Spirepoint Properties

Analyzing a Real Estate Deal (Part 3)

This is the third in a series of articles explaining exactly how we analyze our deals. In this article, we'll discuss financing in detail, as well as some of the calculations we use to evaluate a deal.

Financing
Financing a deal is probably one of the most important concepts to grasp for any type of investment property. It can make the difference between a 'good deal' making money or losing money.

How is that possible? If it's a good deal, won't it always make money? Not necessarily! There are many factors that contribute to this, but ultimately, the more it costs to pay the mortgage each month (also called debt service), the less money you will have to pay expenses and ultimately, generate a positive cash flow.

The following sections describe several mortgage components we evaluate. For more detailed information, each topic can be researched on Google.

  • Leverage - As previously discussed in our premier issue on leverage, your return on increases the less money you put towards a down payment. However, it's a double-edge sword -- the less you put down, the less likely it is the property will cash flow.
  • Mortgage Type - All mortgages are variations of these three types of mortgages: principle and interest (PI), interest-only, and balloon or lump sum payment. The important thing to remember is how much cash comes out of your pocket each month. With that in mind, a balloon payment mortgage is best (because everything is paid back at the end of the term), followed by interest-only, and principle and interest.
  • Interest Rate - Determines how much it will cost you to borrow funds to purchase a property. This has a big influence on your monthly payments for both principle and interest, and interest-only mortgages. It doesn't affect balloon payments as much, because the entire borrowed amount (including accrued interest) isn't due until the end of the term. It stills costs you money, but that money is not payable on a monthly basis.
  • Term - This refers to how long you will pay the stated interest rate before the mortgage is renewed at a new interest rate, or it must be paid off. Watch out for mortgages that must be paid at the end of the term. This can be a HUGE hit to your cash flow if you aren't expecting it. Make sure every mortgage you sign has the option to renew.
  • Amortization - This only applies to principle and interest mortgages. It determines how many years over which the mortgage is paid back to the lender. The longer the amortization, the lower your monthly payment.

Calculations
All of the above elements come together to form the mortgage payments required to finance a property. The total of the annual mortgage payments is called Annual Debt Service (ADS).

Now let's pull together elements from our previous articles (part 1 and 2):

GOI = Rent + Laundry + Parking + Other
EGI = GOI - Vacancy Allowance
TOE = Maint. + Mgmt + Taxes + Insurance + other expenses
ADS = Sum of all mortgage payments
All of the above numbers are expressed on an annual basis. So we add up all the rental income for the year, parking income for the year, etc.

Before continuing, review one of the Cash Flow Proformas in the Real Estate Deals section of our website to see these formulas and values being used on a real-life property.

Let's figure out how much cash flow a property will generate. Subtract the Total Operating Expenses (TOE) from the Effective Gross Income (EGI). The result is called Net Operating Income (NOI):

NOI = EGI - TOE
The final step to calculate cash flow is to subtract the Annual Debt Service (ADS) from the Net Operating Income (NOI).

Cash Flow = NOI - ADS
That's it! Assuming all your income and expense amounts were correct, you now know how much cash flow a property will generate. Most investors never do this level of investigation and analysis, so if you've reached this far, you're ahead of 90% of other investors.

In future articles, we'll discuss quick indicators we use, determining total purchase costs, returns on investment, and more.


This article is copyright © 2004-2010 Spirepoint Properties. All rights reserved.

Paul Blacquiere and Joanne Beehler are full time real estate investors and have been investing in Ottawa, Ontario, Canada since 2002.  They are owners of Spirepoint Properties, a Canadian real estate investing company dedicated to making real estate investing easy.

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