Saturday, April 5, 2014

Real Estate Investing Metrics You Should Know

This post is also an addendum to “Negotiating is Not an Art form or Hidden Talent,” blog post, Thursday, March 20, 2014.

Why was I attempting to lower the asking price on an investment (rental) property in my negotiation with Meridian Pacific Properties?  

Simple, by reducing the asking price, in effect, I’m improving my cost basis, the amount of money I personally put into this investment.  You can also say that I was attempting to improve my Return On Investment (ROI).

What is ROI?  Simply put, ROI is,

Cash Flow (net income – loan payment) / Investment Basis

This will give you a ratio.  Multiply times 100 to get ROI as a percent.

There are only two parts to this equation as you can see.  Your goal as a real estate investor is to either improve your cash flow (better numerator) or lower your investment basis (smaller denominator) to improve your ROI percentage.

A lower sales price would mean I’d put less as a down payment.  I’ve recently signed the sales contract for the property in question.  On a later post, I’ll detail the deal.  I also plan on reviewing Meridian Pacific Properties for other investors.  My negotiation did Not lead to a lower sales price.  However, I got something just as good, if not better: they have agreed to tenant the property for more than what was listed on the property’s sale brochure!  In other words, I improved my cash flow situation.  

You need to be conservative as a landlord when it comes to raising rents.  Keep in line with the rental market where the property is located.  This will ensure that your property is tenanted long-term.  You may be wondering, isn’t tenanting the property your responsibility?  Not with Meridian.  Again, I’ll explain all of this on a later post.  For now, let’s see what other metrics are useful when analyzing a real estate deal.   

What’s an even better metric than ROI?  Enter Capitalization Rate.   

Cap rate = NOI (Net operating income: subtract all expenses this property will have except the loan payment) / Property Price.  

The cap rate % is a hypothetical measure of what you’d get for your money IF you were to pay it outright, i.e., say: “screw financing!”  Will I ever pay for a rental
property outright?  Ha!  Over my dead body.  Why would I when I can employ leverage.

Why is the loan payment amount left out of the Net Operating Income calculation?  Why does it factor all of my expenses: taxes, property management fees, insurance, etc., but not what I have to pay monthly on the loan?  NOI is independent of debt service because this is a wild card.  A seller isn’t going to worry about your financing situation, and we can’t expect them to.  They will tell you, “this is what you can expect to have in net operating income, sir/madam,” and expect you to understand that they’re not factoring in what you’ll be paying on the loan.  Of course you’ll have to verify the numbers they give you for net income too!

Another way of improving your cash flow on a property is with more favorable financing.  Your job will be to get the best possible interest rate on your bank loan.  By the way, decent cap rates are anywhere from 8-12% range.

I love to calculate my Cash On Cash return for an investment property.  This is what investing is all about in my mind: putting as little down for a sweet return.  COC is directly related to what you put in at the start.

COC is, Cash Flow (yearly)/ Investment Basis.

Say you get a Real Estate deal that will generate $200 cash-flow/month.  You had to put 20% down + Closing Costs at the start.  The property price was $100K and it took $2K to close.  Your investment basis is $22K.  Take $200 cash flow x 12 months a year and you have, $2400.  $2400 / $22,000 is therefore your COC return.  In this case it would be 10.9%.  I like to compare my potential COC return with what I could potentially get in the stock market (8-10%).  

If my COC for a RE deal is less then 8%, I begin to doubt the investment.  (It could be worth it for you, especially if you don’t invest in equities).  You could certainly earn 8% in stocks, without doing as much work; however, you cannot view the return on your money from a RE deal with the same lens you’d use to view the return from investing in equities.  Why?

Real Estate has other advantages:

One, there is the factor of appreciation.  The property, if procured during a low in the market, stands a good chance of appreciating over time.  Your “out” will be better.  (You want to make your money when you buy, not when you sell) You cannot guarantee a property will appreciate, however.  

Two, with a rental property, you are building equity.  Your tenants pay down your mortgage.  Again, this helps on the sell side.  Finally, there are taxes.  If you’ve come to enjoy passive income from your rentals, you’ll enjoy it even more as you build your real estate portfolio, replacing salary (income from your job that is taxed at a higher rate) with income from your assets.  The tax consideration is huge!  As I state in my e-book: 

Common Core Money: Financial Literacy for
Educators and Other Professionals, taxes destroy wealth if not handled properly.  Real Estate is a great way of lowering your effective (vs. your marginal) tax rate.

In sum, 8% COC return may not be so bad in comparison to the return you could get with equities.  The stock price of one of your stocks could increase (appreciate) and if you hold it over a year, the gains when you sell will not be taxed as ordinary income.  But you can’t offset income from this investment with things like depreciation, property management fees, repairs, etc.  These are all real estate perks.  The only way to build equity with a stock is to buy more of it!

By the way, including equity, appreciation, and taxes, to the equation of ROI, creates what is known as Total ROI = Total Return / Investment Basis.

Review: Metrics for Analyzing a RE deal are: ROI, Cap Rate, and COC return.  Calculating these will require you to estimate your net income and cash flow as close to the actual as possible.  Good luck, my friends!

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