What we should have done: the 5 steps of property evaluation

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A problem with one of our tenants (this will be explained in details in another post) led me to reconsider the whole investment. I was already updating a financial sheet every month but, this time, I started scrutinizing and analyzing each and every figure. Also, the problem we had (and that is not solved yet actually) made me feel so powerless and frustrated that I suddenly felt a big desire to learn more about investing in real estate in order to be better prepared for the next time some other problem pops up (I must admit that before feeling that urge to learn I first felt depressed and wanted to throw the towel but, oh well…).

So I started to listen to an audio book by Ken McElroy and I realized that we made several mistakes at the time we selected the properties. In this audio book, the author was explaining in details the 5 points to always take into account when it comes to buying a property and it became clear that, although we did the best we could (it wasn’t a compulsive purchase, we really did our homework and math and research), we just made mistakes and overlooked some aspects because we were beginners and had never done something like this before.

Before I keep explaining, let me introduce you to Ken’s 5 steps to evaluate a property:

1/ Property income

- Calculate the actual income that the property brought to the owner in the last 12 months.
- Calculate the actual potential income of the property, i.e the income it would have produced if there had been no vacancies or unpaid rents.
- Calculate the future potential income, i.e taking into account the evolution in rent prices and any other income you might be able to produce with the property.

2/ Expenses

- Estimate repairs and maintenance expenses, based on expenses incurred the previous year and predictions for the year to come (usually, the less expenses the owner incurred the previous year, the more to expect).
- Estimate costs in utilities, based on the previous year.
- Estimate taxes, based on the next year’s rate.
- Estimate insurance costs, asking for proposals.
- Take into account a replacement reserve.

3/ Net operative income

Net operative income = actual income – projected expenses (before loan payments)

4/ Capitalization rate and valuation

If the broker or the owner doesn’t provide you with that type of information, you can calculate it this way: capitalization rate = net operative income / trend in purchase prices for a comparable property in the area.

Valuation = net operative income / capitalization rate. (The valuation is the price you will offer for the property, regardless of the sell price the owner is asking for)

5/ Loan payment and cash-on-cash (also called return on investment)

Your loan payment will depend on your down payment and the interest rate you are offered.

Projected profit = projected net operative income – loan payment

Cash-on-cash = projected profit / down payment

When I look back, I realize that, although we did weigh the income and the expenses, we overlooked some expenses or underestimated them and this is why…we are not even close to breaking even in cash flow.