When it comes to real estate investing, particularly residential real estate, the likelihood that you will fall in love with a real estate asset is greater than that of other less tangible asset classes (bonds, stocks, pensions, etc.).
Many people fall in love with toxic properties that look good to the eye or feel good to the ego. But these kinds of self-indulgent and selfish asset purchases can quickly turn into massive liabilities, eroding balance sheets and destroying income statements. Why? Because investing is an intellectual sport and your emotions must be left out. First and foremost, you must run your numbers. When it comes to real estate investing, sometimes ugly is beautiful. Ironically, sometimes the ugliest looking property has the best numbers.
Cash flow is always king in any commercial or real estate portfolio; Much more important than capital appreciation, if you ask me. Capital appreciation can increase your net worth, but the cash flow will put cash in your bank account and keep it liquid. If you had to choose between net positive cash flow and guaranteed capital appreciation, you would choose cash flow all the way.
The challenge in real estate investing is minimizing your down payment (which will maximize your mortgage) while generating positive net cash flow each month.
Knowing the following 4 numbers will be of great use to you and it should really be estimated to the best of your knowledge and belief before making any real estate investment.
1. Net rental income
I like to buy property on the assumption that there will never be an appreciation of natural capital (although, of course, it will). The property will generally double in value every 7 to 10 years. Note: This is a trend and not a one-way bet! Either way, we don’t want to wait for that natural appreciation to occur before we start building wealth. Therefore, ideally we want each real estate investment to generate a positive net cash flow, that is, a source of passive income.
Therefore, when investing in property, the first key figure to focus on is net rental income. A lots of real estate agents will quote gross yield figures that is, the annual rent as a percentage of the property’s price. While this is a reasonable indicator of your potential return on investment, it won’t actually tell you how much money you are going to make (or potentially lose!). Therefore, I prefer to focus on net returns and ultimately net income – that is, the amount of net dollars a property will put in my back pocket each month.
Net rental income = Gross rental income – (operating costs + debt service)
In addition to debt service costs (i.e. mortgage), the following are typical operating costs that you will need to deduct from your gross rental figure to arrive at a net income figure: administration fees, municipal / municipal taxes / State, Repair / Maintenance Costs, Property Tax / Land Rents, Insurance Costs, Overrides (Vacancy Periods), Utilities, etc.
As a general guideline, you should aim for a gross rent of at least 150% of the property’s mortgage repayments to cover all operating costs and leave some net rental income for yourself.
Interest rates and market forces will affect your cash flow and net rental income figures. So, stress test your cash flow forecast for a 1% or 2% increase in interest rates or a 20 or 30% reduction in rental income and see how this affects the numbers. of net rental income.
The reason I like the net rental income test is that aside from the other numbers we’ll look at below, this income number will actually tell you how much cash a particular property will put in your back pocket each month (we are leaving out the income tax for the time being). So a good question to ask yourself before even calculating your net rental income figure is, “How much net income would you need to get from this property for it to be worth it?”
2. Cash back on cash
Many wealthy investors use cash-on-cash performance analysis as a kind of napkin-back test to establish whether a real estate investment deserves a more detailed analysis.
Cash on Cash Return = Annual Cash Flow (Before Tax) / Total Cash Invested
So, for example, you could buy a property for $ 100,000 and use $ 30,000 of your own cash as a down payment. Assuming the net cash flow (after all expenses) from the rental of the property was $ 700 per month, the cash versus cash return on that investment would be $ 8,400 / € 30,000 = 0.28 (28%)
I like to see a cash on cash return> 20% (and ideally closer to 30%) before considering investing.
3. Net rental income
Many real estate agents will quote the gross return instead of the net return. However, net return is the number to work with, especially if you are investing in new geographic territories; you need to do your due diligence and calculate the running costs associated with that particular property.
Gross rental yield = annual rent / cost of ownership
So, using the same numbers as in the previous example, Gross Return = $ 950 x 12 / € 100,000 = .114, that is, 11.4%
Net Rental Yield = Annual Rent – Operating Costs / Cost of Ownership
So, using the same numbers as in the previous example, Net rental yield = $ 700 x 12 / € 100,000 = .084, that is, 8.4%
So when a real estate agent quotes you for an X% yield on a particular property, ask if it’s gross or net. If they stare at you blankly, be sure to do your own research on the property’s running costs. As a guideline, you can estimate 30% of rental income for operating costs, but again you would have run your own cost analysis on each property to arrive at an accurate figure.
Once you have calculated the net rental return for a particular property, you can compare it to the possible net rental returns of other investment properties to help you decide which offers the best positive net cash flow opportunity.
4. Capitalization rate
Capitalization Rate = Annual Net Operating Income / Cost (or Value) of Property
If a property is purchased for $ 100,000 and it produces $ 10,000 in positive net operating income (the amount of income after fixed costs and variable costs have been deducted), then the capitalization rate for that particular property is:
- $ 10,000 / $ 100,000 = 0.10 = 10%
It is more accurate to use the current value of the property (rather than the initial cost) to determine the capitalization rate. This is because as the value of an asset increases, we should see a corresponding increase in the income it produces in order to maintain a decent capitalization rate. A decent capitalization rate is 10% or more.
Indirectly, a capitalization rate will tell you how quickly an investment will pay off. A capitalization rate of 10% tells you that it will take 10 years for that asset to be fully capitalized, that is, paid off.
Your money is essentially a “capital asset.” As an investor, you should expect a personal rate of return for the use of your money. The Cap Rate gives you this indication. If an apartment can be purchased for $ 100,000 and you, as an investor, expect to earn at least 8% of your real estate investments, then by multiplying the purchase price of $ 100,000 by 8%, you know that this particular property should generate $ 8,000 or more per year, after operating expenses, to make it a viable investment.
Real estate professionals often use Cap Rate to value a property. So, for example, if you knew that a property listed for sale produces a net operating income of $ 10,000 and, as a professional investor, you worked with a projected capitalization rate of 8%, then the value of the asset (or the price that you would consider pay for that property) is $ 125,000 (that is, $ 10,000 /.08).
In summary:
Just knowing these 4 numbers will put you ahead of most novice investors and could save you a fortune by eliminating any potential investment in negative cash flow properties that will only serve to erode your wealth. I wish I had known these 4 numbers earlier in my real estate investment endeavors! It could have saved me a great deal of money! Real estate investment has a relatively high risk. Your job as an investor is to manage and minimize risk. By running your numbers first, you eliminate risk number one and the cause of most real estate investment failures – negative cash flow. Review your real estate investment calculations before you rush out and buy any “investment” property. It could save you a fortune or earn you a fortune!