When evaluating a real estate investment you should be able to answer the following 4 questions. (1) What's the value of the property? (2) Do the numbers hit my return threshold? (3) What is the downside risk? (4) What are the potential upsides?

If you can answer these 4 questions and you are still comfortable with the deal then you can write an offer and further evaluate the properties intricacies (roof age, foundation, plumbing, leases, etc). 

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*You would start this process assuming you like the location, property type, unit type(s) of the property you are evaluating.

1 What’s the value?

Real estate as an investment vehicle needs to be valued on its ability to produce income. That’s it. When you’re looking at deals you should totally ignore the listing price and evaluate the deal purely by the return the property can produce. 

These are two simple concepts to value a rental property.

1. Gross Rent Multiple (GRM)
2. Cap Rate

Gross Rent Multiple (GRM)

A tool used to value property quickly. After understanding the gross annual rents you apply a multiple which brings you to a reasonable value. For example, you’re analyzing a 12 unit property. Each unit rents for $800/mo or $9,600/yr. So the entire property is generating a gross revenue of $115,200/yr (800 * 12mo * 12 units). Next we need to determine the multiple. In South City Saint Louis the value of most rental properties is between 7-11x gross rents. But how do you select which multiple to use? Well you need to look at comparable properties in the area that have sold in the last 6-12 months. Take the sales price and divide it by the gross annual rents. As you might expect, higher end areas have higher GRM’s/

So back to the example. Let’s assume we’ve done our research and we come to the conclusion that other comparable properties in this area sold at 9x multiple to their gross annual rents. So a reasonable value for this property is $1,036,800 (115200 * 9).

The GRM does not consider costs. Therefore, this metric should never be used independently and is usually more accurate with smaller properties (2-4 units). 

Cap Rate

The cap rate is a valuation measure of profitability. First you need to understand the profitability part. You do this by getting the net operating income (NOI). The NOI is the total income (rents) minus the total operating expenses (taxes, insurance, repairs & maintenance, utilities and management fees). For example, we will use the above 12 unit property. We know gross annual income is $115,200. We’ll assume a 5% vacancy. Bringing us to $109,440 (115200*.95) in effective income. We will assume operating expenses are 35% (standard for small rental properties) of income or $38,304. We deduct the operating expenses from the effective income and we get an NOI of $71,136. 

Now we need to apply a cap rate. Cap rates are calculated by dividing the NOI by the purchase price. So like the GRM we would analyze comparable sales and get an idea of the market cap rates. Cap rates in South City Saint Louis are roughly 6%. So this property would be valued at $1,185,600. 

When valuing real estate you are only as accurate as your assumptions. If you’re off by just 1% on the cap rate you are looking at a huge shift in value. Make sure you’re putting in the work -- researching your market or working with someone that researches the market. Once you can value these properties you can apply a return threshold that makes sense to you. You simply pass on deals that don't make sense and dive in on properties that do. 

2 Do the numbers meet my return threshold?

Now you have an idea of what the value of the deal is. But what does that mean? What kind of return do you need to make the deal worth your time and money. Not everyone's return threshold is equal. An institutional investor with cheap(er) debt and a longer time horizon is looking at a deal through a completely different lens than an individual buying fourplexes in their neighborhood. 

You need to be thinking about a return that gives you a margin of safety and a return that makes your time worthwhile (this is a cost!).

Personally, I like to see 100-200bps spread between the unlevered yield and cost of debt. This gives me enough of a cushion for things to go awry yet I am still able to cover my costs. Another way to determine a threshold is to look at the stabilized spread over market cap rates. If you can stabilize at 100-200bps above the market cap rate you’re generally pretty secure in bad times (increasing interest rates, decreasing rents, etc). I want to reiterate. Your threshold is only as conservative as your assumptions you made to get there. Making accurate assumptions is what separates the pros from the joes. 

3 What is the downside risk?

Relative to other investment vehicles, real estate is mostly stable. However, you can get burned. And many investors do. Any inflow of capital that produces a return has risk. The higher the return the higher the risk. The worst thing that can happen is you over leverage a property at a high valuation, the income of the property is insufficient to cover your mortgage payments and the property deteriorates because of this. Forcing you to sell at a cheap valuation and losing your or even worse someone else's hard earned money. 

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As a prudent investor you must insure you can cover your taxes, mortgage and operating expenses. Use a combination of these three metrics to understand your expense and cash flow coverage.

Loan to Value (LTV)

The Loan to Value or LTV is the loan size as a percentage to the purchase price. How much leverage you can take on a deal depends on your wallet, experience, and relationship with your bank/lender. The type of debt/leverage you place on a property is endless so we won't get too in the weeds. Owner occupied deals can lever up to 96.5% of the purchase price. Typically investors use conventional loans and leverage 60-80%. Some investors even purchase all cash or 0% LTV. Something very important to keep in mind is leverage magnifies your downside just as much as your upsides.

Debt Service Coverage Ratio (DSCR)

The Debt Service Coverage Ratio or DSCR is a metric that measures your ability to pay the mortgage. In other words, how much of your cash flow covers the debt payment. Banks typically need to see 125% debt coverage to even loan on a deal. This shows you have a 26% cushion before you’re unable to pay your debt every month. Anything higher than 125% should make you feel increasingly comfortable that you won't have to foreclose on your property in bad times.

Expense Ratio

The Expense Ratio measures the operating expenses against incomes. What percentage of the property's income is going to operating expenses. What’s the cost to run this property? I find that most new investors misjudge this number and under shoot their operating costs. There’s no hard rule here but boutique multifamily operates in the 40-50% range dispensing on management, repairs, etc. If you’re a new investor and hiring 3rd party management. As a risk assessment I would underwrite to 50% and if the deal makes sense still you are in good shape. If the deal is small, 2-4 units, and you’re self managing you can assume a 35-40% expense ratio. 

Once you have a grip on these you need to run a risk analysis. You need to assess the deal from a worst case scenario perspective. Ask yourself “Will I be forced to sell in this environment?”

A few questions you should be able to answer:

• What does the deal look like if rents drop 20%? 
• What if interest rates increase 150 bps? 
• What if inflation runs rampant over the next 4 years and expenses rise?

You can also check out these metrics for risk assessment. 

4 What are the potential upsides?

Now that we’ve valued the deal and we are confident that our capital is safe in a worst case scenario we can look at the upsides. These are the unique attributes of a deal that are often priced out of the deal and missed by 95% of the investor base. These attributes turn maybe deals into confident purchases. This is where the creative and/or experienced investors create massive returns. These upsides may be physical attributes, legal attributes, unique exit, etc.

Example 1: the property has massive 3bd 1ba units. Based on the layouts you know that you could add a bathroom and split the spaces. Doubling the unit count, thus boosting the income. 

Example 2: a property consists of several 4 unit buildings. Your plan is to purchase the entire property and then sell off each individual to an owner occupant willing to over pay thanks to their ability to over-lever and the emotional attachment that comes with occupying the property. 

5 What does the exit look like?

Yes, you need to be thinking about this before purchase. While valuing the deal you probably already know whether you want to hold forever, flip, or refinance. If you were to liquidate you need to understand what that might look like. What are the costs of selling? What are the costs of refinancing? If you’re selling, who are you trying to sell to and what’s the strategy? If you’re holding, what sticky costs may make sense to take on? 

If you’re going to exit, your timing may vary depending on macro economics. The idea is that you have properly evaluated the deal to ensure you have limited downside risk, upside potential and a valuation that makes sense. If you do then you should be comfortable in the fact that you can make money on the deal and never become a forced seller.