what is the best way to determine maximum purchase price. Cap rate? NOI/caprate? GRM? Cash on cash return? thanks for your help.
The best way? Comparable Sales or Cost Approach
The cheapest way? Income Capitalization Approach
V=NOI/R
V = the value you are calculating
NOI = Net Operating Income
R = Cap Rate
Word of Caution: Guessing what your cap rate is ok for “funzyies”, but consult with a commercial lender to get the actual cap rate for the property you are interested in. Cap rates vary from town to town, neighborhood to neighborhood and quite often street to street (2 properties on the same street with two different cap rates).
Another Cheap Way; Min. Cash Flow Approach
NOI x DSCR = Min. Cash Flow Requirement for Viable Deal
NOI = Net Operating Income
DSCR: Debt Service Ratio; use 1.25 which is the industry benchmark for the min. allowable DSCR for commercial lending.
The smart way? Spend a few bucks (as low as 19.95 for 1-4 unit residential properties) and purchase a AVM (automated valuation method). It has the same content/information as a traditional appraisal minus the actual visit to the property by the appraiser (AVMs have gained acceptance with some lenders who allow AVMs to be used instead of a traditional appraisal approach).
Hope this helps.
Regards,
Scott Miller
thank you scott. very informative. how about gross income x grm =maximum purchase price. is that correct.
You are referring to the income approach (gross rent multiplier = Sales price / Monthly Rents.
In order to do this correctly, you need comps…
Regards,
Scott Miller
Johnny,
The vast majority of new landlords (of relatively small rental properties) fail. The number one reason that they fail is lack of cash flow caused by over-paying for the property. Therefore, when you use any market based number, like cap rate, GRM, etc, - you are determining what the average loser paid for his property. If you want to fail, follow their lead. If not, buy at a discount!!!
I am a strong believer in keeping things simple. Determine the price at which you will have an adequate positive cash flow, using real world expense numbers. Forget cap rate, GRM, DSCR, and all that nonsense!
Good Luck,
Mike
If you are borrowing money from anyone other then your mother, it makes sense to make decisions using the same rationalizations that the person that will be footing the bill will use (the bank).
Deciding what your ROI is one thing, making sure it conforms to standards so that you can finance it are another.
The number one reason why new landlords fail is because they fail to account for all the possible operating expenses and end up with a breakeven or negative cash flow property.
But propertymanager is right, if you buy a property at a deep enough discount, you don’t have much need for analysis and can afford to keep it simple.
Regards,
Scott Miller
I’m with Mike - That whole long-winded “Income Capitalization Approach” explanation is textbook and doesn’t hold much ewater with me…I already put it in the box labled “Stuff Too Hard To Do”…you need to do a reality based cashflow analysis…if it don’t make money, it don’t make sense!
Keith
Not meaning to bust chops, but sole focus on ROI with no consideration of the fundementals could = no financing.
I don’t fault anyone for trying to simplify the due dillegence process, but if you want other people’s money, then you’ll need to transfer this into the box labeled “necessary evil”.
At the end of the day, you can do it yourself or someone like me can do it for you (meaning a commercial lender), but the bottom line is these types of rationalizations will be done (if you expect to use the bank’s money).
Regards,
EZLoanz,
What is important with rental properties is that you make money. Cap rate, GRM, and all that other nonsense have absolutely nothing to do with making money or assuring that the buyer will make money. What matters is 1) how much equity you have at closing and 2) the cash flow using real world numbers. I have borrowed money from small local banks many times and have never had to provide GRM, cap rate, or any of that stuff. What I do provide to the bank is an accurate cash flow analysis using real world expense numbers and an equity analysis based on my opinion of the value (which is always very close to what the bank’s appraiser comes up with). It is true that the bank’s appraiser puts all the analysis that you discussed in their appraisal, but it is meaningless to me. I could care less what others paid. All I care about is what I pay and how much I’ll make.
Making money is not that complicated. Equity and Cash flow are the keys to success.
Mike
mike,
thanks for reminding me about k.i.s.s. i think you are right bottom line is cash flow. so if i was to assume that noi is 50% of gross rents, say my gross rents were 25,000 then my noi would be 12,500. if i could service the debt with anything lower than 12,500 annually this would be a good deal? thanks
With an 800+ credit score and a proven track record, when I call for financing, they just laugh and ask when I need the closing…
Keith
understanding the market is key; in the case of rentals you need to understand what comparable properties sell for as well as rents of those particular units. Gross rent multipler is a handy “screening tool”, but I only use it to determine whether I should expend any more brain power to look at a particular deal. I don’t have a “magic number” but that has to be balanced against condition age of property (ie. future operating expenses), rentability (income), neighborhood (likelyhood of appreciation), etc. Lastly, one needs to factor in time to get the deal closed and the property up and running (well). Most people do a poor job of property management so getting joker tenants “in line” can be a time consuming process (this why lease review is important as part of the inital offer).
sorry, no plug-n-chug equations in my book
Johnny,
say my gross rents were 25,000 then my noi would be 12,500. if i could service the debt with anything lower than 12,500 annually this would be a good deal?
No. If your NOI is $12,500 and your debt service is $12,000, that is not a good deal. It is better than nothing, but not much. Would you be happy putting up with tenants and all the hassles of running a business for $500 per year for this property? I would not! Also, I like to consider how much equity I’m picking up at closing. I never pay more than 70% of the market value, so that 30+ percent equity is important to me also.
Mike
I am not debating how much a property cash flows is critical, but the nonsense like NOI and DSCR are a means of evaluating cash flow from both an income and debt vantage point.
Is it necessary for investors to evaluate deals with this degree of scrunity? Perhaps not (although I strongly recommend it), but prequalifying opportunities the way the bank is going to, will save you alot of time on ferreting through the “gem” and the “junk” deals.
The bottom line is that the banks are doing this as a precursory to lending money, and I believe it behooves anyone that wants to use OPM to think in a similar fashion.
Regards,
Scott Miller