How do they do it? How many times have you heard someone talk about their income-producing property? Some properties are more profitable than others. How can you tell before purchasing?
In this post we’re going to explore the Quantitative Measures (QM) you can use to compare the market value of prospective income-producing properties. You may not become an expert in real estate investment, but you will become familiar with the lingo that you could (and should) discuss such matters with your accountant or tax advisor. Math phobics should prepare their favorite cocktail at this time. And now, with calculators and cocktails in hand, let’s begin.
Simply put, QM is a number and you use them all the time. Take temperature, for instance. You might consider a Caribbean vacation in February because an average daily temperature of 75º is appealing. Average daily temperature is just one QM you might use. Others may be the cost of air fare, lodging, meals, etc. Just as you wouldn’t use mean temperature alone to determine where to vacation, no single QM can be reasonably used to determine which income-producing real estate investment best suits your needs. In what follows, we will use several QMs.
An income-producing property may be for you if it results in a better rate of return when compared to other investments, i.e. money market and savings accounts, bonds, dividend yielding stocks, etc. Let’s say you have just inherited $100,000 from a rich uncle. What do you do with this windfall?
A call to your favorite Realtor® reveals that she has a town home available valued (V) at $100,000 that produced an Actual Gross (rental) Income (AGI) last year of $12,000, with Operating Expenses (OE) of $3,500. The owner set aside $500 in Reserves for Replacements (RR) to cover future replacement of such things as air conditioning, carpets, appliances, etc. The property’s Net Operating Income (NOI) is $12,000 – $3,500 – $500 = $8,000 before taxes. In other words,
AGI – OE – RR = NOI
Our first QM is the Capitalization Rate (R). As the term implies, it measures an investment’s rate of return. NOI (Net Operating Income), V (Value), and R (Capitalization Rate) are related by the expression
NOI / V = R
From our example, the town home’s R (Capitalization Rate) for last year was $8,000 / $100,000 or 8%. If this sounds confusing, just think that if you dropped the entire $100,000 into a vehicle that returned 8%, your first year profit would be $8,000. If some other investment vehicle (stocks, bonds, etc.) could reasonably be expected to return, say 8½%, then the town home might be less attractive. As a savvy investor, you determine that a minimum R of 9% may induce you to purchase the property. At that rate, what would you pay for the town home? Rearranging the previous equation into
NOI / R = V
The value of the town home is $8,000 / .09 or roughly $89,000. This QM should not be used alone in evaluating property value because a small change in R results in a large change in V.
Another QM for comparison is the Equity Dividend Rate (EDR). The EDR is probably the most useful to the typical investor because it assumes that the purchase will be financed. Borrowed funds are widely used to finance real estate for two reasons. First, most of us do not have adequate funds to purchase real estate outright. Second, by making a down payment (Equity) (E), and financing the rest, we hope to reap the advantage of positive leverage. Thus, the EDR represents the rate of return on equity. Unlike R, in which the property was purchased outright, we must now account for Debt Service (DS). DS is now an “expense” which must be subtracted from NOI (Net Operating Income) to figure what is left before taxes. Let’s call this amount the Before-Tax Cash Flow (BTCF).
NOI – DS = BTCF
Let’s say that you could purchase our town home for $90,000 with a 20% down payment at 7.5% annual interest. Your first year DS (Debt Service), (the total amount of interest and principle paid), is $6,041., Therefore, the BTCF is $8,000 – $6,041 or $1,959. Finally,
BTCF / E = EDR
and our return on equity is $1,959 / (0.2 x $90,000) = $1,959 / $18,000 = 11%. Recall that our return R on the outright purchase of the property was estimated to be 9%. The EDR shows mathematically the potential advantage of leveraging (financing) at least a portion of your $100,000 windfall. For a constant BTCF, as E (Equity) decreased, the EDR Equity Dividend Rate) will increase.
Rarely will you find a highly leveraged property that immediately provides a positive EDR.
A simple QM your lender may be especially interested in is the Debt Service Coverage Ratio (DSCR). This QM gives an indication as to how much of a decrease in NOI (Net Operating Income) a property can sustain yet still remain adequate to cover the debt service. In our example, the annual DS (Debt Service) is $6,041. The DSCR is defined as
NOI / DS = DSCR
and our DSCR is $8,000 / $6,041 = 1.32. This means that the NOI (Net Operating Income) could decrease by 24% and the lender is still assured of receiving the mortgage payment. Lenders typically look for a debt service coverage of at least 1.15 to 1.30.
Emotions and anxiety can run high at the thought of purchasing real estate. Even if you are positive that income-producing properties suit your needs, determining which property to buy requires careful planning and research. By learning a few ways to evaluate properties, you can help narrow your search so that when you get with your financial advisor before deciding to buy (and you should always consult with a professional before investing), you can save both of you time. And we all know time is money! (Just pray the IRS never figures out how to put a dollar figure on it).
Two other values you obviously want to consider are your gains in equity and potential increases in value of the property during the time you own it. We’ll take a closer look at these concepts next week . . . let’s just let our brains cool off a bit for now.
