Evaluating Rental Properties that Cash Flow - A Very Boring Primer

To evaluate a rental property you need to know four things. Income, expenses, standard rules of thumb for quick gauges of value, and fuzzy logic.

Income
When it comes to income, you can not trust what the MLS printout shows. The income is likely too low or two high. You need to develop your own sense of rental values. Being off by several hundred dollars in rent can make a HUGE difference. For example, $100 per month of cash flow at 5% is worth about $25,000, so if your rental estimates are off by $400 you might under or over value a property by $100,000. Also, it is not too hard to do a rental survey. I have four methods. You can look at what competing units are asking for rent. Compare the MLS advertised rents versus what other units advertise as rents on the MLS. There are also several web sites that can provide comparisons. And finally, I check with local property managers.

Expenses
As a general rule of thumb, expenses should run about 40% of gross monthly rents. These expenses include, property taxes, insurance, property management, property maintenance, utilities, gardening, and licensing.

Rules of Thumb - Quick Gauges of Value
My first quick gauge of value is the Gross Rents Multiplier, (GRM or GM for short). If a building is selling for 10 times its Gross Annual rents, then it would have a GM of 10x. Example, 10 units x $1,000 per unit x 12 months x 10x GM = $1,200,000. Pretty simple.

The GM allows me to quickly tell if a building will make sense or not. It certainly depends on area, because better areas will sell at a higher GM. But for the properties I was evaluating, I simply wouldn’t be interested if the GM was above 12x, providing me with a quick way to screen out properties that didn’t cash flow well enough.

My second check to review is rents per square foot. Rents in marginal areas might be $1 per sqft, while high rent districts might be $2 per sqft. This is helpful because it can confirm quickly if the rents that I have calculated are in line with the area. If the figure is high, maybe I am being too optimistic, and if I have calculated a figure that is low, maybe there is more upside potential.

I also might use this figure to quickly determine what a buildings rents might be. Let’s say I want to quickly calculate the monthly rent of an 8 unit building with a broad mix of different size units. Rather than estimate each units rent, I could just take the total building sqft and multiply it by a typical rent per sqft rate for a quick estimate of total building income. This can greatly increase my ability to sort through lots of properties.

Fuzzy Logic
Up to this point we have talked about income and expenses from a purely theoretical point of view. But some buildings and areas are better than others. It is necessary to walk the building and the surrounding area to help you determine some of the subjective issues. Basically, I want a low maintenance building that attracts a decent quality of tenant that will pay the rent and not want to leave.

Are there garages? Is the building appealing? What is the condition? Is it a high maintenance or low maintenance building? Are there separate gas and electric meters? What might the vacancy factor be? Would it be a management headache? Is there a lot of competition in the neighborhood for tenants?

Final Analysis
If a building passes all of the above tests, then I will plug the numbers into a quick excel spread sheet to determine actual cash flow numbers with real expenses. The spread sheet enables me to determine actual cash flows, returns on cash, internal returns and allows you to test out different scenarios.

I would be happy to send you the excel spread sheet that I use to evaluate properties. E-mail me a request (John@LBRE.com).

Kurt Newnes, a very good local property manager said to me “I try to find all of the reasons not to buy a building, and if I can’t find any I buy it”. But the caveat to this is, “I might have to look at 50 - 100 buildings”. Wise advice from a smart man.