by Sidney Pashkow
© 6/99 Foreclosure News of NJ, Inc.

Every time you purchase an ice cream cone, a hamburger or an auto, you must decide if there is value at the price your are required to pay. This kind of purchase decision is usually dictated by the competitive price for that particular product.

As for real estate, the price you decide to pay should be determined by established criteria. How do you determine value? What criteria should be used?

Many foreclosure real estate investors take the short term, flip type of approach. This approach assumes the property will be held for the shortest time possible and uses the purchase price, closing and repair expenses against the forecasted sales price. Others take a long term viewpoint, where the property will be held, managed for many years and look for value appreciation!

Any way you look at it, you will need to project an investment return to make a sound business decision. This applies to the single family home you purchase to live in, as well as the apartment house complex or shopping center where you rent use to others. Return from real estate investments depend on future rent, operating expenses, financing and tax considerations.

By forecasting these factors you can reasonably decide on how the property will perform. The important thing to remember is projections are only as good as your underlying assumptions!

Rapid increases in rent projections or receiving large tax abatements are usually a figment of your imagination and reflect your desire to own the property. The analysis should be objective. Subjective analysis with unrealistic projections can prove disastrous, if followed. A conservative approach is best.

By taking just a few bits of information, one can determine if a foreclosure property is worth pursuing. There are four formulas that apply to most investment properties.

GROSS RENT MULTIPLIER
Property Price/Total Gross Rent

This is the price of the property divided by the total gross rent. The lower the number, the less you are paying for the gross income. Example: The property sells for $100,000. and rents for $1,000 per month. The gross rent multiplier is 100. All things being equal, this is a bargain compared to another property that costs 125 times the monthly rent.

Most professional investors rely on the next two examples.

OVERALL RATE OF RETURN
Net Operating Income/Property Value

This is the net operating income (rent minus the operating expenses) divided by the value of the property. This method is preferable because it accounts for operating expenses and is expressed as a percentage. The rate of return percentage can also be used by the investor to compare alternative investments. Example: A property rents for $1,000 per month and the owner is responsible for taxes and insurance which total $250 per month. The amount left is $750 per month times 12 months equals $9,000, or a 9% return on a $100,000. investment. The overall rate of return, 9%, can be used to compare alternative investments . This example was kept simple for illustration. There are many other factors that can go into your formula such as a vacancy factor, rent collection allowance and other operating costs that the owner will have to bear under normal conditions.

CAPITALIZATION RATE
Net Operating Income/Rate of Return

The capitalization rate is the net operating income divided by the (desired) rate of return. The result is the value of the property. This formula can be used to determine the price you should pay for a property to meet your desired rate of return. Example: The net operating income for a property is $12,000 per year and your target rate of return is 12%, then the most your should pay for the property is $100,000.

CASH ON CASH RETURN or
EQUITY DIVIDEND RATE
Cash Flow/Required Equity Invested

This is the cash flow divided by the required equity investment. This is especially useful when you know how the property will be financed. Example: The monthly rents for a property are $1,000. The property costs $100,000 and you will make a $10,000 down payment. The cash on cash return is 10%.

This kind of analysis is most important to any foreclosure property purchaser. Equally important, is this kind of investment is not passive. Even if you are fortunate enough to hire a property manager to do all of the necessary tasks (collect rent, perform maintenance etc.), you are responsible for the success or failure of each investment property.

There are quite a few books written about this subject that can be found at your local library or book store. Before investing, you should study from as many sources as possible.

Knowledge is Power!