949-392-1999
SHOW NOTES FOR EPISODE 042 – ANALYZING RENTAL PROPERTIES – PART 3
In this episode, Bill completes the three-part series on analyzing rental properties. In part three, we plug the data you’ve collected on a property into the equations to generate the ratios that determine if an investment is a good or bad investment. We also include a link to a spreadsheet that shows what a final a Financial Analysis Summary looks like.
Now, in Part 2, I talked about collecting the information you’ll need. You played the detective or CSI guy or gal and you’ve done everything you can to get the best detailed data. You’ve dove deep and collected the “real numbers” on the property. Now, here is where you’re going to “do the math” and plug in the numbers you’ve collected into your model
I am going to use references from An Introduction to Real Estate Deal Analysis by J. Scott to help drive part 3 home for you.
Now with all the info you’ve compiled, you have enough to determine if this property meets the financial bar you have set. This is where the key “ratios” come in
The Ratios
You are going to plug the info you’ve collected in Part 2 into simple formulas to help you determine key ratios. These key ratios will help you to determine how good the deal is.
Let’s start with…
NOI – Net Operating Income
The total income a property generates (after all expenses), not including debt service costs (loan costs and monthly mortgage payment). In mathematical terms, it’s the total income minus the total expenses of the property.
NOI=Income – expenses
You calculate the monthly numbers then multiply by 12 for annual numbers. You can average expenses but make sure you get detailed info to make your best analysis. In winter, for example, outside of most sunbelt states, expenses can change pretty significantly. Heating costs, snow clearing, etc. will affect your averages. So try to be accurate as you cam.
Once you’ve come up with your NOI, you can now calculate…
Cash Flow
Cash Flow = NOI – Debt Service (your mortgage payments, personal loan payments)
If you pay cash for a property the NOI is your Cash Flow
Next, we look at your “rates of return.”
Rates of Return
Cash Flow is important – as we say in every episode – “cash flow is king” — but it isn’t the only important number. Rate of Return (or ROI – return on Investment) measures the amount of cash flow you receive relative to the amount of money you invested. In other words, this is the part where you can really see if it’s a “good investment.”
ROI or return on investment
ROI= Cash Flow / Investment Basics (or the money you actually put into the deal)
Obviously ROI is going to be higher when one or both of the following are true: Cash flow is higher or Investment Basis is lower. If you don’t get that, just hang on…
You can see from the equation, but it should be obvious when you think about it: if you can make a lot of money from putting in a small amount of money, then things are good! And with real estate investing, leverage and stretching your actual cash is key!
What is a reasonable ROI? Well, look at other investments: how much do you earn on a typical savings account (right now it’s less than 1%), in the stock market (if you’re managing well – 8-10%), and so forth…
For example, let’s look at $100. Let’s say, hypothetically, that you put that $100 in a Money Market fund and that Money Market fund earns you $5 for the year – your ROI is 5%.
However, with Real Estate Investing, there are three ROI numbers or ratios you need to know: CAP Rate, Cash-on-Cash and Total ROI.
First, let’s look at Cap Rate
Cap Rate
This value is known as the “Capitalization Rate” or CAP Rate and I actually spent a whole Fun Facts Friday on this topic and key ratio. Look it up! It’s episode #024.
Just like we have a key income value (we call that NOI or Net Operating Income) that is completely independent of the details of financing, we also have a key ROI value that is independent of the buyer and the details of the financing.
It’s that important. In fact if there is a single number that is most important in doing the financial analysis of a property, the Cap Rate may be it. Because the Cap Rate is independent of the buyer and the financing – it is the most pure indication of the actual return a property will generate.
The equation to calculate CAP Rate is..
Cap Rate= NOI/Property Price
Another way to look at Cap Rate is that it is the ROI, (your return on investment or annual percentage return that you would earn if you paid all cash for the property). This is because Cap Rate assumes that the investment amount is the maximum (the full price of the property).
So what is a good Cap Rate? It really depends on the area of the country you’re in, but, in general, most areas of the country see maximum Cap Rates at 8-12%. Not in California, where I’m from) but on average. And just like SFRs are based on comps from similar properties, the value of larger investment properties is usually based on the Cap Rate of comparable investment properties in the area. So, for example, if the average Cap Rate for your area is 10%, you should at least get 10% for your property.
Next, is our second key Rate of Return rations, cash-on-cash return.
Cash-on-Cash Return
income) and Cash Flow (financing dependent income) – there are also multiple measures of return. As we’ve discussed, the financing independent rate of return (the theoretical return on a fully paid property) is the Cap Rate, and, of course, there is the real (not theoretical) rate of return, as well. This is called – Cash-on-Cash return, because it is the exact cash you will get back relative to the actual cash you put into the deal.
For example, we discussed that if you took $100 and put it in a Money Market account, you’d earn $5 or a ROI of 5%. The Cash-on-Cash is the equivalent measure of how much return you will make if you put $100 into the property.
COC = Cash Flow/ The ”out of pocket” money you put into the deal.
For example, if your annual cash flow is $15,000 and you put $100,000 cash into the deal (to cover your down payment, improvements and closing costs) the COC return is $10,000 divided by $100, 000, or 15%.
Comparing this to the Money Market account investment, you can see you get a better rate-of-return on the real estate example.
It’s up to you on what your minimum rate-of-return will be but as you can see, getting less than 10% is probably not worth your time.
But, before you run off and make any final decisions based on Cash-on-Cash returns, consider that the Cash Flow you make on a property isn’t the only that that affects your bottom line… Finally, let’s look at Total ROI
Total ROI
In addition to Cash Flow, there are several other key financial considerations that affect a property’s performance. Specifically:
Tax Consequences – You will receive direct tax benefits, for example, depreciation, operating expense deductions and mortgage interest, that additionally affect your bottom line.
Property Appreciation – You may not be able to accurately predict this, but as the property increases in value and you eventually sell, that will definitely affect your bottom line.
And finally,
Equity Accrued – Remember, your tenants are paying off your property for you and each month, with each mortgage payment, your equity increases.
Next, the difference between COC and your Total ROI is that COC only considers the financial impact of Cash Flow. Total ROI considers all the factors that affect the bottom line. Your Total ROI is calculated as follows
TOTAL ROI = Total Return / by your total “out-of-pocket” investment
Where “Total Return” is made up of Cash Flow, Equity Accural, Appreciation, Tax Benefits)
Let’s use the following for our Total Return calculation:
Let’s assume we expect a 2% appreciation on the value of the property this year, based on the improvements that we would do upon purchase.
Next, we would calculate the equity accrued in the first year of the mortgage.
So, given the following assumptions
- A property priced at: $400,000
- Out-of-Pocket Cash: $98,000
- Cash Flow: $11,621
- 2% Annual Appreciation: $8,360
- Equity accrued in the first year mortgage: $3,251
Let’s also assume that, for the sake of this example, that there are no tax breaks (or extra taxes due) by owning this property.
The Total Return of the property for the first year would be:
Total Return = Cash Flow of $11,621 + Appreciation of $8,360 + Equity Accrued of $3,251 + $0 = $23,232.
Take that amount and divide that by your “out-of-pocket” cash of $98,000. So,
Total Return of $23,232/$98,000 cash “out-of-pocket”
= 23.71%
Not bad, eh?
Now to help make this clearer, I have attached a copy of a spreadsheet that J. Scott uses to show how this all fits together.
Financial Analysis Summary
We now have all the data to assess the value of this property, but keep in mind, our assessment is only for the first year of ownership. In subsequent years, accrued annual equity will increase, expenses may rise (with inflation), rental rates may increase or decrease, depending on the market, your tax situation may change, and a host of other factors may contribute to the return on your investment either increasing or decreasing.
While we can’t predict the future, you should extend your analysis out a couple years, using trend data or demographics data that indicates the direction of the market, inflation, etc.
You can set up your own analysis spread sheet from the example given.
It is very important that you get your numbers right. If you do, you are on your way to Real Estate Investing Success!
Key Links:
- Analyzing Rental Properties – Part 1
- Analyzing Rental Properties – Part 2
- Cap Rate episode – What is Cap Rate and Why is it Important?
- Financial Analysis Summary Spreadsheet Image: http://olddawgsreinetwork.com/analysis/
So, until next time, remember CASH FLOW IS KING AND REAL ESTATE INVESTING THE MEANS. Thanks again for listening and God bless!
IF YOU LIKED THIS PODCAST, we would love if you would go to iTunes, Stitcher, GooglePlay, iHeartRADIO and Subscribe, Rate & Review our podcast. This will greatly help in sharing this podcast with others seeking to learn real estate investing as a means to achieve a successful retirement.
Check out our other podcasts at olddawgsreinetwork.com/blog.
Get a FREE copy of our 3-Minute Rental Property Analyzer at olddawgsreinetwork.com.
Episode Sponsor: Meno Studio – menostudio777@gmail.com
