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Evaluating Your Real Estate Investment For Cash Flow, Potential Appreciation And Liquidity

Apr 6, 2008
How many properties can you afford if each one costs you $400/month?

When we moved to Toronto seven years ago we bought a small condo in North York. Rents were higher than a mortgage at the time, and we thought we would live there for awhile and then rent it out. It wasn't a bad plan, but market rent when we moved out was not high enough to cover all of the costs. We ended up putting in $400/month to carry it after we moved out. We kept it for awhile because we were able to cover it, and it was actually still making us money. That's one of the things we love about real estate - there is more than one way to make money from it.

In an ideal world you would find a property in a desirable location that will give you:

1. Positive cash flow each month (you are taking in more money from rent than you are paying out in mortgage and expenses)

2. High potential for appreciation over a five to ten year term (or sooner!)

3. High level of liquidity (in other words, it wouldn't be hard to sell in a cold market).

Unfortunately, we don't live in an ideal world and you will likely have to prioritize which criteria are more important to you based on what your short and long term investment goals are.

Cash Flow

One of the most common methods of evaluating a purchase in commercial and residential real estate investment is cash flow. In commercial real estate you will often here everyone talk about the cap rates. In residential real estate a common one is the gross rent multiplier (GRM). To calculate GRM:

* Estimated (or known) rent x 12 months = Annual Rent
* Asking price (or what you plan to pay for it)
* GRM = Asking Price / Annual Rent.

For example, if your monthly rent is $1,000, and the asking price is $100,000 your GRM is:

$100,000 / $12,000 = 8.33.

The basic rule of thumb is that you need a GRM of 10 or less to have decent cashflow. This is based on the assumption that your operating expenses are less than 40% of your monthly rent. Operating expenses include your property manager, taxes, insurance, and maintenance and repairs. It also assumes that your financing costs do not exceed 60% of your monthly rental income.

Just to give you an idea of expenses, our properties average about 37% of our rental income each month for operating expenses.

Once you narrow down your list of potential investment properties, contact the listing realtor and obtain an income and expense sheet for the property or ask for actual receipts to determine the true expenses and possible rent of each property. Now, you will be more informed whether to continue looking at this property on a cashflow basis or you should move on.

If your goal is to find properties that will provide you monthly income, then you will need to focus on this method of evaluation. The two other considerations (appreciation and liquidity) should be less of a concern. If you are holding properties for the long term, and looking for ones that are less likely to cause you problems with tenants or repairs, then you are likely also going to be factoring in the other two evaluation criteria.

Potential Appreciation

It is difficult to evaluate appreciation potential as it is based on what happens in the future. There are ways to feel more confident in the potential of your property increasing in value though. For example, consider:

* Are more people moving into the area than out of the area?
* Are there new developments around? What about schools, stores and other services?
* Is there a shortage of land to build new homes?
* Are new roads being constructed? Is the economy in the area diverse and growing?
* Is it a Starbucks area? (We like to find the areas that Starbucks has just moved into because in our experience they are just slightly ahead of the curve on improving areas)
* Are people renovating their homes and spending money on landscaping improvements?

None of the above guarantees appreciation of a property, because there are factors like interest rates, overall economy and employment that must also be considered. But, a watchful eye on the above will help you spot good potential for appreciation.

Liquidity of a Property

Many of the same factors that may help to identify properties that will appreciate are the same ones that will help you evaluate it's potential liquidity. The objective here is to determine whether you could sell the property in a hot or cold market at a good price.

For us, liquidity is important, but comes in third because we make all our purchases with the intent of holding them for 5 - 10 years or more. In a long term hold situation, liquidity is less of an issue because you do not need to sell it in the short term, and can hold on to it in bad market conditions and wait for the cycle to return to one of strength.

How do you evaluate liquidity? Current market conditions will help you in the short term (how many listings there are on MLS relative to sales is one), but when trying to figure out liquidity in the future, you can consider:

Who the most likely purchaser of this property is going to be in the future. If it's a family - what would they like or not like about this location or property? Our North York condo was one of two units in the building that didn't have a balcony. It also was right above the entryway. A balcony was of no use to us because you were not allowed to put a BBQ on it and we don't smoke, so it didn't bother us. But we ended up selling the condo for $15,000 less than another similar unit above us because it was less desirable. Something we did not consider when we bought it.

Other things to consider:

* Single family, detached homes are always more in demand than any other product, especially ones that are well taken care of
* Safe locations near parks, schools and shopping are in demand no matter what the market is doing
* Properties that are without extras that people do not need and will not pay for in hard times (pools, 3 car garages, large acreage) will be easier to sell.

Essentially, you want your property to appeal to the masses in order to ensure liquidity. If it is too unique or too specialized then your market is smaller, and therefore it will be much harder to sell in a market downturn.

Really, what you try to find in your next investment depends on your goals. If you only want one investment property and you want the most appreciation potential and least hassles, putting $400/month into it is not a bad thing. Especially if you are in a higher income tax bracket. You can write-off the mortgage interest as well as most of your investment property expenses (speak to your accountant). Furthermore, if your mortgage interest rate is reasonable (less than 6%), your tenant will be paying down a portion of the principal, helping you to build equity (which was our situation with the condo in North York and why we really weren't losing money on it for the years we did carry it). If you can't afford to put a dime into the property each month, then you must find one that has good cashflow regardless of the other criteria.
About the Author
Julie has an MBA in Real Estate and Finance and has been investing in real estate with her husband Dave for nearly 8 years. Together they've built a multi-million dollar portfolio of residential properties and share their advice and stories for free at http://www.revnyou.com Click here to sign up for their free monthly newsletter or read some of their past success stories and investing advice.
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