When
it comes to real estate investment, particularly residential real
estate, the likelihood of you falling in love with a real estate asset
is stronger than it is for other less tangible asset classes (bonds,
stocks, pensions etc).
Many
people fall in love with toxic properties that look good on the eye or
feel good to the ego. But these kind of self indulgent, ego-trip 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 have to be left on the side lines.
You’ve got to run your numbers first and foremost. When it comes to
property investing, sometimes ugly is beautiful. Ironically, sometimes
the ugliest looking property runs the best numbers.
Cash flow is
always king in any business or property portfolio; far 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 you liquid! If I had to choose between net positive cash flow
and guaranteed capital appreciation I’d chose cash flow all the way.
The
challenge in property investment is to minimise the down payment (which
will maximise your mortgage) whilst at the same time generating net
positive cash flow each month.
Knowing the following 4 numbers
will stand you in good stead and really must be estimated to the best of
your knowledge prior to making any real estate investment.
I
like to buy property assuming no natural capital appreciation will ever
occur (even though of course it will). Property will generally double
in value every 7 to 10 years. Note: This is a trend and not a one-way
bet! Either which way, we don’t want to wait around for that natural
appreciation to occur before we begin building wealth. Therefore,
ideally we want each property investment to generate net positive
cash-flow i.e. a source of passive income.
So, when investing in property the first key figure to focus on is net rental income. Many real estate agents will quote gross yield figures
i.e. the annual rent as a percentage of the property price. Whilst this
is a reasonable indicator of your potential return on investment it
won’t actually tell you how much money you’re gonna make (or potentially
lose!). So, I prefer to focus on net yields and ultimately net income
i.e. how much net dollars a property will put in my back pocket each
month.
Net Rental Income = Gross Rental Income – (Operating + Debt Servicing Costs)
In
addition to debt servicing (i.e. mortgage) costs, the following are the
typical operating costs which you will need to deduct from your gross
rental figure to arrive at a net income figure: Management Fees,
City/Council/State Taxes, Repairs/Maintenance Costs, Property
Taxes/Ground Rents, Insurance Costs, Voids (Vacancy Periods), Utilities,
Etc.
As a general guideline, you should be aiming to achieve a gross rent of at least 150% of the property’s mortgage repayments to cover all operational costs and leave some net rental income for yourself.
Interest rates and market forces will impact your cash flow and net rental income figures. So, stress 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 this impacts net rental
income figures.
The reason I like the net rental income test is
that apart from the other numbers we will look at below, this income
number will actually tell you how much cash a particular property will
put into your back pocket each month (we’re leaving aside income tax for
the moment). So, a good question to ask yourself even before you work
out the net rental income figure is: “How much net income would I need to get from this property in order to make it worth my while“?
Many rich investors use the cash-on-cash return analysis as a kind of back of a napkin test to establish if a property investment is worth further analysis.
Cash-On-Cash Return = Annual Cash-flow (Before Tax)/Total Cash Invested
So,
for example, you could purchase a property for $100,000 and use $30,000
of your own cash as a down payment. Assuming the net cash-flow (after
all expense) from renting the property was $700 monthly, than the
Cash-On-Cash return for that investment would be $8,400/E30,000 = .28
(28%)
I like to see > 20 % (and ideally closer to 30%) Cash-on-Cash Return before I’ll consider investing.
Many real estate agents will quote gross yield rather than net yield. However, net yield
is the figure you need to work off particularly if you’re investing in
new geographic territories; you need to do your due diligence and work
out the running costs associated with that particular piece of property.
Gross Rental Yield = Annual Rent/Property Cost
So, using the same numbers as the above example, Gross Yield = $950 x 12/E100,000 = .114 i.e. 11.4%
Net Rental Yield = Annual Rent – Operating Costs / Property Cost
So, using the same numbers as in the above example, Net Rental Yield = $700 x 12/E100,000 = .084 i.e. 8.4%
So when a real estate agent quotes you a yield of X% for a particular property, ask him/her whether that’s gross or net.
If they stare at you blankly than make sure you do your own research on
the costs of running the property. As a guideline, you can estimate 30%
of the rental income for operating costs but again you’d have run your
own costing analysis on each property to arrive at an accurate figure.
Having
worked out the net rental yield for a particular property, you can
compare it against the potential net rental yields from other investment
properties to help you decide which offers the best opportunity for net
positive cash flow.
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 in
positive net operating income (the amount of income after fixed costs
and variable costs have been deducted), then the Cap Rate of that
particular property is:
It
is more accurate to use the current value of the property (rather than
the initial cost) in determining the cap 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 cap rate. A decent
cap rate is 10% or more.
Indirectly, a cap rate will tell you how
fast an investment will pay for itself. A cap rate of 10% tells you
that it will take 10 years for that asset to be fully capitalized i.e.
paid for.
Your money is essentially a “capital asset”. As an
investor you should be expecting a personal rate of return from 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 make at
least 8% on your real estate investments, then by multiplying the
$100,000 purchase price by 8% you know that that particular property
must generate $8000, or more, per annum, after operating expenses, in
order for it to be a viable investment.
Cap Rate is often used by
real estate professionals for valuing 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 off a
projected Cap Rate of 8%, then the asset value (or price you would
consider paying for that property) is $125,000 (i.e. $10,000 / .08).
In summary:
Just
knowing these 4 numbers will put you streets 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 these 4 numbers earlier on in
my property investing endeavours! It could have saved me an awful lot
of money! Property investing is relatively high-risk. Your job as an
investor is to manage and minimise risk. By running your numbers first
you eliminate the no.1 risk and cause of most property investing
failures: negative cash flow. Brush up on your real estate investment
math before you rush out and buy any piece of “investment” property. It
could save you a fortune or make you a fortune!