How To Evaluate An Income Property
November 11th, 2007 Categories: Investing
Cap Rate
We hear many different ways to evaluate rental property. The one method that is the most effective is called the Capitalization Rate, affectionately called the Cap Rate.
I have heard many variations of the cap rate, things like 100 times the rent. That is called the rent multiplier, takes the rent and times it by say 120. The problem with that approach is it doesn’t account for expense variations. It is a good rule of thumb measure to see if it is worth drilling down.
Are you ready for the unequivocal simple version of the Cap Rate, drum roll please?
Income, Minus Expenses, Divided By The Sales Price, Equals Rate of Return. It really is that simple. Always use annual numbers.
| Gross Income | $18,000 |
| Minus Expenses | $3,600 |
| = Net Income | $14,400 |
| Divided By Sales Price | $200,000 |
| = Rate Of Return | 7.2% |
Property evaluations are based on cash purchases. When you leverage a property that is a different equation and has more factors than evaluating just the property, remember we are evaluating the property. If you are going to leverage a property, the property must perform at a higher interest rate than what you can borrow at.
Click for full functioning Excel Spread Sheet
Now the trick is getting real income and expenses on a piece of property you don’t own. Remember the seller’s motivation is the highest price. So based on the above formula, they like to overstate income and understate expenses.
When purchasing an income property the surest way to get the most accurate information is, for income use a tenant landlord estoppel letter. This letter is signed by both parties stating the basic terms of the lease, start date, end date, monthly payment, how much security deposit and where is it, that the tenant is current. Compare the letters to the leases and now you have your income.
As for expenses, if you really want to know how much a property owner has spent ask for a copy of the Schedule E of their tax returns. You know they didn’t leave anything out there.
Here are some things to consider when looking at the expenses.
How Many Utility meters are there?
How old is the-
Roof
Furnaces
Water Heaters
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GRM = gross rent multiplier, the “quick & dirty” cashflow estimate that neglects expenses.
One aspect of analyzing expenses is that the owner often invests tremendously in updates (e.g. roof, hvac, tuckpointing, etc.) prior to putting the property on the market. Technically speaking, this will kill a cap, but the owner will likely exclude these capital expenses from typical maintenance concerns. Should you, as a buyer, include this in your analysis of the real value, and maximal purchase price? Tough call, but it’s not something that most sellers have a differing opinion of.
Hi Alex,
You brought up a great point and that starts a whole new set of factors. The owner cannot depreciate it because it is a capital expense. However the new buyer would start their depreciation at their basis. That combined with the fact that the new owner will not have these major expenses for a long time will certainly factor in the price because in theory it should lower the expense.
There are two ways of increasing the performance of the property.
One increase the income, two lower the expense.
So it definitely plays, to what extent is hard to say without a real scenario and all the facts.
Thanks for the excel work sheet
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