Yay or Nay – Evaluating Your Next Rental Property

By Douglas Katz – 02/07/23

While reality shows about real estate investing make the process look quick, easy and light on the math, the truth and reality is very different.  Successful investors use one or more financial models to determine whether new projects make sense and what to adjust in their existing portfolio to optimize return.

While there are many different models ranging from the established to the hyper-sophisticated homebrewed models, it is always best to start with the most simple ones.  Many of the customized models are based in these basic methodologies, so understanding them is critical for a sound foundation.  In general, I focus on several financial models that investors commonly use for analyzing the viability of a rental property investment:

Gross Rent Multiplier (GRM) – a simple method to determine if a property is over- or under-priced based on its rental income compared to its purchase price.

Cash Flow Analysis – a detailed calculation of the rental property’s expected monthly cash inflow and outflow to determine the net positive or negative cash flow.

Capitalization Rate (Cap Rate) – a measure of a property’s potential return on investment based on its net operating income divided by its purchase price or market value.

Debt Service Coverage Ratio (DSCR) – a calculation of a property’s ability to service its debt obligations, which includes mortgage payments and other expenses.

Return on Investment (ROI) – a measure of the property’s overall financial performance, including both its rental income and appreciation.

Each model provides a different perspective on the viability of a rental property investment, and a comprehensive analysis often combines multiple models to provide a comprehensive understanding of the property’s potential financial performance.

Gross Rent Multiplier

Gross Rent Multiplier (GRM) is a simple method used to determine if a rental property is over- or under-priced based on its rental income compared to its purchase price. It is calculated by dividing the purchase price of a property by its gross rental income.

GRM = Property Purchase Price / Gross Rental Income

For example, if a property is purchased for $300,000 and has a gross rental income of $2,000 per month, the GRM would be 150 (300,000 / 2,000).

GRMs vary by market and property type, but in general, a lower GRM indicates that a property is priced lower relative to its rental income, making it potentially a good investment. A higher GRM, on the other hand, indicates that a property is priced higher relative to its rental income, potentially making it a less attractive investment. However, it is important to note that GRM should not be used as the sole factor in determining the viability of a rental property investment, as it does not take into account other factors such as operating expenses, market trends, and property condition.

Cash Flow Analysis

Cash Flow Analysis is a method of evaluating the expected monthly inflows and outflows of a rental property investment in order to determine its net positive or negative cash flow. This analysis is used to determine the financial viability of the investment and to understand the property’s ability to generate income, pay expenses, and potentially provide a positive return on investment.

The process of cash flow analysis involves estimating all expected monthly income from rent and other sources, as well as all expected monthly expenses, such as mortgage payments, property taxes, insurance, maintenance, and repairs. The net difference between these inflows and outflows is the property’s expected monthly cash flow.

A positive cash flow means that the rental property is generating more income than expenses, which is desirable for an investment property. A negative cash flow, on the other hand, means that the property is generating less income than expenses and may not be a financially viable investment.

It is important to note that cash flow projections are based on assumptions and may not reflect actual results. For this reason, it is important to be conservative in estimating expenses and to regularly review and adjust cash flow projections as necessary.

Capitalization Rate

Capitalization Rate (Cap Rate) is a measure of a rental property’s potential return on investment, calculated as the ratio of the property’s net operating income to its purchase price or market value.

Cap Rate = Net Operating Income / Property Value

Net operating income is calculated by subtracting all the property’s operating expenses, such as mortgage payments, property taxes, insurance, maintenance, and repairs, from its expected rental income.

The Cap Rate provides a quick and simple way to compare the relative value of different rental properties and assess their potential returns. A higher cap rate indicates a higher potential return, whereas a lower cap rate indicates a lower potential return. Cap Rates also vary by market and property type, and a higher cap rate in a given market typically indicates a higher level of risk associated with the investment.

It is important to note that the Cap Rate should not be used as the sole factor in determining the viability of a rental property investment, as it does not take into account other factors such as market trends, property condition, and the investor’s personal financial goals and risk tolerance.

Debt Service Coverage Ratio

Debt Service Coverage Ratio (DSCR) is a financial metric used to measure a property’s ability to pay its debt obligations, specifically its mortgage payments. It is calculated as the ratio of a property’s net operating income to its debt service payments, which are its mortgage principal and interest payments.

DSCR = Net Operating Income / Debt Service Payments

A DSCR of 1.0 or higher indicates that the property is generating enough income to cover its debt service payments, which is typically a requirement for obtaining financing. A DSCR lower than 1.0 indicates that the property is not generating enough income to cover its debt service payments and may struggle to pay its mortgage.

DSCR is an important factor that lenders consider when evaluating a loan application, as it provides insight into the property’s ability to generate enough income to cover its debt obligations. A high DSCR, typically above 1.25, is typically viewed as favorable by lenders and can increase the chances of loan approval.

It is important to note that the DSCR calculation only takes into account the property’s net operating income and debt service payments and does not consider other factors such as market trends, property condition, and the investor’s personal financial goals and risk tolerance.

Return on Investment

Return on Investment (ROI) is a financial metric that measures the performance of an investment by calculating the ratio of its net profit to its cost. It is used to determine the profitability and efficiency of an investment, and to compare different investment opportunities.

ROI = (Net Profit / Investment Cost) x 100

Net profit is calculated by subtracting the investment cost, including the purchase price, closing costs, and any other costs associated with the investment, from the total gains from the investment, such as rental income and any appreciation in property value.

ROI provides a simple and straightforward way to evaluate the performance of an investment and compare its profitability to other investments. A higher ROI indicates a more profitable and efficient investment, while a lower ROI indicates a less profitable investment.

It is important to note that ROI calculations are based on projected or historical data, and actual results may vary. Additionally, ROI calculations only consider the financial performance of the investment and do not take into account other factors such as market trends, property condition, and the investor’s personal financial goals and risk tolerance.

It is important to remember that there is no best model.  I look at it the way I approach martial arts.  It is the system that counts and that system is comprised of the best components of different arts that best suit my resources and strengths.  Success in real estate investing is dependent upon taking these established rental property analysis models as well as finding or even making homebrewed financial models to create the system that best supports your strategy.

 

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