT THE SAME THING AS NET INCOME
CASH FLOW IS NOT THE SAME THING AS NET INCOME
Sorry about that, but I needed to catch your attention. Most new investors do not understand the difference so here it is: Cash Flow is what your bank statements say at the end of each month (money in / money out). Net Income is an "accounting" number that shows how much profit you're making in a year. The difference between these are because of things that you either don't pay or don't collect. For example, you get to depreciate your building for tax purposes (Net Income decreases), but you aren't actually paying any cash for this expense (Cash Flow is unchanged). Another example: the value of your building will increase over time (Net Income increases), but you don't get paid for this increase because you didn't actually sell the building (Cash Flow is unchanged).
End of rant... now back to the analysis!
When you look at the sample property you might want to change some assumptions. Maybe you would want a conventional loan instead of an interest only loan. Maybe you can rent the property for a little more. Maybe you think property will appreciate by 15% each year for the next 5 years. It's a lot of fun to play around with your assumptions to see how a deal might be more or less profitable, but don't ever change your assumptions to "make a deal work". The numbers are what they are and you should find deals that fit in with your assumptions, not assumptions that make your deal look good.
The second page of the report (Financial Ratios) give you a quick and dirty evaluation of the property. These will give you a quick estimate of the property's value as well as the risk you will take.
Perhaps you have heard people say that "rent should be more than 1% of gross monthly rent?" This is the same thing as saying "the Gross Multiplier should be less than 8.33". Yes I know the Gross Multiplier is less useful and more confusing, but it is one way of comparing sales price to value.
The Cap Rate is much more commonly used and is a better indication of value. If you had to rely on just one piece of information to make your decision then this might be it because it tells you how much yearly income you will get compared to the price you pay for the property.
Debt coverage is an important measure of risk. Ideally you want debt coverage to be more than 1.00 because this means you have positive cash flow.
Ownership percentage is another important measure of risk. The more that you own of the property the more that you have to lose. If I put 20% down a property (20% ownership) and I default on my loan then I will lose a lot more than if I had only put 5% down on the property.
For our demo property we see that the Gross Multiplier is quite high (17.05) and the Cap Rate is 3.73 (I don't know if this is the market rate for this area or not). The Debt Coverage Ratio is less than 1 for the first 5 years so I know that it will take more than 5 years for me to get cash flow positive on this property. The strangest thing is that the ownership percentage will go from 20 percent up to 40 percent in 5 years; this is peculiar since this is an interest only loan! In any case, to summarize what we have found:
Low rent compared to price
(Average?) income compared to price
Negative cash flow
Large equity position is at risk
If I was looking for a pure rental / cash flow property so that I could quit my job today then at this point I would just move on and look for another property. However, if you are looking at this property over the long haul (more than 5 years) then you can keep looking.
The next page in the report (Annual Property Operating Data) is your budgeted income from the property. Sometimes people will call this the "P & L statement." These numbers will vary a lot from area to area and they might even be different within the same area. The main thing that I notice when I look at this P&L is that there are no management fees at all! Typical management fees range from 8% - 12% of Gross Operating Income. You either pay a management company to work or you would have to pay some of these other expenses.
The Net Operating Income for rental property is very important! If the expenses turn out to be higher than the original estimates then your Net Income will likely be lower than this. In my opinion: if the yearly rent is really 26,400 then I think this property owner is probably going to be closer to $14K net income.
On page 4 (Cash Flow) you get a picture of how much money will go in / out of your bank account. The before tax cash flow for this property is negative for 5 years. 5 years! However, because of the high purchase price you get an extremely large depreciation allowance of $9818. As you see this can decrease your taxable income by quite a lot and depending on your tax bracket your cash flow might even become positive.
BUT BEWARE! If you are not a "real estate professional" then this is considered "passive loss" instead of "active loss". In year 1 for the demo property there was a taxable income of -$13,147. If you are not a professional then you can only deduct this from your passive income (income from bonds, sale of stock, CD's, etc.). So if you aren't a professional and you don't have passive income then your passive losses don't give you any benefit. Put another way... your After Tax Cash Flow will be exactly the same as your Before Tax Cash Flow (which is negative).
After the first 4 pages you are probably thinking that this property is a total dud. And as I stated before: if your goal is immediate cash flow so that you can go quit your day job then yes this property is a dud! However, page 5 (Rate of Return) shows you how this property might actually be a good investment. And of course I will help you break it down.
The rate of return pages are very, very important for your analysis because it will show you where you need to scrutinize the deal. In case any one wasn't sure you want high rates of return! After all if you were only going to earn 10% (or less) then you could take less risk and invest in the stock market. This analysis will show you where you are creating most of your value and you want to make sure that the estimates supporting your returns are good estimates.
Note that the Rate of return on Loan Reduction for this property is 0%. The buyer of this property is doing an interest only loan so they are not paying down any of the loan principal.
The Rate of Return from Appreciation (30%) is clearly where this property is earning most of the value. Now that you know this you can go back to your assumptions and ask yourself "is this really what I think the appreciation rate will be or will it be higher/lower than this?"
The Rate of Return from Before Tax Cash Flow (BTCF) is -4%. This is moderately important so you might pass over the Net Operating Income assumptions one time to double check those values, but you don't need to scrutinize them. After all... wouldn't you pay -4% if you could get 30%?
Rate of Return from Tax Saving is 4%. But remember that if you are not a real estate professional then you will not be able to get the full value of this return until you sell the property. If you don't sell the property within 20 years you wouldn't get any of this benefit.
Cash on Cash returns are very important if you are trying to build up your real estate empire quickly. If you have a high Cash on Cash return then it enables you to reinvest your money quickly into other properties.
So when we take all of this together we get the profile of the ideal buyer of this property: a real estate professional that already has a lot of cash on hand and believes that this market is going to be hot for the next 5 years. They have a lot of cash on hand and a steady outside income so they don't need to rely on the cash flow from this property while they wait for their big payday. If this describes you then congratulations you just found a good property. If not, then you need to keep looking.
On page 6 (Debt vs. Equity) we get a picture of the property's assets, liabilities, and equity. For those of you that don't know, the basic accounting equation is this:
Assets - Liabilities = Owner's Equity
We're all in the real estate game for Owner's Equity. Equity is the good stuff that we get to keep in our war chest and you want to protect and build up this equity. This is another place where things start to get cloudy for people so I will try to make this simple.
Some people will tell you that a mortgage is a bad thing. Owing money to other people can cause stress (especially if you have trouble making payments). Getting collection calls or a notice of default is not fun!
The reality is that mortgages allow people to spend more money on properties than they otherwise could. This is a two-edged sword. Yes, it opens doors for you and it can get you in the game. On the other hand some people will spend more money on a property simply because "they can". You probably know someone that has done it... "my bank told me I qualified for a $450K loan so I decided to buy this $450K house" when in all reality this person could get a lesser house for $300K that would be good enough for their family. Now that we have that aside let's look again at the report.
The total mortgage balance is $360K and because this is an interest only loan the balance does not decrease. As long as the value of the property increases (or at least doesn't decrease) then this isn't a problem. However, if the value of this property plummets then you would have to PAY OUT the difference between the loan and value of the property when you sell. Worst case you would have to shell out $360K (100% of the loan).
Then there is the Debt Coverage Ratio, or what I call the "sleep at night" factor. In this case the debt coverage ratio is less than 1.00 which means you won't be able to pay your debt payments with the profits from renting this property. A ratio less than 1.00 makes it "harder to sleep at night" and a ratio higher than 1.00 makes it "easier to sleep at night". This is why landlords are always harping about positive cash flow!
The rest of the information on the page is mostly obvious, but let me summarize this page once again: debt can be a good thing so long as you are comfortable with the additional risk that comes with it. If you're a cash-hungry investor then it can get you started and it can improve your returns.
The last page (Critical Output Report) takes all of the data from the previous pages and packs it onto one piece of paper. As you become more skilled at evaluating deals you will find that this sheet will tell you what you need to make a financial decision.