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Fishing for Hot Investments in A Cool Market
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The seller is asking $1 million. He provides the following financial information. (All revenue and expense numbers are annual, from 2005.)
· Gross annual rent: $90,000
· Utilities: $10,000
· Repairs and maintenance: $2,000
· Insurance: $3,000
· Taxes: $6,000
That means the property brings in $90,000 a year in rent, and expenses are $21,000. That means revenue minus expenses, known as net operating income, is $69,000.
Is this property a good investment? Let's take a look.
First, as with any investment, you must determine a way to evaluate the rough attractiveness of the investment before proceeding. For instance, in the stock market, many investors use the price-to-earnings ratio, or P/E. In real estate, investors often use the property's capitalization or "cap rate." This, too, measures how the price of a property relates to its earnings stream. The cap rate is calculated by dividing the net operating income by the purchase price. Because it is calculated without factoring in financing costs, the cap rate shows you the rate of return you would expect if you bought the property with all cash.
In this hypothetical example, if you relied only on the information provided by the seller, it would appear that this property's cap rate is 6.9 percent. In Washington, 6.9 percent is currently considered a good return for this type of property, though cap rates fluctuate over time. (An investor who will accept a lower cap rate will be willing to pay more for a property than one who insists on a higher return on the investment.) Historically, 6.9 percent is on the low side, but more on the implications shortly.
Remember that the seller's information is only a starting point. Your next task is to develop your assumptions and build your own financial model. Here are some basic due-diligence questions to consider.
· Are the rental income projections realistic? Check newspaper and Internet ads and visit similarly priced rental units. Ask to review existing lease agreements. Make sure that you can get the rents the seller is saying you can expect. Are there opportunities to raise rents? Are any rent-control laws in place?
