Thoroughly Analyze the Deal Before Making an Offer

Thoroughly Analyze the Deal Before Making an Offer

Throughout this book, I will refer to average costs plus several rules of thumb I use to determine whether a property is a good candidate to consider purchasing. The ones I most commonly use are gross rent mul­tipliers (see previous chapter), cost per unit, and annual rent returns. One of the most important worksheets you’ll use is the income property analy­sis form. I always use the form to help uncover the answers in an impor­tant financial examination of a property.
Study the Numbers and Keep It Simple
Everyone who knows me or seeks my advice understands rather quickly how strongly I feel about doing the basics. That means buying properties that will start returning profits before very long.
I determine this by studying all the dollar numbers before I make the purchase. Most of my longhand studies are done on yellow legal pads. They usually take the form of a sketch with a bunch of dollar numbers plotted in year by year. I want to visualize clearly, in picture form, how much money I’ll be putting into the deal to start (down payment). Next, I figure how much more for fix-up and what my monthly fixed costs of operations will be when I’m done. After that, I calculate my expected income, month by month, usually for five or 10 years, or sometimes to a predetermined sale date.

My yellow pad studies are purposely simple. I’m interested only in cash returns. The two questions I ask myself are “Will I make profits on this deal if I spend X number of dollars?” and “When do I get to have those profits in my hand?” That’s what most investors need to know.

Keep it simple and keep it basic. You don’t need to know the internal rate of return (IRR) on a duplex to make a profit. You’re far better off knowing if both toilets flush. Later on when the money rolls in, let your accountant explain about the IRR. Perhaps he or she might even agree to do your plumbing when not doing the books.
Unit Cost and Rent-to-Value Ratios: How to Determine if a Property Will Be Profitable
As I’ve already told you, fixers can be purchased for substantially less than comparably sized properties in good condition. After rehabilitation, how­ever, fixers will normally rent for almost the same monthly rates as the better properties. By converting this information into numbers, it becomes easy to determine future profits for a property.
There are two key numbers I consider to be most important because they will tell me the expected cash flow and profitability of a property. And by the way, income property is supposed to provide cash flow regardless of what your real estate professional tells you about the extra tax breaks you’ll receive. As far as I’m concerned, tax benefits are merely a bonus for investing in real estate.

The first number I’m always concerned about is the unit cost. How much will it cost to purchase and rehabilitate each house or apartment? Let’s say I purchase a four-unit property for $72,000. That means I’ll pay $18,000 per unit. Next, I estimate it will cost $6,000 each to rehabilitate the units. My total unit cost will be $24,000 when my fix-up work is com­pleted.

The second important number has to do with rental income return. I call it rent-to-value ratio. If you don’t remember some of the other things I tell you here, try not to forget about this part. It’s very important to your financial future, because it’s the difference between having cash flow and not—ultimately, between success and failure. The rent-to-value ratio is a number that expresses the percentage of monthly rent as related to the unit cost or my assigned value to the property.
For example, if I own an apartment that rents for $300 per month and the apartment has my assigned value or unit cost of $24,000, then the rent-to-value ratio would be expressed as 1.25%. To arrive at that number, you divide the rent by the unit cost ($300 ÷ $24,000 = 0.0125) and then move the decimal two places right.
My goal is to achieve a minimum ratio of 1.25, but when you really get the hang of this stuff, 2.0 and more is well within your reach. It’s also lots more fun going to the bank.

Jay’s Income Property Analysis Form

The income property analysis form helps me discover many easy-to-over-look property expenses. It also provides an excellent tool for negotiating with sellers. I consider the negotiating value of the form just as important as its use in assessing the income and expense data for a property. Even though the form is quite simple to use and filling in the blanks shouldn’t require an MBA degree, it’s still easy to overlook important information, believe me. Therefore, I’ll guide you, line by line, and explain my reason­ing, as well as how I came up with the numbers. The example I’m using is an actual case history for an eight-unit property I negotiated to purchase several years ago. Let’s call the property “Jay’s Rundown Houses,” Elm Street. (A blank copy of my income property analysis form can be found in the Appendix.)
The information I’ll need is the actual income and expenses that will transfer to me if I should purchase the property. Notice that the income and expense data is shown on a monthly basis.
Line No. 1—Total Gross Income. This figure is the total income from all sources, including rents, laundry, storage, or whatever else is earned by the property when it’s fully rented. That is, 100% of all the income.

Line No. 2—Vacancy Allowance. Allow a minimum of 5% of total gross income for this line, even if the units are 100% rented at the time of pur­chase. The reason is that no rental property stays 100% rented all the time. If the seller suggests it does, request a copy of his or her tax forms, 1040 Schedule E, for the past two years. Simply divide the income each year by 12 to establish the average monthly income reported to Uncle Sam. This check proves very enlightening to most buyers.

Line No. 3—Uncollectable or Credit Losses. Allow a minimum of 5% of total gross income for this line. Generally it’s more for rundown prop­erties, like I purchase, because people problems are likely to be present with property problems. This line reflects losses from tenants who skip out without paying and evicted tenants who are forced to leave after a judg­ment. Chances of collecting any money from them are slim to none.
It’s difficult to argue against vacancies (Line 2) and credit losses (Line 3). That’s because all rental properties have vacancies from time to time and tenants who don’t pay rent for one reason or another. The combined total of 10% for both of these occurrences is not the least bit exaggerated. Some properties consistently operate at much higher losses.

Line No. 4—Net Rental Income. This line represents the actual net amount of money you have left to operate the property—sometimes referred to as gross operating income. It’s the actual money you get to hold in your hand each month.

Now let’s talk about all those nasty expenses.

Line No. 5—Taxes, Real Property. This line needs to show what the property taxes will be per month on the day you acquire the property. First, you’ll need to estimate approximately what you think you’ll end up paying for the property, then apply your local county tax rate to the esti­mate. For example, for the Elm Street houses, I anticipate paying approx­imately $195,000. My county taxes will be slightly over 1% of that. $195,000 times 1% equals $1,950 in annual taxes. This amount divided by 12 months equals $162.50 (rounded to $165) per month.

In California, the seller may have been enjoying low property taxes if he or she has owned the property for a length of time. However, because of Proposition 13, the purchaser’s taxes will immediately jump to 1% of the selling price as soon as the property transfers title. Don’t use the sell­er’s lower tax bill when computing your expenses on this line.

It’s easy to check out property taxes. To determine the tax expense, call the tax assessor’s office. Ask what the taxes will be if you purchase a prop­erty for $195,000. Don’t tell them the exact location of the property; just the dollar amount and the proposed purchase date will be enough.
Line No. 6—Fire and Liability Insurance. You must apply the same logic on this line as for Line 5 taxes. Ask yourself, “What will insurance cost me based on the condition of the property and the amount of fire and liabili­ty coverage I will need for proper protection?” Some sellers I’ve bought properties from have been grossly underinsured because it’s cheaper.

Fire policies are based on footage construction costs to rebuild the property in case you suffer a loss. If actual construction costs are 60¢ per square foot in your area and you decide to take over or assume the seller’s policy calculated at 30¢ per foot, you’ll quickly become stuck if you ever suffer a loss. Line 6 should be the monthly amount for insurance that pro­vides you with adequate protection if you become the new property owner. Don’t be caught underinsured after the fire trucks leave.

To find out the insurance cost, call an agent and ask him or her to give you a “quickie” cost estimate for a policy covering both fire and liability on the proposed purchase. The agent will need to know the property address, but he or she needn’t go inside the houses to give you a ballpark figure. Provide the agent with the approximate square footage of each unit and an estimate of the age.

Line No. 7—Management. I personally charge 10% for my management services because I’m worth it! Professional managers charge anywhere from 5% to 10% for the job. At any rate, properties don’t manage them­selves. People must do it and, obviously, it costs money. It’s a very legiti­mate property expense.
Here’s the problem you will always encounter when you negotiate to buy properties from owners who do their own management. They don’t understand this expense and will always ask, “Why are you showing a prop­erty management expense of $250? Aren’t you planning on managing the property yourself?”
I always tell them, “Yes, but I don’t plan on doing it for nothing.”

They usually respond, “We do our own management and we don’t take a fee.”

I ask, ”Are you trying to tell me you will manage property for nothing? If you are, I’d be happy to let you continue managing for me at the same price.”
Managing property and tenants is not an easy job and whoever does it should receive compensation. I allow 10% on this line. However, that also includes legal and accounting, too. I do my own evictions when necessary. That’s a bargain.

Line No. 8—Maintenance. I always allow at least 5% for maintenance expenses. It might be a bit less for newer properties, but it could go high­er for older houses and apartments. Maintenance is the routine upkeep that’s necessary to keep the property in good condition, so that it can con­tinue to earn income. Maintenance does not necessarily improve the prop­erty. It merely keeps it running in proper order and at the same level.

Line No. 9—Repairs. When the doorknob falls off, you must put it back on. That’s a repair. When the roof leaks and causes damage to the ceiling plasterboard, you must repair the roof and then the ceiling. It’s important to remember that all properties will need repairs because things fall off and things break. Obviously, older properties will require more repairs. I always allow a very minimum of 5% for older houses, but 10% is not unreasonable.

Line No. 10—Utilities Paid by Owner. It will pay you to research and verify which utilities the owner pays. Sellers tend to state their expenses on the low side. Sometimes they’ll produce receipts for heating bills in the summer months. Quite often they will group all their utility expenses and give you an estimate like $100 per month for everything. What you need to know is whether or not each house or apartment unit has its own sep­arate meters for gas and electric service. Quite often apartments will have a separate owner’s meter for the laundry room and exterior lighting for porches, hallways, and parking areas.

Utility companies will furnish printouts of electric, gas, and water usage. The owner of record is the only person who can obtain this information. My advice is to ask the seller to provide you printouts for the past 12 months of service so you can average out the costs for a full year. As a gen­eral rule, apartment owners must pay water, sewer, and garbage service.

The key here is to check everything out for yourself. You don’t want any surprises after you purchase the property. Again, the most important thing to verify is if each house or apartment has its own separate meter, meaning that the tenants pay for their own utility services.

Line No. 11—Total Expenses. This line is the addition of lines 5 through 10. If the total of this line is more than 40% of line 1, reevaluate your pur­chase offer to make sure you are not overpaying for the property.

Line No. 12—Operating Income. This line is the amount of money that’s left to pay the mortgage payments (debt service) after all operating expens­es are paid.

Lines No. 13 and 13A—Mortgage Balances and Payments. Show each of the existing mortgages, monthly payments, and dates when each mortgage will be paid off (due dates). Total lines 13 and 13A—remember: these are totals for just the existing mortgages on the property, before you buy it.

Line No. 14—Monthly Cash Flow Available. Subtract line 13A from line 12. This is the amount of money you’ll have left each month after paying all expenses and all existing mortgage payments. It’s the cash flow avail­able to pay the remaining balance of the seller’s equity—in this example $29,600

In this particular transaction, I propose to pay the seller a $20,000 down payment and assume both existing mortgages (a total of $145,400). The balance I will still owe the seller for his unpaid equity is $29,600. As you can see, on line 14, $66 is the amount of cash flow I’ll have left each month to pay the seller’s equity.
Proposed purchase price: $195,000
Proposed cash down payment: 20,000
Mortgages (two) buyer assumes: 145,400
Balance of seller equity: 29,600
Total: $195,000

Note: Line 14 shows available funds to service new mortgage debt from operation of property.

Remarks: All lines must be completed for proper analysis. Enter the actual amount on each line or 0.

Figure 9-1. (Completed)

The Basis for Negotiating a Purchase

Armed with a properly filled out income property analysis form, your negotiations will be much more objective. That’s because they will be based on accurate and reasonable projections.
All income should be verified by you and the seller. This can be done using current rent receipts or last year’s tax return (1040 Schedule E). Either way, both parties can establish and agree on the figures.
The Most Controversial Expenses
Management, maintenance, and repairs are the expenses most frequently argued by sellers. Again, I ask for income tax records to substantiate the expenses. Two full years of 1040 Schedule E tax returns will do the job. I have never received tax returns that show the same numbers as given to me by the seller or his or her agent. In almost every case, the income fig­ures shown on the tax returns are lower and, for some odd reason, the expenses are always much higher. I think it’s something like the unex­plained difference between the miles people drive, as stated on their auto­mobile insurance forms, and the mileage they report for the very same period on their 1040 tax forms. Based on the auto insurance mileage, it would seem that many cars will never wear out; but for the purpose of tax deductions, they travel more miles than a Greyhound bus.
Always Get a Second Opinion
Doctors will often send their patients out for a second opinion, so why not get one for your real estate deals? My good friend and skilled investor, John Schaub, says, “The day you buy an investment property, you should be able to sit down with your wife/husband or someone and explain, in detail, exactly how you will make your profit from start to finish.”

I find John’s excellent advice is right on the money. I did not follow that same advice when I started investing and I always had problems mak­ing my houses’ cash flow. My two biggest problems were overestimating net income and paying too much.

I’ve found that wives, husbands, and friends can always spot the things that are wrong with most plans. Write down your profit numbers and show them. Explain how much income you’ll be taking in every month from rents. Then, using conservative appreciation numbers, estimate the profits you’ll make when you sell 10 or 15 years from now. See if anyone else agrees with you. You don’t have to make this exercise complicated. It’s only a checkpoint, but it makes you prove your case—it’s very objective. Outsiders—people other than you—are seldom as optimistic as you might be. This is especially true when you must explain to your spouse why you’re investing the vacation money on rundown ugly houses instead of a family trip to Disneyland!

Fixer-Uppers part 10

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