It takes hard work and effort to be successful but most importantly it takes an exit plan before you even purchase a property! Yes, I said that right! You must plan your exit before you buy! That is done by analyzing the area in which you want to purchase in to determine the job and population growth potential. If jobs are leaving, the people will eventually follow, and you end up with declining demand for real estate which means no appreciation. Go to the municipality or county website and you’ll typically find info regarding the major employers there as well as demographic info from the most recent census. It’ll tell you if the population is growing, static, or declining. Look up those employers and see how their business is going. Are they expanding and hiring or contracting and laying off.
While you’re on the municipality’s website, it should also tell you how fiscally responsible they are. Are they operating at a deficit or surplus? If they’re operating at a deficit, the real estate taxes may be increased soon! If you’re not sure, call the County Assessor and ask them about the real estate taxes and the prospects of them increasing anytime soon. There’s lots of valuable information you can get from the municipal government, you just have to ask for it!
Next, if you find a potential property to acquire, get the actual income and expenses from the seller or broker. Ask for a T-12 (trailing 12 months) preferably get the last 24 months along with a current rent roll. Don’t waste your time with proforma projections! In my 25+ years of experience, I’ve never seen a proforma that projected losses! If you can’t get it, move on to another property. Either the seller isn’t serious about selling or the listing broker is trying to attract offers to create a bidding war to not only escalate prices but remove contingencies!
Now evaluate the information and be sure to see exclusions that may artificially inflate the Net Operating Income (NOI, calculated by subtracting the expenses from the income). These may be items the seller claims they perform themselves like landscaping or leasing, but those items must be assigned an actual expense for 2 reasons, an appraiser will build in the expense of a third party performing those function as well as the lender because if they ever have to foreclose and take over the price, they’re going to hire a third party to do the job. Other items that should also be included on the expense side are management fees as well as reserves.
Now set up an excel spreadsheet and list every line item income and expense. Total that column to determine your NOI. Now calculate your annual debt service if you’re financing the property. Subtract that from the NOI to determine your cash flow. Divide the cash flow amount by the down payment to determine your cash on cash return.
Now go back through each line item for the next 5 year period and project each increase and/or decrease for each item, column by column. How much can you raise your rents? How much will raising your rents increase your vacancies? Are you projecting your utilities to increase correctly? What about your real estate taxes? Insurance? Are you increasing your cash flow every year?
Now go back to your year one column to determine your Cap Rate (Capitilization Rate). This is calculated by dividing the NOI by the Purchase Price. For example, NOI of $100,000/ Purchase Price of $1,000,000 equals .10 or 10% which is the return you’d have if you paid all cash for the property. It’s one of a number of methods to determine value. Now go to the last column and take the NOI number and divide it by the original Cap Rate. This number is a rough approximation of the potential future value. If this is an acceptable valuation, you should make an offer on the property. If not, lower the original purchase price and recalculate to determine your potential exit value.
Keep in mind the discipline to maintain the expenses at the annual projected amounts as well as accurately projecting the increases to the rents.
This is a basic valuation exercise and more methods such as Internal Rates of Return should also be calculated with this model. This will at least provide a starting point and annual map for you to be successful.