I agree that a teacher's ability in dance performance is of very secondary importance to their skills as a teacher, but it's a bit daft to say that the skills are mutually exclusive, surely?
Teaching is a vocation, as much as anything, and naturally gifted teachers are pretty rare (while decent performers are ten-a-penny). The only way to evaluate a teacher properly is to work with them. Personal recommendation is very important, and you can form some sort of impression by observing their pupils dance, but that is a very crude measure (and largely meaningless unless you know what experience and aptitude the students had to start with).
A key factor is whether the teacher can adapt his/her teaching methods to the learning style of the student, and there's only one way to find out.
If they ask you to pay for more than one lesson at a time, laugh in their face, and walk away.