By Rena Henderson Mason
The Investment Paradox
Why will a 3-flat sell for $400,000 but a 12- unit on the same block will sell for only $600,000? This is the investment paradox that many new investors don’t understand. They assume that the 12-unit is a real bargain because the price per unit is significantly less than a 3-flat. They believe if they buy and rehab the 12-unit, it will sell for $1 million or more since it should trade like the 3-flat. If an investor proceeds under this premise, they are doomed to lose some or all of their investment. The foreclosure market is full of investors who did not understand how to value their property.
The reason for the value contradiction is that investment properties (six units or more) are valued based on a property’s income and cash flow. Smaller multi-units (less than six units) are valued based on market comparables, the buyer’s income and the property’s income to a lesser extent.
Also, an owner is more likely to live in a small multi-unit and thus, is willing to give up some of the cash flow in exchange for a more affordable living alternative than a single family home. Investors are not as likely to walk away from their investment if they live in it, nor will they tolerate situations like drug dealing and deferred maintenance that contribute to troubled properties. Therefore, lenders will underwrite loans for smaller properties with favorable terms such as small down payments and low fixed rates. By contrast, investment property loans usually require down payments of at least 20%, higher variable rates and shorter amortization periods. These terms reflect the greater risks associated with investment properties.
Understanding this paradox and how to value investment properties is an essential skill for those who want to make money buying and selling larger multi-family properties. This article details how to figure the most important aspect of valuing an investment property: the cash flow.
JOE INVESTOR CASH FLOW ANALYSIS
Rents for a 15 unit Property
Average Monthly Rent: $555.55
Number of Units: 15
Scheduled Rental Income: $100,000 ( $555.55 *15 *12)
OPERATING STATEMENT
351 Boardwalk Avenue
15 Units
INCOME
Scheduled Rental Income $100,000
Parking 5,000
Laundry 1,000
Gross Income $106,000
Less: Vacancy @ 10% (10,600)
EFFECTIVE GROSS INCOME $ 95,400
OPERATING EXPENSES
Real Estate Taxes $ 7,000
Insurance 4,000
Gas 12,000
Electric 1,000
Water & Sewer 2,000
Scavenger 1,000
Repairs & Maintenance 5,000
Janitor 4,000
Property Management Fee 4,000
LESS: Tot. Oper. Expense ($ 40,000)
NET OPERATING INCOME $ 55,400
Less: Debt Service ($ 35,000)
CASH FLOW = $ 20,400
Cash Flow, Cash Flow, Cash Flow
The most common phrase in real estate is “Location, Location, Location.” While that axiom still holds true for investment property, a more important concept is “Cash Flow, Cash Flow, Cash Flow.” Most investors would rather own an investment property in a marginal location with a strong cash flow than one in a strong location with a marginal cash flow.
The first step in the investment process is to analyze the numbers. An investor should do this before walking through a property. If it does not make money on paper or have the potential to make money quickly, don’t waste time looking at the property. It’s easier to walk away from a property when none of your time, energy and money have been invested.
Some investors ignore the cash flow and are looking for appreciation in the short term by flipping or converting to condos. Although there are many who have made substantial money following this strategy, there are just as many who have had significant losses when the market has changed, costs have risen and they did not have adequate reserves to ride out any problems they encountered.
The new investor should be looking for an investment property that generates a positive cash flow. It is the primary way a property will be a viable investment. The property’s cash flow is the return on investment the investor receives for all his or her hard work. It’s always the first and last item an investor should review when analyzing a property.
Elements of Cash Flow
In order to value a property you need to have accurate operating information on the property including the income, operating expenses and debt service (See Exhibit 1).
· Income – Monthly rents for each apartment are totaled and multiplied by 12 to get the Scheduled Rental Income for the year. Add in any other income such as parking or laundry to get the Gross Income. Then apply a vacancy factor as a percentage of the Gross Income. This factor should be based upon current market conditions and the property’s current occupancy. Subtract the vacancy expense from the Gross Income to get the Effective Gross Income.
· Operating Expenses - Includes Real Estate Taxes, Insurance, Utilities, Repairs & Maintenance, Scavenger, Janitor and Management Expenses. These are deducted from the Effective Gross Income to arrive at Net Operating Income.
· Net Operating Income – Effective Gross Income minus Operating Expenses. This is the money available to pay the mortgage after all other expenses have been paid.
· Debt Service – Monthly mortgage payment (principal and interest) multiplied by 12. Yahoo Finance! has a calculator for mortgage payments if you know the inputs (interest rate, loan amount and term). You can find the calculator at http://finance.yahoo.com/loan/mortgage.
· Cash Flow – This is what remains for the investor after all expenses have been paid including the mortgage. It’s the investor’s return on his or her investment.
Sensitivity Analysis
In most cases, the first pass of a cash flow analysis will show enough cash flow for an investor to remain interested in the property. But it’s important to perform several sensitivity analyses to test the impact of changes of key variables.
What happens to the cash flow if rents are increased or decreased by 5% or 10%?
What happens to the cash flow if the vacancy increases from 10% to 20%? Usually, if rents are raised too much, the vacancy will also go up.
What happens to the cash flow if the taxes increase by 30%, the insurance increases by 40% or the gas increases by 50%? Also, look at a worst-case scenario where all four variables of vacancy, taxes, insurance and gas have increased all at once while rents remain flat. Unfortunately, this may be a reality since this has been the situation for many investors in the past few years.
Lastly, perform an analysis of the impact of changes in the mortgage terms. What happens if interest rates rise by 50 to 100 basis points? What happens if the down payment is 25% instead of 20%?
Understanding these income and expense variables allows the savvy investor to negotiate more favorable terms from the seller and/or with their lender. Such favorable terms can turn a property with a marginal cash flow into one with a substantial return on investment.
The Bottom Line
Ultimately, an investor must feel comfortable with the projected cash flow from the property and his or her ability to manage it. The investor must search for opportunities to add value to a property by increasing rents, reducing vacancies and/or reducing operating expenses. The focus should always be on the bottom line: the cash flow.
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Rena Henderson Mason is an Investment Specialist at the Broz Group, a real estate brokerage firm specializing in multi-family sales and 1031 tax exchanges. Rena provides services to a variety of investors from hands-on rehabbers of six flats to investor groups that own 200 + units with a focus on South Side communities. Contact Rena at 773-275-1500 ext. 217 or rhmason@brozgroup.com.
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