Repair Allowance, Gross Rent Multiplier and Cash Flow
In our previous article, we explored 3 widely used rules of thumb in real estate: Loan to Value, Capital Expenditures and Buying on Actuals. We want to continue introducing more rules of thumb to use when analyzing properties. In this article, we are going to discuss: Repair Allowances, GRM (gross rent multiplier) and the vital Cash Flow.
When you purchase a property with significant deferred maintenance, ask the seller if he can provide you with a repair allowance at closing. The rule of thumb for repair allowances is that the bank will permit a maximum of 3% of the purchase price to be credited back to you at closing. Many brokers will say “you can’t do that,” but that’s not the case. You just have to demonstrate that there’s a need for the repair allowance.
Let’s say you’re buying a $700,000 property and you estimate you need $15,000 for repairs. Fill out a property repair cost form that details all the necessary repairs and show the bank and seller.
Next, tell the lawyer to make the purchase price $715,000 and have the seller credit back $15,000 to you at closing. The seller still receives their $700,000 and you receive your $15,000 for the repairs.
DO NOT reduce the purchase price by $15,000 to $685,000 otherwise you won’t get any of that cash to perform repairs. This is a fantastic strategy to accumulate capital in order to perform the deferred maintenance on the property.
An important member of your investment team will be your building inspector. We are fortunate to have an inspector who provides very detailed reports with plenty of pictures and arrows pointing the actual issue.
Sometimes you may find units that were completely gutted or a non-working hot water heater. If the current owners don’t want to fix this, this is a great opportunity to ask for a repair allowance. Your contract will state that you are buying “x” amount of units, make sure you are getting “x” amount of “rent ready” units. The repair allowance is money that will be transferred from the seller to you at closing.
The GRM is a simple calculation that’s used to estimate a property’s value. It has several shortcomings; for example, it doesn’t take into account features such as expenses, location, type, and age of the property. It’s a widely used financial measure because it’s quick and easy to calculate, and it will give the buyer an idea if the property is overpriced in comparison to other properties on the market.
The GRM is calculated as follows: market value/ income
Example: If a property is worth $100,000 and the income is $10,000, then the GRM is 10 times rent roll. Every market is unique, but be wary if the property has a GRM of less than 4 or greater than 10. The rule of thumb in our market is 6 times gross rents.
The cash flow is the life blood of any business, and one of the main reasons to invest in real estate. There are two types of cash flow: before taxes and after taxes. When we refer to cash flow, we’re typically referring to cash flow before taxes. Our rule of thumb for cash flow is to NEVER purchase a property that is producing a negative cash flow.
We’ve heard people give tons of excuses as to why they have to buy a particular property, such as “It’s going to be worth double next year.” or “I need it for a write off.”
If you wouldn’t buy a business that loses money, why would you buy a property that’s doing the same thing? A property that is negatively cash flowing is referred to as an alligator because the property will eat you alive. This is one rule of thumb that should always be adhered to.
In our next article, we are going to look at 3 more rules of thumb. We hope this article has helped you understand the importance of using rules of thumb when investing. Please post a comment and let us know what you think!