Should I Buy This Home as the right investment Property?
I firmly believe real estate investment opportunities will become abundant again before too long. What gives me that certainty? Very relaxed credit terms have slowly crept back into the mortgage approval process after the great recession. Most areas have recovered nicely and banks are eager to lend again, often with the help of government agencies that guarantee and facilitate these loans, enabling many first-time home buyers to purchase homes with very low credit scores and little or nothing down. To be prepared to take advantage of these opportunities, be sure to have readily accessible cash for a quick down payment.
If you encounter such an investment opportunity and think you could “flip” or resell the home at a profit even after some sprucing up or updating, to get at a selling price, you would use the market value price analysis. That is, price the home based on its size, location, updates, home and area amenities, current market trends and so on.
Real Estate agents often offer free home price analyses to their buyer clients, as a reality check. This study, commonly known as Comparative Market Analysis (CMA) typically consists of an evaluation of comparable homes that were recently sold in the immediate area, are in contract to be sold, plus those that are still on the market (competition). Most agents are reasonably adept at doing this, but not all are comfortable with investment analyses.
I once received a request for a CMA for a single family home that was already on the market, which was a bit puzzling. As it turned out, the enquirer was not a seller at all, but a buyer, who was interested in this house as an investment property and wanted to know if the asking price was “right”.
Having crunched the CMA numbers before calling this gentleman, I was able to assure him that the price of the home in question was in line with the current market for a RESIDENTIAL property. However, to view it as an investment property, I offered the capitalization rate approach to provide a better measure of Return on Investment, or ROI.
In other words, if you are purchasing a home as a longer-term investment property and intend to rent it rather than sell it outright (based on your tax or cash flow preferences), the price evaluation would be somewhat different.
Capitalization Rates (Cap Rates) are used to establish value for investment properties. What to a residential buyer is PRICE, to an investor is VALUE. A higher Cap Rate indicates more efficient use of your money.
You could consult a friendly local commercial lender to get a sense for what the current Cap Rates are in your area. Generally, a Cap Rate of about 8% is considered respectable, but sometimes lower ones may be acceptable.
The Cap Rate (CR) formula is:
NI/Value = CR, where NI is Net Income and Value is the Price
To get a TRUE Cap Rate, one would need a thorough understanding of the detailed operating expenses of the property (e.g. insurance, tax, water, sewer, maintenance, etc.) so as to arrive at the proper number for NET Income. In the absence of that, for a rough comparison of potential returns from different properties, one can use gross rental income.
FINDING THE CAP RATE
My potential investor client would need to determine what the going rental rates are for homes similar to the one he is considering (BTW, we love investors because they normally represent repeat business). Let’s say this 4 Bedroom Single Family home in that particular area could be rented for $2,500/month, yielding an annual gross income of $30,000. The asking price for the home is $500,000.
Using the formula: NI/Value = CR: $30,000/$500,000 = .06 or 6% Cap Rate TOO LOW
FINDING THE RIGHT RENT NUMBER
Going at the matter a different way, you could ask HOW MUCH DOES THE RENT NEED TO BE to make this price worth my while, i.e. for me to get my 8% Cap Rate?
Using the formula: RENT = CP x Value: .08x$500,000 = $40,000/year or about $3,333/month. My investor would have to charge $3,333/month in rent to get his desired return.
FINDING THE RIGHT PRICE OR VALUE
Since it’s not likely that tenants would be willing to pay an above-market price for a rental, investors can focus on the VALUE of the property. To arrive at a worthwhile value, or the amount an investor is willing to pay to get his ROI:
Using the formula:
VALUE = NI/CP: $30,000/.08 = $375,000
According to this analysis, to achieve his target Return On Investment on the property in the current rental market, the investor should not pay more than $375,000 for the home.
This methodology for analyzing the value of potential investment properties is clearly very rough, but it’s a good starting point or tool to determine how far the price might need to be negotiated down to get to the value of the property to you, or phrased differently, how to arrive at what the maximum price should be, based on what profit you want to get out of the investment.
For any in-depth investment considerations, professional advice (perhaps from a Certified Public Accountant), is always recommended, particularly in establishing detailed operating expenses, debt service costs and tax liabilities. For real estate advice, don’t hesitate to contact Olga at firstname.lastname@example.org.