Weekly Wealth Tactic 10

by Ed Barriskill (co-founder, 37th Parallel Properties)

The Five (5) Stage Evaluation Process is an important step in due diligence when you are purchasing Real Estate. It is imperative that you conduct this evaluation process when you are contemplating purchasing a particular property.  If you ignore this process you are basically using the “Hope System” – which doesn’t work.  Most successful investors use this system to evaluate properties they are purchasing; so why not do what other successful investors do?

The Five (5) Stage Evaluation Process is an effective tool to help you determine the value of any property you purchase. If you follow the process and rely solely on the actual numbers of the property you won’t get emotionally involved and as a result you will make good, wise decisions.

Listed below are the five (5) stages of the evaluation process.

1. Verify the Property’s Income: The property’s income is the first and perhaps the most important factor when determining a property’s value. To determine the property’s income there are three types of income to consider: a) Actual Income b) Actual Potential Income and c) Future Potential Income. Each of these types of income are needed to determine the present performance and potential performance of a property.
   1. Actual Income: The actual income is the total income (all income) that the property you are contemplating on purchasing has generated in the last twelve months. If you can obtain records for the last 24 months -all the better!
   2. Actual Potential Income: The Actual Potential Income is the total income (all the income) the property could have generated in the last twelve months had the unit or units had been 100% occupied and the owner had taken advantage of all other income opportunities. This is where you have to get creative and brainstorm with your team members and find every single income producing event possible.
   3. Future Potential Income: The Future Potential Income is the total income (all income) the property could generate at today’s market rents, 100% occupied, and taking full advantage of all other income opportunities that are possible.
      1. Note: The goal is to find income from every possible available source.  In the first quarter of 2010 look for our EBook, 37th Parallel Properties 101 ways to increase income (revenue) and reduce expenses.
2. Verify Expenses - Verifying expenses is the second important variable to consider in evaluating a property. At this stage your goal is to verify all expenses such as operational costs, services, repairs, as well as upgrades to the building in a micro and macro viewpoint. These include the Capital Improvements that you are going to implement in your entry strategy. The goal here is to find all actual expenses and then decrease those expenses to the minimum and from year to year evaluate them again and again.
3. Determine Net Operating Income or NOI - Your Net Operating Income is a extremely important number used in establishing the value of the property. The NOI is the basis for many other real estate calculations and is the foundational number used to value a property.
   1. Formula:     Income – Expenses = Net Operating Income (NOI)
4. Find the Capitalization Rate and Valuation – The Cap Rate is a ratio (expressed as a percentage) used to estimate the value of an income producing property. Simply put, a Cap Rate is the return you expect to get from your investment. Investors, lenders, and appraisers use Cap Rates to estimate the purchase price or value for income producing properties.
   1. Formula:  Net Operating Income/Sales Price X 100% = Cap Rate
   2. Note – The Sales Price may also be the “Value” of the property.
5. Calculate the Loan Payment and Your Cash on Cash Return – To establish your loan payment you will need a mortgage calculator or ask your favorite lender to provide you with that information.  The next step is to establish your Cash on Cash Return. Cash on Cash Return measures the return on cash invested in an income producing property. The Cash on Cash Return is the true measure as it takes into consideration the mortgage (your loan) and all expenses, giving you an accurate number to base a good decision.
   1. Formula:     Net Operating Income/Total Cash Invested X 100% = Cash On Cash Return

The Five (5) Stage Evaluation Process is an essential step in evaluating investment properties. These steps give you the ability to evaluate real estate investments without emotion and give you an accurate measurement of how the property is operating currently and in the future.  By consistently utilizing this process, you will make disciplined, informed and smart investment decisions.
Each step will give you an accurate fact-based accounting of the properties performance, plus personal confidence to make the best decision possible to either purchase the property or pass on it.  So, put away the “Hope System” and start using the Five (5) Stage Evaluation Process to accelerate your wealth!

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