Every property, resident, owner, and Property Management Company is different. Each one has their unique characteristics and special qualities that set them apart from one another.
It is obvious that properties are different. The same car driven by different drivers will perform differently over time. The same is true with buildings. The care and preventive maintenance performed will only extend the life and performance of the property. And just like there are different types cars, BMW, KIA, and Rolls Royce, the same holds true with property types.
Usually, the different types of properties will attract a specific type of resident also. Once a property manager understands the complexion of the property they can develop the strategic evaluation of the targeted area (SEOTA) as well as comprehensive market surveys that periodically change based on economic conditions.
Components of the SEOTA Marketing Plan
- Management Agreement: This is the agreement or management contract between you and the client. Understanding that not every property will operate the same, the property manager will use the SEOTA to help set up the basics of the property analysis, which will include setting up the properties.
- Property Qualifying Criteria
- Property Rules and Regulations
- Lease Contract
- Rental Rates
- Late Fees
- Management Fees
Step 1: Help your clients find the opportunities for rental investments through the strategic evaluation of a target area (SEOTA). The first goal of the SEOTA process is to identify areas that are good rental markets for your clients.
SEOTA, Key Marketing Steps
- Building Permits
- Average household size
- Mortgage interest rates
- Rental market rates
- Occupancy Rates
- Additional Potential Opportunities
- Close to highways and public transportation (bus lines, subways, etc.)
- Close to retail and shopping
- Close to large employment centers
Step 2: Know your asset classes. There are several different classes of properties that a real estate investor can own. Each one of these classes has its own opportunities and challenges.
These classes are:
- Class A and Class B properties
- Class C properties
- Class D properties
Step 3: Examine the Financial DNA Strand to understand the value of a property. Lets go over all of the Financial DNA key terms and formulas. Then we can put these definitions and formulas to work in practical application to determine the property value.
GPI (Gross Potential Income)
An investor’s main source of income is the rents they take in. As a property manager, this is your main source of income as well, as property managers are usually paid a percentage of those rents. The GPI is the maximum possible rental income if all of the units are rented, and this figure is calculated on an annual basis. To find the GPI, add up the monthly rent on each unit and multiply the amount by twelve, to calculate twelve months of collections. As an example, if you manage a triplex with each unit collecting $950 per month, you take the total rents you will collect each month ($950 x 3 = $2,850) and multiply that number by twelve ($2,850 x 12) to get an annual total of $34,200. That is your gross potential income (GPI) of the property.
VAC (Vacancy Loss)
In a perfect world, all of your rental units would be rented all of the time. Unfortunately, that’s not always going to be the case, so we have to allow for some vacancies when we put together a financial forecast for the property. This is known as vacancy loss. We also have to assume that not everyone will pay rent all of the time. This is known as collection loss. The average vacancy rate used by investors is 5 % percent. We like to apply a more conservative approach of 10% percent vacancy loss when analyzing financial reports for our clients. It’s more accurate to determine the average vacancy rate in your specific target rental area, which is one of the steps in marketing SEOTA. Now, to determine what a vacancy loss means to your property evaluation in dollars and cents, take the GPI (the total yearly rent of all units added together) and multiply that figure by your vacancy rate.
GPI x estimated vacancy rate = VAC (vacancy loss)
So, continuing with our triplex example, let’s assume an average vacancy rate of 5 percent. We would multiply our GPI of $34,200 by .05, which would equal $1,710. This is our expected vacancy loss for the year. If the vacancy loss were at a rate of .10, or 10% percent then the vacancy loss for the year would be $3,420.
EGI (Effective Gross Income)
Effective Gross Income is defined as your total income from possible rents minus VAC and collection loss. Again, continuing with our Triplex example at 5% percent, our GPI of $34,200 minus our VAC of $1,710 gives us an EGI of $32,490. This is the amount we can expect to collect on the property per year from the rent roll.
GPI – VAC = EGI
OI (Other Income)
Other Income (OI) is defined as money received from sources other than rent. Washing machines and dryers, vending machines, parking fees, application fees, and other sources of income are examples.
GOI (Gross Operating Income)
When you add OI to EGI you get the gross operating income (GOI). The GOI is the total amount of cash the property has available to pay expenses.
EGI + OI = GOI
OE (Operating Expenses)
Any expense incurred in operating the property is considered an operating expense. Some of these are fixed and others are variable. An example of a fixed operating expense is property taxes. An investor knows in advance what that dollar amount will be. A variable operating expense is something like eviction costs. The investor knows he will pay them, but he doesn’t know how often he will have this cost or what the amount will be.
NOI (Net Operating Income)
When you take the gross operating income (GOI) and subtract the operating expenses (OE), you get the net operating income (NOI). NOI is the income remaining after all expenses are paid, except for your mortgage payment. NOI is a key figure in all of the calculations of a property’s value from here on out.
GOI – OE = NOI
RRA (Replacement Reserves Account)
An RRA, is intended to be used for replacement costs of items and materials that wear out over time, such as roofing, boilers, exterior paint, and parking areas. This is also known in some investor circles as a sinking fund to build up reserves to have the money for these eventual repairs down the road. This is a predetermined amount that will be put aside every month to build up cash reserves for future capital expenses.
DS (Debt Service)
Debt service is better known as your mortgage payment. Multiply your monthly mortgage payment by twelve to get your annual debt service.
BTCF (Before Tax Cash Flow)
GPI – VAC + OI = EGI – OE – RRA = NOI – DS = BTCF
When we put all of this together, we get Before Tax Cash Flow (BTCF). This is the cash flow the property will produce before paying the taxes.
AC (Acquisition Cost)
Your acquisition cost is the total amount of your down payment for the mortgage, broker fee’s, appraisal, annual insurance cost, home inspection, and all other inspection costs and fee associated with the purchase of your target property.
ROR (Rate of Return)
AC/(BTCF – DS) = ROR
You will need to determine the rate of return for your investment property before your purchase the property to see if it will yield a desired return. To calculate your rate of return you are looking to see how many years it will take for the net profits to pay you back for your investment to purchase the property. By summing up all of your acquisitions costs, then dividing that total by the before tax cash flow minus the annual debt service will yield your rate of return.
Cap Rate (Capitalization Rate)
CAP RATE = NOI/Value
Cap rates are primarily used to help estimate the value of income properties. The cap rate is a measure of the absolute return on the dollars invested. It does not consider the use of borrowed funds (i. e. leverage); it considers only the return on an investment as if you paid all cash for the property investment. For example, if a property has an NOI of $100,000 and the price of the property is $1,000,000, then the cap rate is 10 percent.
COC (Cash on Cash return)
Cash-On-Cash Return = NOI – Debt Service = BTCF/Owner’s Equity
The cash-on-cash return is the ratio of annual before-tax cash flow to the total amount of cash invested, expressed as a percentage. In other words, cash-on-cash differs from the cap rate when the investor that they have used leverage, i.e., have acquired a mortgage. So, simply put, the cap rate is the return on investment when the investor has paid all cash for the investment, while the cash-on-cash return factors in the use of borrowed funds. Being said, the investor surely wants the cash-on-cash return to be higher than the cap rate. If the cap rate is higher than the cash-on-cash return, then the investor has borrowed money with a negative repayment rate. The cash-on-cash return formula is extremely important because it allows the investor to determine returns after using other people’s money (OPM) to help purchase the asset.
To Sum It All Up…
A reputable property management agency will be able to assist you in determining the property value in a target rental market as they are in the know for vacancy rates, rent rates, and they will typically know the classes of properties in a given market. By working with your property manager to analyze deals, you will quickly see if a deal is a deal or not, saving both you and your property manager valuable time and money from purchasing and managing the wrong asset.
Take a few moments to re-read the above list to digest the acronyms above and get familiar with them. It will take some time utilize these formulas in your everyday life as a real estate income property investor, but the time will be well worth when you can quickly see whether or not you are looking at a diamond in the rough, or a dog that just don’t hunt.
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Belaire Property Management
Regional Property Manager
(978) 448-0669 office
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