A property's income production often is more important to investors than appreciation

Dr. Ken Rich, investor

As published in Scotsman Guide's Commercial Edition, March 2009.

In today's commercial real estate market, one thing seems clear: The true value of any property should be based solely on its income-production capability. Including anything more than that in determining a property's value often is a gamble.

Commercial mortgage brokers should understand this and work diligently with investors to evaluate properties. They also should examine prospective borrowers carefully.

There are numerous things brokers should keep in mind when working with investors, from how to best examine clients' investing acumen to what best practices investors follow.

What's a good investment?

Generally, investors who purchase single-family residences look to houses that are smart investments -- meaning that they make money as income-producing rentals. They typically don't worry about appreciation, although it's certainly a bonus if its value appreciates.

Say the investor buys the house for $120,000 total (i.e., purchase plus rehabilitation costs). Depending on the loan type, a loan for $120,000 may be less than $800 per month. The investor rents the house out and has a net income of $1,080 per month after expenses. This results in a positive cash flow of almost $300 every month. This therefore covers full debt service, all expenses and has extra safety cash each month.

Some brokers and lenders think that investment properties aren't as secure as owner-occupied properties. This isn't so, however. If owners lose their jobs, they often stay until they're foreclosed upon. In an investment-property situation, however, if renters lose their jobs, they move out, and the investor often can find another renter.

Even if comparables indicate that a property's fair market value is $500,000, consider an investor's point of view. If a similar property rents at an average of $1,800 per month, that means that most people in the area can pay $1,800 per month to live in that house -- nothing more.

Some investors make the mistake of looking at the top rent, however. Rather, they should look at the lower third of the market rental rates to best determine a property's income-producing capabilities.

Other tricks of the trade

When working with investor clients, it helps to think like them so that you can best advise them.

First, look at the property's true income potential. Look at rental comparisons, not sales comps -- and be sure to look at the lower end of those comps.

Next, subtract a reasonable expense from income to arrive at the bottom line you really need to consider as net spendable income for monthly principal and interest payments.

Third, base the loan on those numbers. Let the investor take advantage of having found an underpriced property. The investor certainly should put money down, but make it worthwhile to work with you and your lender partner (say, 5 percent to 15 percent). You can base this on how much below the market rate the investor is getting the property for, who is going to manage the property and how much positive cash flow will be left over each month.

Brokers and lenders may wonder how they can verify the numbers an investor gives them. It's simple: Call other brokers in the area, check rental rates on online trading Web sites, call the local rent-subsidy board to see what's covered and how it works, and ask for a different inspection and rehab proposal from an inspector of your choice. Doing these things can help ensure that your client is proposing a solid deal.

Many brokers avoid working with clients who invest in single-family homes because they feel these clients are riskier than others. If you work with savvy investors, however, you'll find great opportunities to help them fund their deals and to build your business.

Dr. Ken Rich is a retired physician and a professional real estate investor. He was a commercial real estate broker and worked with savvy, profitable investors before entering the medical field. He works on deals where he can buy low, rehab to prime condition, set up government-subsidized rental income for a large positive cash flow, and turn many of them over to other investors. Reach him at seniordirector@IHLPro.com or (562) 694-8060.