Due Diligence Process Pt. 1 - Cash Flow

PeerInvest strives to offer high-quality investments with a reasonable margin of safety. We also seek to provide transparency and spread education amongst our users. In the spirit of education, we will be sharing our due diligence process in a series of posts. This is a snapshot in time look at our process, we are always growing, improving, and building new technologies to enhance the quality of our diligence. With that said, the first post will be all about cash flow and how we calculate it!

Cash Flow Analysis

The basis and starting point of our due diligence process lies in the numbers. We focus on offering high-quality rental properties on our platform which means we have an emphasis on strong cash flow, appreciating asset prices, and conservative leverage.

Rental Income

The financial analysis always starts with the top-line number. How much in rent can this property generate? We first make estimates based on market data. By collecting rental comps from units similar in location, quality, size, and the number of bedrooms we can form a basis for estimating rental income per unit on the prospective property. Later in the due diligence process, we will have our property manager verify our rental estimates and make any adjustments accordingly.

Operating Expenses

The expense lines are extremely important in determining the quality of an investment opportunity. New investors make the mistake of using a fixed number across all properties they analyze or use a generic percent of rental income. However, each property is unique and deserves to be treated as such.

Taxes

There are only two guarantees in life, death, and taxes. Fortunately for analysis purposes, taxes are public records and can usually be found on any MLS listing site, such as Redfin and Zillow, or retrieved from the county/city treasurer's office. Tax adjustments occur when the assessed value of the property changes. Different jurisdictions have different rules for when this is done, sometimes at the time of sale and other times on regular yearly schedules. For our analysis, we use the current tax amounts for our preliminary numbers.

Insurance

Every property on our platform is fully insured for two reasons. Most importantly, to protect the value of investments on our platform in the event of a catastrophe, fire, or other event resulting in an impairment to the property. Also, lenders will require insurance before lending on any property as the property and its value are collateral for the loan. How do we estimate this? Based on experience for our preliminary numbers and verified before the time of purchase by getting a quote from our agents.

Maintenance

Maintenance is work required to keep the units in a livable and safe condition. For example, if the toilet breaks we are required to fix it, and the expense would fall into this bucket. How we budget for maintenance expenses relies heavily on our experience, we typically set aside 3-5% of monthly rental income.

Capital Expenditures

Every 20-30 years an asphalt roof needs to be replaced, a water heater's estimated life is typically 8-10 years, and so on. Capital expenditures are typically the big-ticket items that occur infrequently but are guaranteed to need replacing. PeerInvest has developed a model for estimating cap-ex and is based on the expected remaining lifetime of the items multiplied by the price and adjusted for inflation. After calculating the total for all items on a property we budget a monthly reserve amount.

Property Management

Property managers (PMs) are responsible for placing tenants, handling maintenance requests, and more. A good property manager is worth the money they charge and can make or break an investment. PeerInvest has spent time developing relationships with many property managers and looks to ensure all properties are well taken care of. The main expenses in this category include tenant placement fees (typically 50-100% of the first month's rent) and management fees (Typically 8-10% of gross monthly rental income). These expenses vary case by case and are handled accordingly.

Utilities

Electricity and water, sewer, and trash (WST) are two utility expenses that may or may not fall on the owner of the property. For single-family rentals (SFRs) these expenses typically fall on the tenant. For multi-family rentals, it depends on whether the units are separately metered or not and local rules around how utilities can be managed. For example, in Cleveland OH, one of our main markets, WST must be in the name of the owner and therefore we either pass along the expense or include it in rent.

Vacancy

A very important expense that shall not be overlooked by investors is expenses relating to vacancy. Every property will have tenant turnover at some point in its lifetime and turnover carries two types of expense along with it, rental revenue loss and turnover expenses. The former being straightforward, loss of rent from the former tenant, and the latter is the work required to put the unit back on the market. Typically this includes new paint, miscellaneous maintenance work, and more. PeerInvest typically estimates vacancy expense as a percent of rental revenue and is highly dependent on location, better areas having higher quality tenants and less turnover than lower-quality locations.

Debt Servicing

The debt-related expenses are dependent on how the investor chooses to finance the purchase of the property. On the one hand, if an investor purchases a property in an all-cash deal then this expense will be $0. On the other hand, the investor could choose from several different loan types with different interest rates and this expense would be the monthly principal and interest payment. PeerInvest obtains a loan quote from its preferred lenders to determine what number to use in its calculations.

Calculations

Now that we have discussed the income side of the equation, let's discuss how we use this to determine the quality of an investment and whether it meets our standards. As mentioned earlier, we are cash flow investors seeking a solid yield and a healthy margin of safety therefore this is where we will begin.

Cash Flow

Let's get into the fun part! At this point, we have discussed all the details so the calculation becomes pretty simple. The following formula is used to calculate the estimated cash flow provided by the property.

Cash Flow = Rental Revenue - Operating Expenses - Debt Servicing

Cash to Close

To determine a yield (cash on cash return) for the property we need to calculate the cash required to acquire the property. Simply put, add together the down payment (100% of the purchase price for all cash purchases), closing costs, rehab costs, and any other upfront expenses.

Cash to Close = Down Payment + Closing Costs + Rehab Costs + Other

Cash on Cash Return

Cash on cash return is an important metric in the real estate industry as it is a proxy for yield. Think of it similarity to how you would view a dividend yield on a stock, it is our target cash return to investors in a given year.

At this point, the calculation is straightforward.

Cash on Cash Return = Cash Flow / Cash to Close

Wrap Up

If you are an investor looking for yield, this is the analysis for you. PeerInvest strongly prefers properties with high cash flows as they provide a margin of safety during operations and provide our investors with yearly returns that they can reinvest in other opportunities. Feel free to reach out with any questions or comments at support@peerinvest.io!

Disclaimer: PeerInvest is not a financial advisor and this post is for informational purposes only. Please consult a financial advisor before acting on the information in this post.