Rules of Thumb – How Far Can They Take You?

A client of mine who is mulling over the idea of acquiring some real estate for investment purposes, started doing some reading on her own and came across a piece about rules of thumb.  She read, in addition to other bits of wisdom, that:

The rule of thumb is that the purchase price of investment property should be 10 times the gross annual income; for example, if the total rent for the year is $12,000 the purchase price should not exceed $120,000

I had been planning to write a post on capitalization rates for residential properties, and the misinterpretations thereof, but hadn’t had time to craft it.  Lo and behold, I rattled off a partial answer to my client that happens to serve as an introduction to this topic. Here it is:

There are indeed a lot of things you can read in books or online about investment properties and rules of thumb. Unfortunately, rules of thumb often give the wrong impression of a property, either positively or negatively.  Also, in the Ottawa market for many years the 10 times factor for income vs. value has not been true – it is pretty much impossible to find.  Most properties when sold will show a cap rate around .5, meaning the price is around 20 times the net income – often around 15 times the gross income (give or take a sizable standard deviation) – not 10 times as it used to be in the “good old days.”

But expenses vary wildly from one property to the next, as do some of the income factors, interest rates, amortization, etc.

I believe it is critical to understand your requirements for cash flow and long term returns that including potential upside in property value bolstered by any improvements to the property that may or may not be possible.  They created rules of thumb to make it easy for people to quickly decide whether or not to pursue a more detailed analysis – I think they did this in the days long before spreadsheets on laptops, tablets, or even smartphones.  I have built a spreadsheet that allows me to analyse the returns, change assumptions, analyse again, very quickly, looking at a 5 year window.  I’m currently working on changing it to look at 5 years and 15 years.

In general, any single family property, like a condo for example, will go up in value based on sales of comparable residential properties, following the typical normal appreciation rate for the Ottawa residential market. Most of these properties do not cash flow positively with a minimum downpayment, and if you put a larger downpayment, you lose leverage and the overall returns suffer.  Multi-family properties have better cash flow (in general – plenty of them do not have good cash flow either) and also offer you protection with respect to the vacancy rate.  They do not always appreciate in value in step with the single family residential market as their valuation is more closely tied to the rents.

Rules of thumb like capitalization rate (going in and forecast going out after your diligence) can help you to quickly decide whether or not to perform a more detailed analysis. But, before considering an offer on a property, that detailed analysis is required.

There is really no excuse for not doing a reasonably detailed paper analysis within the first 10 minutes of identifying a potential acquisition.  So my “rule of thumb” is a 10 page spreadsheet, not an equation with 2 inputs.

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