The chief hurdle for
beginner property investors is usually a lack of knowledge. What questions do I need to ask? How do I
evaluate a potential investment property? Most homeowners that want to own an investment property simply
don’t know what to look for. If they find particular information on a potential investment property they have
trouble digesting what the information means. Whether experienced or a beginner in the property investment
arena, you need some basic info to help you.
There are two items you will want to consider when looking at investment property: Net Operating Income, and
built equity. I will touch on building equity, and address a few things regarding Net Operating Income,
commonly referred to as “NOI” or, in plain English, cash flow.
Net Operating Income is simply the amount left over at the end of the day after your carrying costs have been
paid for. I would like to point out that I used the term “carrying costs,” and not “mortgage payment.” Your
carrying costs on a property take into account your mortgage payment and other costs such as monthly property
tax installments, heating costs, maintenance costs, vacancy allowance and property management amount. Net
Operating Income can be expressed either monthly or annually. If expressed monthly it typically means what
you can expect as profit on a monthly basis. If expressed annually, it is typically used in other areas of
property analysis. Regardless of the way it is expressed it still means one thing for certain: the estimated
amount of money you keep per month or year after your costs have been covered on a particular investment
property.
For qualification purposes you will want the NOI to be 25% more than your carrying costs. This makes
the property you are looking at self-sustaining. (For more on this topic see my previous editorial “The
Secret 1.25 Rule” — Lifestyle British Columbia fall 2008 issue) This brings me to the next acronym
relating to cash flow: DCR.
“DCR” is short for “Debt Coverage Ratio.” This ratio is a percentage of how much your rental income exceeds
your carrying costs. “Hold on a second, back the bus up,” you say. “Haven’t we just discussed this?” We have,
but only half of it. The chief difference between NOI and DCR is that NOI is a hard money number, a
quantified dollar amount. DCR is a percentage ratio. DCR can be applied to a single property or across an
entire portfolio of multiple properties. In some cases, a lender may qualify an application on the basis of
Debt Coverage Ratio across all rental properties owned. Alternatively a lender may consider DCR strength as
one criterion for qualification.
The last item to cover today is that of built equity on an investment property. Total equity accumulation is
simply the sum of market value increase + the amount of principle you have paid off from any associated
mortgage. This is considered over a specific pre-determined time frame. It could be one year, three years,
five years, or any other chosen time frame. Market value increase can be referred to as “top-end” equity,
while loan principle pay down is considered “bottom-end” equity. Of these two, market value increase is
by far the most powerful part of equity as it generally increases faster than loan principle pay down
amounts.
Now that you have a basic understanding of a few analytical tools with which to evaluate an investment
property, you can begin to look at a few on a basic level. As an alternative, I have also developed a report
generation tool that will give you a complete, sophisticated multi-page report on a prospective property.
You can find it on my website: michaelmcivor.com, under the “products” section. When you
do decide to hunt for investment property, look at these few things to help you decide if you want to
investigate the potential investment property further. These are not the only items to look for, but they
will help you hit the ground running. •
Contact Michael McIvor at michael@michaelmcivor.com
