So how does an investor assure himself that s/he is making the right decision and assembling an income and expense statement that is accurate?
1) Examine many similar properties at the same time. It is helpful to examine similar proformas at the same time. You will see what one owner or broker may include, and what another may leave out. Look at the market to see how long it is taking to find a new tenant.
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2) Review operating numbers for the past two years. Most financial analysis reports will exclude capital expenses. Bear in mind that you must reserve for capital expenses. Things will happen that you do not expect. Prepare financially for potential problems. Remember that real estate is an asset that wears out. By reviewing two years of income and expenses, you will have a much better idea of vacancy rates as well as real expenses.
3) Obtain comparable rent income numbers. Drive around the neighborhoods where your potential property is located. Call the brokers and the managers to find out what the rents are. Are there any concessions being given to rental units or lease space? Use this information to verify the figures you received for the property you wish to buy.
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4) Examine the vacancy rate in the market place. Each market and specific type of real estate investment has a vacancy rate. Some locations are better than others, and will perpetually have a higher occupancy rate. Look for concessions that have been offered. How will they affect your cash flow when you own the property? Why is your property full? Did the seller hastily rent to tenants from emergency aid shelters (yes, this has happened in weak markets). Banks will not loan on buildings with more than a 5% vacancy rate. They will, however, offer construction loans if you are renovating the building. This may give you some time to find tenants to fill a building, otherwise you will be forced to guarantee the rents, which means your hard-earned cash will not be at work making more money for you.
5) Talk to an appraiser regarding common incomes and expenses in the marketplace. This seems like common sense, but no one seems to do it. The agent representing you is motivated to close a transaction. They may not be experienced, or may not provide all of the information you need. You need accurate information to make an informed decision.
6) Ask for schedule "E" tax return information for the property. Many sellers will refuse to supply the schedule, but in my mind, the proof is in the pudding.
If your property has an 8% - 10% positive cash flow after all of the adjustments above, it should make sense. Many buyers also use CAP rates as an indicator of value. Just because other investors are buying a 4% CAP property, does not mean you should. Maybe the market is overheated, perhaps there is more demand than supply, maybe you should look in a market with 8% - 11% CAP rates, or perhaps low interest rates give you the opportunity to buy something with a low CAP rate and still make money. You should look at comparison indicators as you pursue your investment strategy: CAP rate, cash-on-cash return, debt coverage ratios, price per unit (or price per square foot for comparable properties in the same marketplace), percentage of expenses (are they inline or understated). Don't forget to look at the financing and due diligence costs as part of your transaction.