When evaluating a property, the most important item is the cash flow. Can the property produce the needed cash flow to create a “positive cash flow” investment?  You never want to buy a property where you continually put money into the property for either the expenses or the mortgage each month.

The first step in evaluating a property to purchase would be to get a copy of the Annual Property Operating Data (APOD) from the seller or have your estate agent obtain it for you. An APOD is simply a spreadsheet or financial statement that shows all the expenses and income. The expenses should be broken down into categories like, taxes, insurance, vacancy factor, repairs, etc.). The income should be the actual monthly income or annual income and whether the rents are based on month to month or a lease.

Now remember the mortgage is not an expense item so don’t enter that figure into your calculations yet. Once you get all the expense figures, subtract that amount from the gross annual income figure. What left is the “Net Operating Income” (NOI). This number must be a positive number.

Example

Gross Annual Income                                     $30,000

Total Annual expenses                                       8,000

You Net Operating Income (NOI) would be  $22,000

Next you would divide you NOI by 12 to get your monthly NOI.

 Then you would figure out different monthly mortgage amounts based on different scenarios like 10% down or 20% down. Once you have your monthly mortgage calculation, subtract the monthly mortgage amount from you monthly NOI figure. If say the 10% gets you a negative cash flow amount, then try the 20% down mortgage amount.

This is where you can play the “what if” scenario to determine your best strategy. Maybe you need to offer less then the asking price to make the deal a positive cash flow or maybe you can afford to put more money down to get the monthly mortgage payment lower

Ok, you probably saw this coming. This is where I plug our handy dandy software program you can buy on this site for a very modest fee. This software program truly takes the pain out of calculating each scenario with paper and pencil.

Besides evaluating cash flows, there are other factors or items that investors use to determine if a deal is right for them.  These factors are Capitalization Rate (Cap Rate), The Gross Rent Multiplier (GRM) and Return On Investment (ROI).

The Cap Rate is a simple calculation  taking the annual NOI and dividing it by the purchase price or what is determine to be the Fair Market Value (FMV) of the property.

Example:

Annual NOI is                         $9,000

Purchase price                    $125,000

Cap Rate would then be         7.2%

The higher the Cap Rate is the better the deal. Generally the Cap Rate is used for larger multi-family buildings or commercial type property. On smaller properties, most all Investors use the Gross Rent Multiplier instead of the Cap Rate. The calculation for a GRM is gross annual income divided into the purchase price or the Fair Market Value of the property.

Example:

Gross Annual Income             $24,000

Purchase price                      $125,000

GRM would be                       5.2

Since the GRM does not take into consideration expenses, it is used more as a benchmark for evaluating properties. Thus you are able to determine if the property warrants a closer look. But first you would need to know what the Gross Rent Multipliers are for your market area. It’s best to contact a real estate Broker who specializes in multiple units and ask him/her what the range is for GRM’s in your market.

The other formula that some Investors used is the cash-on-cash return. Also known as the Return on Investment. The formula is easy, you simply take the net profits (that’s the gross income minus all the expenses including debt service) and divide it by the cash invested in the deal.

Example:

Annual Net Profit                   $9,000

Cash invested                         $30,000

ROI would equal                   30% ROI

In closing, there are other ways that some Investors valuing a property, like Cost Per Square, Average Cost Per Unit and Cost Per Bedroom. But the examples above are the more common ways that most Investors evaluate a property.