When it comes to real estate investing, especially residential, the likelihood of you falling in love with real estate is higher than with other less tangible asset classes (bonds, stocks, pensions, etc.).
Many people fall in love with toxic properties that are good for the eye or good for the ego. But these kinds of self-indulgent, self-serving asset purchases can quickly turn into massive liabilities, eroding balance sheets and destroying income statements. For what? Because investing is an intellectual sport and your emotions should be left aside. You have to run your numbers first and foremost. When it comes to investing in real estate, sometimes ugly is beautiful. Ironically, sometimes the ugliest property has the best numbers.
Cash flow is still king in any business or real estate portfolio; far more important than capital appreciation if you ask me. Capital appreciation may increase your net worth, but cash flow will put money in your bank account and keep you 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 with real estate investing is to minimize the down payment (which will maximize your mortgage) while generating positive net cash flow each month.
Knowing the following 4 numbers will be very useful to you and should really be estimated to the best of your knowledge before making any real estate investment.
1. Net rental income
I like to buy property assuming that no natural capital appreciation will ever occur (although of course it will). Property will typically double in value every 7-10 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 happen before we start building wealth. Therefore, we ideally want every real estate investment to generate positive net cash flow, i.e. a source of passive income.
So when investing in real estate, the first key number you need to focus on is net rental income. A lot estate agents will quote gross return figures i.e. the annual rent as a percentage of the price of the property. While this is a reasonable indicator of your potential return on investment, it won’t really tell you how much money you’ll make (or potentially lose!). So, I prefer to focus on net returns and ultimately net income, which is how many net dollars a property will put in my back pocket each month.
Net Rental Income = Gross Rental Income – (Operations + Debt Service Charges)
In addition to debt servicing costs (i.e. mortgage), here are typical operating costs that you will need to deduct from your gross rental figure to arrive at a net income figure: management costs, municipal/council/state taxes, repairs/maintenance costs, property taxes/ground rent, insurance costs, cancellations (vacancy periods), utilities, etc.
As a general rule, you should aim to achieve a gross rent of at least 150% of the property’s mortgage repayments to cover all operating costs and leave you with net rental income.
Interest rates and market forces will impact your cash flow and net rental income. So, test your cash flow forecast for a 1% or 2% rise in interest rates or a 20 or 30% reduction in rental income and see how that affects the net rental income figures.
The reason I like the net rental income test is that aside from the other numbers we’ll look at below, this income figure will actually tell you how much money a particular property will put in your back pocket each month (we’re leaving income tax aside for now). So a good question to ask yourself before even calculating the net rental income figure is: “How much net income should I get from this property to make it worth it”?
2. Cash back
Many wealthy investors use cash-on-cash yield analysis as a sort of back-of-the-napkin test to determine if a real estate investment merits further analysis.
Cash-on-cash return = annual cash flow (pre-tax)/total cash invested
So, for example, you could buy a property for $100,000 and use $30,000 of your own money as a down payment. Assuming the net cash flow (after all expenses) from renting the property was $700 per month, the cash return on this investment would be $8,400/€30,000 = 0.28 (28%)
I like to see >20% (and ideally closer to 30%) Cash-on-Cash Return before I consider investing.
3. Net rental yield
Many real estate agents will quote gross yield rather than net yield. However, net return is the number you need to calculate, 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 property
So, using the same numbers as in the example above, gross return = $950 x 12/€100,000 = 0.114 or 11.4%
Net Rental Yield = Annual Rent – Operating Costs / Cost of Ownership
So, using the same numbers as in the example above, Net Rental Yield = $700 x 12/€100,000 = 0.084 or 8.4%
So, when a real estate agent offers you a return of X% for a particular property, ask him if it is a gross or net return. If they’re staring at you, be sure to do your own research on the running costs of the property. As a rough guide, 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 calculating the net rental yield of 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 positive net cash flow.
4. Capitalization rate
Capitalization rate = annual net operating income / cost (or value) of the property
If a property is purchased for $100,000 and it produces $10,000 of positive net operating income (the amount of income after deducting fixed costs and variable costs), then the cap 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 original cost) to determine the cap rate. Indeed, as the value of an asset increases, we should see a corresponding increase in the income it produces in order to maintain a decent cap rate. A decent cap rate is 10% or more.
Indirectly, a cap 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 this 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 from the use of your money. The Cape 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% on your real estate investments, then by multiplying the purchase price of $100,000 by 8%, you know that this particular property must generate $8,000 or more, per year, after operating expenses, for it to be a viable investment.
The Cap Rate is often used by real estate professionals 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 worked on a projected capitalization rate of 8%, then the asset value (or the price you expect to pay for this property) is $125,000 (i.e. $10,000 / 0.08).
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 only wish I had known those 4 numbers earlier in my real estate investing endeavors! It could have saved me a lot of money! Investing in real estate is relatively risky. 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. Review your real estate investment calculations before you rush out and buy an “investment” property. It could save you a fortune or make you a fortune!