Seven checks on one specific building. The two that decide most outcomes - the deduction list and whether the income covers the borrowing - are the two that never appear in a listing.
14 min read · Level 2
The most useful thing a property appraisal does is separate the building from the loan, and almost nobody does it, because the two arrive together in every conversation about a purchase. An agent quotes a yield, a broker quotes a payment, and the buyer forms a single impression of the deal in which the asset and the financing are welded together. The trouble with that impression is that it is unstable in one direction only: the building's economics barely move from year to year, while the financing can be repriced by somebody else entirely, on a schedule set out in a document the buyer skimmed. So a deal that looked sound is re-underwritten by a lender at renewal and turns out to have been a bet on a rate all along. I would go so far as to say that a property is worth owning only if you would still want it at a loan size the income can actually cover, because that is the version of the deal you may end up holding whether or not you chose it. Everything above that level is a decision about leverage, which is a perfectly legitimate decision and an entirely separate one - and the discipline that keeps it separate is running the cash-on-cash figure with no loan at all, every time, even when you have no intention of buying that way.
Seven checks on one building, ordered by how much each one changes the outcome rather than by how easy it is to run.
One. The deduction list. Lesson two's lines, sourced from documents. Property P: 8.00% gross becomes 4.264% net. Property Q: 10.00% gross becomes 2.772% net. The check is not whether the yield is good; it is whether you can put a document behind every line. A line you estimated is a question you have not asked.
Two. Whether the income covers the borrowing. The debt service coverage ratio is net operating income divided by annual debt service. Property P with a 225,000 mortgage at 6.00% over 25 years:
Monthly payment 1,449.68 Annual debt service 17,396.14 Coverage 12,792.00 / 17,396.14 = 0.7353
Below 1.00. This property does not pay for its own mortgage at that loan size: the shortfall is 4,604.14 a year, out of the owner's other income, every year, whether or not anything goes wrong. Lenders commonly want coverage of at least 1.25, which on this income means annual debt service no greater than 12,792 / 1.25 = 10,233.60, a monthly payment of 852.80, which at the same rate and term supports a loan of about 132,360 - 44.12% of the price rather than 75%.
Three. The cash return on the cash you put in. Cash-on-cash return is the year's cash flow after financing divided by the cash actually invested. At the 225,000 loan that is -4,604.14 on 87,300, which is -5.2739%. At a 130,000 loan, annual debt service is 10,051.10, coverage is 1.2727, cash flow is 2,740.90, and the cash invested is 170,000 plus 12,300 of costs - so 2,740.90 / 182,300 = 1.5035%.
Both are true and they describe the same building. Which one you get is a decision about financing, not about property.
Four. Condition, and what is due. A roof has a life, so does a boiler, so does a bathroom. Capital spending is not maintenance and does not belong in the deduction list - it is lumpy, forecastable and frequently ignored. A survey is the instrument here, and its job is to date the expensive items.
Five. The tenant. Who pays the rent, on what terms, for how long, and what happens when they leave. A long lease with a stable occupier and a rolling monthly arrangement produce the same rent line and completely different risks.
Six. The location, in the only sense that is checkable. Not whether the area is pleasant. Whether people who can pay this rent will keep wanting to live or work in this specific street: employment, transport, supply of competing units, planned construction nearby.
Seven. The exit. Who buys this from you, on what evidence, and how long does it take. A building whose comparable set is thin is a building with a thin buyer pool, and lesson three's dates are the clue.
Because two properties can produce the same headline and require the opposite decision, and the checks that separate them are the ones a listing is structured to leave out.
Put P and Q side by side on everything computed so far.
Property P Property Q Price 300,000 180,000 Gross rent 24,000 18,000 Gross rental yield 8.00% 10.00% Vacancy allowance 8.0% 15.0% Maintenance basis 1.0% of price 1.8% of price Service charge nil 1,800 Net operating income 12,792 4,990 Net rental yield 4.264% 2.772%
On the line every listing prints, Q is 1.25 times P. On the line that describes what an owner receives, P is 1.538 times Q. Nothing in that reversal is subtle or contested - it is a short list of subtractions - and it is invisible without them.
Now look at where the reversal came from, because that is the transferable part. Q's vacancy allowance is 15.0% against P's 8.0%, its maintenance basis is 1.8% of price against 1.0%, and it carries a 1,800 service charge P does not have. Three of the six lines, and all three are consequences of the same facts: an older building in a weaker letting market with communal costs. The deduction list is not an accounting exercise. It is where the building's actual condition and its actual market arrive in the numbers.
That is the general principle behind all seven checks. A high gross yield is usually a low price, and a low price is usually the market pricing something. The checks exist to find out what. Sometimes the answer is a genuine mispricing and the building is fine; far more often the answer is in the deduction list, in the survey, or in the tenant's covenant.
The second check earns its place at number two for a different reason. Coverage below 1.00 does not make a property a bad investment - plenty of buildings are bought on the expectation that rents rise into the payment - but it converts a passive holding into an ongoing claim on your other income, and it does so for years. Somebody whose salary changes during that period discovers that their property, their employment and their obligations are all connected, which is exactly the arrangement illiquidity-and-forced-selling describes.
And the seventh check is the one people skip because it feels premature. It is not premature. A building you cannot readily sell is a building whose price you do not control at the moment you need it.
Educational, not personalised financial advice. Nothing in the Investor Academy is a recommendation to buy, sell or hold anything — what is right for you depends on your own circumstances and the rules where you live.
One property, three financings, and how completely the numbers change while the building does not.
Property P throughout: price 300,000, purchase costs 12,300, net operating income 12,792, mortgage rate 6.00% over 25 years.
Loan 225,000 130,000 nil Cash invested 87,300 182,300 312,300 Annual debt service 17,396.14 10,051.10 0 Coverage 0.7353 1.2727 n/a Cash flow -4,604.14 2,740.90 12,792.00 Cash-on-cash -5.2739% 1.5035% 4.0961%
The left column is the one most buyers want, because it needs the least money and gives the largest exposure. It also produces a negative cash flow of 4,604.14 a year that has to come from somewhere else, and a coverage figure most lenders would decline. The right column is safe, unexciting, and requires three and a half times the cash of the left.
None of these is the correct answer. They are three different propositions, and the point of computing all three is that the choice becomes visible as a choice. Buyers who run only the middle or only the left column usually believe they are evaluating a property when they are evaluating a loan.
One detail in that table is worth isolating, because it is where a common error lives. The annual debt service of 17,396.14 is not all cost. In the first year of that 225,000 loan, 13,391.05 of it is interest and 4,005.09 is principal repayment, which reduces the balance to 220,994.91. The principal portion is not an expense - it is a transfer from one of your pockets to another, converting cash into equity in the building. So the cash flow of -4,604.14 overstates the economic cost, while the interest-only view of -599.05 understates the cash you actually need each year.
Both numbers are useful and they answer different questions. Coverage and cash flow tell you what the arrangement demands of you month to month, which is what determines whether you can survive it. The interest figure tells you what the financing actually cost. Confusing them is how somebody concludes a property is losing money when it is building equity, or concludes it is profitable when it is quietly consuming their salary.
Verifying the rent and estimating everything else. The rent is the one number the seller is happy to document, which is precisely why it is the one that needs least checking. Every deduction, by contrast, is a line the seller has no incentive to produce and every incentive to leave you to assume.
Reading a high gross yield as an opportunity rather than as a question. Q's 10.00% was the best-looking number in this lesson and it belonged to the worse building. A low price is usually the market pricing something; the seven checks exist to find out what it priced.
Treating capital spending as maintenance. Maintenance is the annual allowance for things wearing; capital spending is the roof, the boiler and the rewiring, arriving in single large amounts on a schedule a survey can date. Folding one into the other produces a net operating income that looks stable for four years and then does not.
Evaluating the loan and believing you evaluated the property. The three columns above are the same building. If your appraisal changes completely when the loan changes, you have been appraising the financing - and a property that only works at one loan size is a fragile proposition with a hidden dependency on a rate you do not control.
Skipping the exit because the purchase has not happened. The thinness of the comparable set is available before you buy, it is the best evidence you will get about how long a sale takes, and it costs nothing to look at. Lesson three's completion dates are the whole check.
Accepting the seller's own survey. It was commissioned by somebody whose interest is in the transaction completing. Commission your own, and read the dated items rather than the summary.
Insurance quotation, agent's fee schedule, the property tax bill, the service charge accounts, the letting history. Where you cannot get a document, write the line in a different colour and treat it as an open question rather than an estimate. The unsourced lines, taken together, are the information request the-information-request describes.
Three years of it if you can: what it let for, how long each void lasted, whether rent was ever arrears. That is the evidence behind your vacancy allowance, and it is the difference between an 8.0% figure you can defend and a 15.0% figure you should have used. A seller who cannot produce it is telling you something.
Net operating income divided by annual debt service, at the loan you actually intend to take. Below 1.00 means the building requires money from you every year. Property P at a 225,000 loan is 0.7353, which is a shortfall of 4,604.14 a year. Knowing that before you commit is what makes it a decision rather than a discovery.
Including no loan at all. For Property P that is -5.2739%, 1.5035% and 4.0961%. Seeing all three at once separates what the building does from what the financing does, and it is the fastest cure for the belief that a property is good because a particular mortgage makes it look good.
Not the summary, the schedule: the age of the roof, the boiler, the wiring, the windows. Convert each into an expected year and an expected amount and hold them as a separate list from the deduction list. The purpose is not to reject the building; it is to know which years will be expensive before you agree a price that assumes none of them are.
Term remaining, notice provisions, who is responsible for what repairs, whether the rent can be reviewed, what a re-let would cost in agency and void time. A rolling monthly arrangement and a five-year lease produce an identical rent line and materially different risks, and only one of them is visible in a listing.
Who buys this building from you, what evidence they will price it on, how many similar units sold nearby in the last year, and how long each took. If the comparable set from lesson three was three sales spread across eleven months, that is your answer about the buyer pool, and it should affect the price you offer rather than being discovered later.
On any specific property before making an offer, when re-underwriting something you already own after a rate change or a tenant leaving, and whenever a deal looks unusually attractive on the one figure a listing chooses to print.
Do not run this appraisal on a property whose letting history, service charge accounts and survey you cannot obtain - the absence is itself the finding. And do not use it to compare a direct purchase against a listed trust, which is a different comparison requiring the trust's own debt and management costs to be brought in.
A shape that recurs whenever borrowing costs have been stable for a long stretch: buildings are underwritten at the prevailing rate, coverage comes out just above the lender's minimum, and the arithmetic is accepted as the arithmetic of the property rather than of the moment. Then the fixed period ends. The same building, the same tenant and the same rent produce a payment the income no longer covers, and the owner is choosing between funding the shortfall from elsewhere and selling into a market where every other owner is facing the same renewal. Nothing about the building changed. The variable that moved was never a property variable at all, and it was visible in the loan documents from the first day.
Underwrite the building at a payment materially higher than today's, and see whether you would still buy it. If the answer depends on the rate holding, the deal is a rate position wearing a building.
Surveys are commonly reduced to a single question - did it pass - when the valuable content is the dated inventory underneath: the age of the roof covering, the boiler, the wiring, the windows, and the expected remaining life of each. A building that is entirely sound today can carry thirty thousand of capital spending arriving across the next six years, all of it forecastable from that inventory, and none of it visible in a net operating income figure that only allows for routine maintenance. Buyers who read the summary and file the schedule meet those amounts one at a time and experience each as bad luck, when the report had already told them the year.
Convert the survey's component ages into a year-by-year capital spending forecast before agreeing a price. It is a schedule, not a verdict.
Create a free account to read the rest and apply it to your own investing.