Potential Deal Analysis

Question 1

Highest and best use

Answer 1

The way to make the most money on any particular property

Question 2

Net Operating Income (NOI)

Answer 2

Income - Expenses (excluding the mortgage/financing)

Question 3

Capitalization Rate

Answer 3

Cap Rate =Expected NOI/ Property Value
Property Value = NOI / Cap Rate

Rate of return you expect to get on your investment (not including financing/mortgage), determined by the type of property.

Expected cap rate typically depends on the market. A lower cap rate often corresponds to better valuation, higher potential return, and lower risk.

Question 4

Strike Price

Answer 4

the maximum you are willing to spend on the property

Question 5

How to determine potential rent price?

Answer 5

Should be based on the market value of your property and the rental costs for comparable properties

Question 6

Cash-on-cash return

Answer 6

Compares annual cashflow (projected or actual, including financing) against the cash invested. Different from standard return on investment (ROI) because it only looks at cash returns from operations, not the total return including sale or refinance.

Indicative of the operational performance, but not overall performance.

CoC = Annual Cashflow (including mortgage/financing) / Initial Investment

Question 7

Price to rent ratio

Answer 7

Compares the home price and rent value to evaluate potential profitability of an investment. For individual home, divide the purchase price by the total annual rent. Rule of thumb is to consider buying when the ratio is less than 15 (for residential?)

Question 8

Gross rental yield

Answer 8

Annual rent divided by the total property cost, including purchase price, closing, and renovation costs. Then multiplied by 100 to create a percentage. Results can be used to compare comparable properties

Question 9

Equity Multiple

Answer 9

How much an investment will multiply over the hold period.

Equity Multiple = total cash distributions / total equity invested

Question 10

Preferred Return

Answer 10

The % of one’s investment a deal will return per year before the operators receive any benefit

Question 11

Average Annual Return (AAR)

Answer 11

The % of one’s investment a deal will return per year overall, including operations and equity events.

AAR = Sum of Annual Returns / Years Held

Question 12

Internal Rate of Return (IRR)

Answer 12

The compounded rate of return of the overall investment. Best way to compare investments.

Easiest to calculate using a spreadsheet or model. In basic terms, a calculation that assumes annual returns are reinvested back into the deal each year.

Question 13

The issue with ROI metric

Answer 13

Doesn’t take time into account. Say you paid $100k for a property, sold for $200k, so you made 100% return. But this doesn’t tell us what that return was over the given time period. AAR is better metric - would be 20% if it was a 5 yr time period, 10% if over 10 yr time period.

Question 14

Expense ratio

Answer 14

Expenses/Income (doesn’t include utilities, assumes they are paid for by tenant)

Question 15

Expense Ratio Rule of Thumb

Answer 15

(assuming tenants are paying utilities): for 2 to 20 units normally 35 to 40 percent. Closer to 50 percent on larger properties. 50% Rule.

Always base offers on the more conservative numbers even if seller says they are less.

Question 16

Reasons for expenses being reported as too low:

Answer 16

Seller is either: 1) Not doing regular repairs (most common), 2) doesn’t know true expenses, 3) Lying

Question 17

What to do if seller claims low expense ratio?

Answer 17

Ask for repair invoices and if owner doesn’t have them, ask for permission to call vendors to get last two years of invoices. Can also ask for last year’s bank statements to see who was paid and when.
- always verify

Question 18

P&L always available before making offer?

Answer 18

Nice to have, but sometimes seller can only provide pro forma P&L before you offer. Always make sure to check actuals when doing DD