Every single person, business, and organization has an income statement and a balance sheet. This is the foundation of looking at a potential property investment. Does the investment cash flow? How much is this property worth paying for? How much liquidity do you have to invest? How much equity does the portfolio have? I want to offer a fundamental and simple approach to determine if you should buy a property and how much you can pay.
Let’s discuss the Income Statement. This is the “Holy Grail” many investors seek- Cashflow. How is this properly calculated? A classic approach is to look at the 1% rule. If you buy a property for $100,000 and it generates $1,000 in rents, you’ll be safe. Some investors look at their mortgage and consider all rents above that profit. When the mortgage, taxes, and insurance are $800 and the property brings in $1,200, the perception is a $400 profit. I beg to differ. There are other real expenses that need to be accounted for. Maintenance, capex, vacancy, property management, and utilities are real expenses. In multifamily there can be other expenses- common space cleaning, lawn and snow care, and garbage disposal.
Before purchasing a property, stress test it to determine its accurate cash flow. Every investor can come up with different allocations for each of these line items. Generally, investors can expect 7-10% management, 10-17% maintenance or $75-150/unit, 5-10% vacancy, and the 12 month average utility cost. This analysis can be calculated on an individual property basis, and to an investor’s whole portfolio. Be accurate with this. It’s easy to fudge the numbers to make sense of an investment.
While we’re here, let me describe my favorite metric to determine if a property cash flows enough to purchase- Debt Service Coverage Ratio, or DSCR. This is the ratio of the Net Operating Income divided by the Mortgage. A 1.0 means the asset is expected to break even. Say there is a property that rents for $1,600. Let’s assume the operating expenses, expenses to maintain the property not including the mortgage, listed above total $600. The Net Operating Income is $1,000. If the mortgage on this property is $800, the DSCR is calculated as $1,000/800 = 1.25
Consider how valuable this is. The assumptions can be wrong by $200, and the property will still break even. This protects the downside. This increases the probability you’ll keep paying all your bills, even when the unexpected appear. Keep in mind, if your mortgage has a balloon, the interest rate will be higher which will be reflected in your mortgage. This is the slippery slope of leverage. It may cash flow in years 2, 3, and 4, but will the property cover itself if the interest environment is less attractive at that time? It’s prudent to prepare for those mortgage, property tax, and material cost increases over time.
A balance sheet is commonly described as someone’s net worth or personal financial statement. List out all of your assets- cash, investments, property, vehicles, and subtract any liabilities- debts, mortgages, credit card, student loans, etc. If someone owns an investment property worth $100,000 (remember those days?) and owe $80,000 on a mortgage, they have a loan to value of 80%. This can also be described as $20,000 in equity or a 20% equity position. The equity is real, but it fluctuates until it is realized at one of two points: a sale or refinance.
What’s worth highlighting is liquidity. Some investors will only buy property in cash, while others are leveraged up to 75-90%. Leverage can allow greater purchasing power, but subjects the investment to a mortgage that must be paid. Each investor must consider their own tolerance for exposure to risk and reward. My personal philosophy is to leverage, but keep strong cash reserves. Even if all my rentals stopped paying rent, I can cover the mortgages for a long time. There is a difference between getting into a property with no and low money down, and not having any money. High leverage should be balanced out with the ability to make the mortgage payments from savings or a strong working income.
As an investor, look at your total position. Does it have enough cash flow and liquidity? Does your portfolio need more cash flow in the next acquisition? With enough cash flow, it may be time to buy a higher quality property that will break even, but has a greater probability to appreciate. All these come together to guide your decisions. Invest well, my friends.