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Analyzing The Rental Property Operating Statement – Part 4

By
Real Estate Broker/Owner with Cordon Real Estate 01370983

In this series, we're analyzing rental property operating statements to find ways to maximize our return on investment.  In Part 1, we looked at ways to maximize revenue.  In Parts 2 and 3, we looked at controlling direct and indirect expenses.  In Part 4, our final installment, we'll look at how operating statements influence common performance measurements.  We'll also look at how those measurements support buy, sell and hold decisions.

Although there are dozens of measurements that can be applied to the financial performance of any business, rental property investors are most commonly concerned with these two:

Capitalization Rate:

    Cap Rate = Net Operating Income/Purchase Price

Cash On Cash Return:

    Cash On Cash Return = Annual Cash Flow/Initial Cash Invested

Let's apply each of these measurements to our example operating statement, which reflects the operation of a single family home purchased for $100,000.  Is this rental worth buying, holding, or selling?  Let's look at the numbers.

  Cap Rate = 6,938/100,000 = 6.9%

  Cash On Cash Return = 6,428*/52,000 = 12.4%

      *Cash Flow includes mortgage P&I on a loan of $50,000 at 7%

If we're considering this property as a potential purchase, we'll look at comparable cap rates in the area to determine if this property is performing well in its market.  But since we can buy anywhere, we are mostly concerned with how it performs for us.  If our target cap rate for purchases is 5% or more based upon current market conditions, 6.9% is a healthy metric and this property is probably a good buy based only on these numbers.

If we already own this property and we're considering selling it, we would look at these numbers from the other direction.  In other words, if we know that most buyers are looking for a cap rate of 5% or higher, we could raise our selling price so that the cap rate would be closer to 5% without scaring away potential buyers.  For example, if we raise the selling price from $100,000 to $120,000:

    Cap Rate = 6,938/120,000 = 5.8%

This higher selling price would need to be supported by other factors used by appraisers to value property, but if the property is in good condition and 5% is a good cap rate in this neighborhood, we are justified in asking for a higher price based upon the good numbers originating in our operating statement.

Looking at our Cash On Cash Return with the terms given above, we see that this property is generating a return of 12.4%, based upon a $50,000 down payment and $2,000 paid in closing costs.  If we are considering purchasing this property and are confident we could achieve the same return as the current owners, we'd be very happy to make the purchase and receive 12.4% return on our cash, plus enjoying appreciation in the asset as market conditions improve.  If we already own this property, we'd also consider ourselves lucky to get this return on our investment on a regular basis and hold on to it.  If we're selling, we'd again review our pricing options to see if we can increase the asking price based upon the high operating returns.

We've used a very simple example for our analysis and have not taken into consideration other common factors that usually influence our buy, sell, or hold decisions.  These might include our income or capital gains tax situation, capital improvements needed to keep the property competitive, special taxes and assessments, and other issues.  We should always consider these other factors and seek the advice of qualified professionals before making a final decision to buy or sell real estate.

This concludes the final installment in this series.  We've used the operating statement as a tool to discuss how to increase our revenue, how to control our expenses, and how to make common financial measurements that support our buy, sell and hold decisions.  We've really just scratched the surface of the world of rental property investment, and I hope you will contact me if you have any questions.

More millionaires are created through real estate than through any other form of investment.  As is often said, "don't wait to buy real estate, buy real estate and wait."  Every down market eventually leads to an up market, smart investors know how to profit in both.

Happy investing!

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If you are an investor looking for additional information on real estate investment or are interested in buying or selling real estate in the Bay Area, drop me a line at john@jsrealproperty.com .

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© 2011 John A. Souerbry

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