Property Criteria and Analysis

Once you've identified a potential investment property, it's time to closely study the property for both short-term and long-term opportunities. You will want to put each prospective property through a rigorous review, using the following criteria:

1. Guiding Investment Principles a. Leverage b. Cash Flow c. Cash-on-Cash Return d. Capitalization Rate e. Gross Rent Multiplier

2. S.W.O.T. (Strengths, Weaknesses, Opportunities, Threats)

3. Trends

4. Demographics

Now, I could write an entire book about these four key areas of property analysis. Here, though, let me summarize each of these points quickly.

Leverage

Leverage simply means that you want as little of your money as possible used to secure the biggest opportunity possible. The less money you have to invest in a property, in other words, the larger the opportunity for a big payoff. When analyzing a property, know exactly what you will initially need to invest.

Positive Cash Flow

A key to building my real estate fortune over the years has been cash flow. We call cash flow "king" because having cash is always our primary objective. Positive cash flow creates and maintains your investment's momentum. It also has significant financing and lending implications. For example, when purchasing an apartment building containing more than five units, the bank will base the amount it will lend you on the building's cash flow abilities. (Your credit score is secondary.) Cash flow also is a significant factor in the building's overall value. A building with poor cash flow will appraise much lower than another comparable building in the same area that has a stronger cash flow. Never forget that.

DoUBlE DiGiT CASH-on-CASH RETurn

This is the velocity of your money. In other words, you want to know at the beginning of an investment how long it will take the money you invest (primarily the down payment) to come back to you. This is critical because you want to invest that down payment over and over again in other investment properties, so the quicker that you're able to receive back that initial payment, the quicker you can apply it to another opportunity.

TIP Cash-on-Cash Return defined: This is the amount of cash you receive from a property investment in a specified time period as a percentage of your initial investment in that property.

Here are several examples using the same down payment amount ($20,000) but different cash flow amounts per year.

table 10.2

Down

Yearly

Years to Pay Back

Cash-on-Cash

Payment

Cash Flow

Down Payment

Return

$20,000

$20,000

1

100%

$20,000

$10,000

2

50%

$20,000

$6,000

3

33%

As you can see, this table shows how many years it takes for your down payment to come back to you. In the first scenario, it takes one year. In the second scenario, it takes two years, and in the third, three years. Your cash-on-cash return is 100 percent, 50 percent, and 33 percent, respectively.

Your goal as an investor should be a cash-on-cash return in the 10 percent to 20 percent range. Anything above 20 percent is considered an exceptional cash-on-cash return.

Capitalization Rate of 7 Percent or Higher

The cap rate measures a building's performance without considering the mortgage financing. If you paid all cash for the invest property, how much money would it potentially make? What's the return? A high cap rate usually means a higher risk investment and a low sales price. High cap rates are typically found in poor, low-income areas. A low cap rate usually indicates there's less risk and a high sales price. Low cap rates are generally found in middle-class to upper-income areas. If you know the net operating income (NOI) and the cap rate, you can calculate what the sales price should be using this formula:

NOI / Cap Rate = Sales Price

TIP The Cap Rate measures a building's performance without taking into consideration the mortgage financing. It is the Net Operating Income divided by the sale price.

Gross Rent Muitipiier of 9 or Lower

Gross Rent Multipliers (GRM) are used as a measure to compare income properties within a particular area or neighborhood. For example, for three properties within a similar area of town, you could calculate the gross rent multiplier for each, then compare the three. If all other factors were equal, you would select the property with the lowest GRM. In general, as the gross rent multiplier decreases, cash flow increases. And conversely, as the GRM increases, cash flow typically decreases.

TIP Gross Rent Multiplier is the ratio of the price of a real estate investment to its annual rental income. The lower the ratio, the better.

S.W.O.T. stands for Strengths, Weaknesses, Opportunities, and Threats. A common business evaluation tool, S.W.O.T. also applies to investment real estate simply because each property will have its own unique strengths, weaknesses, opportunities, and threats. The savvy real estate investor—the one seeking guaranteed success—will put each property through a detailed S.W.O.T. analysis.

Please note that generally speaking, this is a subjective analysis. In other words, there are no "right" or "wrong" answers. Likewise, many factors are interconnected. For example, a property's weakness—such as needing a fresh coat of paint—might also be an opportunity—a fresh coat of paint can quickly increase the overall look of the property, and thus its value.

Trends

Part of your property-seeking work should be to pay close attention to trends, or similar new tendencies displayed by a large number of people. For example, in the past, many city dwellers moved out of the city into the suburbs. Over the last several years, however, the trend has become the opposite. Because of rising gasoline prices and other factors, people in cities are "cocooning"—they want to live within walking distance of work, stores, restaurants, and so on.

Learning about new trends through the media and other information outlets is important. An investor will have become exposed to even more opportunities if he "sees" a new or developing trend before it becomes known and published through the media.

How can you spot new trends as they begin to develop? It's a bit of an art, but generally speaking you can:

• Observe what's going on around you. Pay particular attention to what people are doing differently. For example, eight or ten years ago, SUVs were all the rage. It seemed like everyone had one. Over time, however—again, because of rising gasoline prices and other environmental issues—SUV purchases declined, and a new type of transportation emerged called hybrid cars.

• Read, read, read. Read as much as you can: newspapers, magazines, local real estate magazines, and so on. And vary the sources and subject matter. What do I mean by "varied"? Every so often, read something different, a newspaper or periodical that you normally wouldn't read. As well, do a little Web surfing. What are people discussing on blogs in your community? What new Web sites are popping up on housing, community life, and other related topics? The more that you can broaden the information you take in, the more you can begin to see emerging trends and other issues. This is known, generally, as "connecting the dots." Become a dot-connector.

• Listen, listen, listen. Get out in the world, and then listen to people. What are they doing differently? What are thinking about doing differently? What are they interested in? Excited about? Fed up with? Your friends, family, neighbors, and business colleagues are a fantastic wealth of information regarding what's going on in the world. Ask questions, then listen to them.

Demographics

A final part of your property analysis should be demographics, or statistical data about a particular population, such as the people in the city in which you want to invest. Demographic research provides a snapshot of population, income, industries, biggest employers, and other economic details for a particular city or area.

Demographic information can be found at libraries, city and county government offices, and of course the Internet offers an abundance of demographic information. Suggested Web sites to locate demographic information include:

www.freedemographics.com

http://realestate.yahoo.com/Neighborhoods

http://realestate.yahoo.com/Homevalues

www.elook.org

www.economy.com (fee site)

www.city-data.com

http://quickfacts.census.gove/qfd/

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