When it comes to real estate investing, particularly residential real estate, you are more likely to fall in love with a real estate asset than other, less tangible asset classes (bonds, stocks, pensions, etc.).
Many people fall for toxic properties that look good to the eye or feel good to the ego. But these kinds of self-indulgent and self-serving 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 aside. You have to run your numbers first. When it comes to investing in property, sometimes the ugly is beautiful. Ironically, sometimes the ugliest looking property has the best numbers.
Cash flow is always king in any business or property portfolio; much more important than capital appreciation if you ask me. Capital appreciation may increase your net worth, but cash flow will put cash in your bank account and keep it liquid! If I had to choose between net positive cash flow and guaranteed capital appreciation, I would choose cash flow all the way.
The challenge in real estate investing is to minimize your down payment (which will maximize your mortgage) while also generating a net positive cash flow each month.
Knowing the following 4 numbers will come in very handy and really should be calculated to the best of your knowledge before making any real estate investment.
1. Net rental income
I like to buy property assuming that natural capital appreciation will never occur (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 net positive 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 return figures that is, the annual rent as a percentage of the price of the property. While this is a reasonable indicator of your potential ROI, it won’t actually tell you how much money you’ll make (or potentially lose!). So I prefer to focus on net returns and ultimately net income, ie how much net money a property will put in my pocket each month.
Net Rental Income = Gross Rental Income – (Operating + Debt Service Costs)
In addition to debt service (i.e., mortgage) costs, the following are typical operating costs that you will need to deduct from your gross rental figure to arrive at a net income figure: management fees, council/consular taxes /State, Repairs/Maintenance Costs, Property Taxes/Land Rentals, Insurance Costs, Vacs (Vacancy Periods), Utilities, etc.
As a general guideline, you should aim for a gross rent of at least 150% of the property’s mortgage payments 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 1-2% increase in interest rates or a 20-30% drop in rental income and see how that 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’ll leave tax income aside for now.) 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 to make it worth your while?”
2. Cash back against cash
Many wealthy investors use cash-on-cash performance analysis as a kind of napkin test to establish whether a real estate investment is worth further scrutiny.
Cash-on-Cash Yield = Annual Cash Flow (before taxes)/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 renting the property to be $700 per month, the cash-on-cash return on that investment would be $8,400/€30,000 = 0.28 (28% ).
I like to see > 20% (and ideally closer to 30%) cash return 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 you should work with, especially if you’re 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 i.e. 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, i.e. 8.4%
So when a real estate agent quotes you a return of X% for a particular property, ask if it’s gross or net. If they stare at you, be sure to do your own research on the costs of managing the property. As a guideline, you can estimate 30% of rental income for operating costs, but again, you would have done your own cost analysis on each property to arrive at an accurate figure.
After you’ve calculated the net rental yield for a particular property, you can compare it to the potential net rental yields of other investment properties to help you decide which offers the best opportunity for net positive cash flow.
4. Capitalization rate
Capitalization Rate = Annual Net Operating Income / Cost (or Value) of Property
If a property is purchased for $100,000 and produces $10,000 in positive net operating income (the amount of income after deducting fixed costs and variable costs), 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 cap rate is 10% or higher.
Indirectly, a capitalization rate will tell you how quickly an investment will pay for itself. 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 on the use of your money. The capitalization 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 investment, then by multiplying the purchase price of $100,000 by 8%, you know that this particular property should generate $8000 or more. per year, after operating expenses, to make it a viable investment.
Real estate professionals often use the capitalization rate to value a property. So, for example, if you knew that a property advertised for sale produces a net operating income of $10,000 and, as a professional investor, you calculated a projected capitalization rate of 8%, then the value of the asset (or the price you would consider paying for that property) is $125,000 (that is, $10,000 /.08).
Simply knowing these 4 numbers will put you ahead of most novice investors and could save you a fortune by eliminating any potential cash flow negative property investments that will only serve to erode your wealth. I wish I had known these 4 numbers earlier in my real estate investing endeavors! It could have saved me a huge amount of money! Real estate investing is relatively high risk. Your job as an investor is to manage and minimize risk. By running your numbers first, you eliminate the #1 risk and cause of most real estate investment failures: negative cash flow. Brush up on your real estate investing math before you rush out and buy any “investment” property. It could save you a fortune or make you a fortune!