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Every day anywhere from 10 to 20 duplexes either are newly listed on the Twin Cities MLS, or have their asking prices reduced.
How can you tell which ones are good investments?
I suppose you could stop and do the math on each of them. Of course, that would take a lot of time.
Is there a shortcut?
Over time, seasoned real estate investors and Realtors use to learn two tools to quickly assess whether or not a property is likely to be a good investment: the gross rent multiplier and something called a cap rate.
While the cap rate is a useful tool for larger commercial properties, I haven’t found it to be as effective a measure on smaller multi-family units. Nonetheless, I’ll discuss the cap rate later in the week.
The gross rent multiplier is a very simple math problem. To arrive at it, just take the asking price for a property and divide it by the amount of rent a building generates annually.
For instance, if a duplex is priced at $240,000, and the MLS indicates it is receiving $24,000 in rent for the year, 240,000/24,000 = 10. The gross rent multiplier is 10.
How do you use this number?
Generally speaking, the lower the gross rent multiplier number is, the more likely the duplex is to cash flow.
So if a property has a low GRM, do I recommend a client buy it?
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Over the past few weeks, I have been reminded that just because someone holds a real estate license, they are not necessarily qualified when it comes to buying or selling multi-family housing.
I saw evidence of this over and over during the boom years. Countless Realtors sold their clients over-priced properties that didn’t cash flow.
I see many of those properties re-listed now. The MLS information almost always reflects a short sale or foreclosure, which makes me angry. I truly believe if the buyer had competent representation, the foreclosure could have been avoided (because the property would not have been purchased at that price in the first place).
Many of those types of agents have been shaken out of the business this year. As a result, most of the Minneapolis and St Paul duplexes that sell today make financial sense. However, I don’t think anyone can sound the all clear alarm just yet.
The other day a property came on the market that I thought might be suitable for a client. As I studied the MLS listing, however, I noticed while it stated that the tenants were responsible for their own fuel costs, the seller was also reporting annual heat and electric expenses of thousands and thousands of dollars. Certainly a mixed message there.
I called the listing agent for clarification. It seems the property owner had called the power and gas companies, gotten the annual totals for both units and reported them to the agent. While the tenants were in fact responsible for paying for everything but water and sewer, the data reported the owner was. As I’ve explained before, if the landlord pays for heat, the property has a different value. The listing agent didn’t understand.
I also recently received an e-mail from an agent who had property their client wanted to do a 1031 or Starker exchange with. The agent did not explain what the property was, so I called with the hope that it would be multi-family housing. It was a chunk of land. And it was the agent’s understanding that a 1031 exchange was a straight up trade of one piece of property for another. Nope.
When getting a real estate license, the educational background for the state test is broad and general. After that, it is up to individual agents to pursue continuing education courses and expertise in an area they’re interested in. Commercial and multi-family properties, as well as land for development, each have their own unique sets of challenges and rules.
It is absolutely essential that you work with an agent who understands the nuances of the investment you’d like to make. After all, not every foreclosure is the result of predatory lending.
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I read a Reurters article the other day about a gentleman in California who since the year 2000, purchased nine single family homes. All of them are now being foreclosed upon. The article blamed negative amortization loans for his demise. What the article doesn’t say is just exactly what this man’s investment strategy had been. Had he intended to simply ride the appreciation? Was he renting the homes out?
I’ve had my California real estate license. And I know, at least in the Los Angeles area, that investors use a little tool called the gross rent multiplier or GRM. In fact, it is so prevalent that it’s even calculated and displayed on the MLS.
What’s a GRM? Well, like its big sister the cap rate, it’s a way I use to quickly look at an investment property and decide whether or not it makes financial sense compared to the others on the market. Call it a quick and easy way of comparing apples and oranges.
To determine the GRM, simply take the purchase price of the property and divide it by the amount of rent it generates annually. So, if a property is listed for sale at $200,000, and it takes in $2000 a month in rent, or $24,000 a year, its GRM would be 8.33 (200,000/24,000= 8.33). Conversely, if it only generated $18,000 in rent a year, the GRM would be 11.11 (200,000/18,000 = 11.11)
A general rule of thumb is the lower the GRM, the greater the cash flow.
I’ve done too many of these to count. And after endless late nights doing entire spreadsheets on properties, I realized that in the Twin Cities market, anything that’s got a GRM higher than a 10 isn’t going to cash flow. There are exceptions, yes. But we’ll cover those some other time (hint: owner occupied & tax write offs).
If the property meets my criteria, I will stop and do an investment worksheet. I’ll consider all the costs involved in ownership, as well as the market’s current vacancy rate. If I see a negative cash flow, I don’t necessarily discard the property. I just know it’s probably overpriced, and deserves a lower offer.
In the boom years, I warned buyers they wouldn’t hear from me very often. Properties that paid their own way were few and far between. Most of my clients stayed on the sideline. None of those who bought, however, are in predicaments like the California gentleman. Why?
Nobody can predict how much appreciation any real estate market will experience in a coming year. Any agent who tells you otherwise is either the world’s best psychic (and should be sharing lottery numbers) or full of it.
At one point, the market in southern California was experiencing appreciation of as much as 20% a quarter. People bought simply on the hope the value would skyrocket. But they never stopped to do the math. The properties may well have had negative cash flows from the start, meaning the owner had to go into his own pocket to make up the difference. This guy may have been doomed from the moment he started.
Remember, when a property manages to pay for itself from the first day of ownership, it’s a great investment. Any amount it goes up in value is a bonus, not a guarantee.
