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 minimize the down payment (which will maximize 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.
1. Net Rental Income
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”?
2. Cash-on-Cash Return
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 $8,400/30,000 =.28 (28%)
I like to see > 20 % (and ideally closer to 30%) Cash-on-Cash Return before I’ll consider investing.
3. Net Rental Yield
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 12/100,000 =.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 12/100,000 =.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.
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 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:
- $10,000 / $100,000 = 0.10 = 10%
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 this 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).
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 endeavors! 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 minimize 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!