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Real Estate Math
or
Why We Did (or Didn't) Buy Your Property
 

  If we didn't decide to buy your property, it may have been simply because our money was tied up in other investments. But sometimes it's just a cold, hard business decision.  We try to explain these decisions to you, but if we failed to satisfy you, the answer is probably contained in the following article.  If we made an offer that you refused, this also explains why we made the offer we did.  It's all about return on investment...

 

Real Estate Investor Math - Cap Rate and Return on Investment

Every real estate investor should know some basic math. There are calculations that are indispensable to the business. I have seen plenty of fast and loose interpretations of these formulas. Remember when you are buying a property the seller is going to try to get creative to minimize expenses while you the buyer must use proper formulas to determine the purchase price for the property.

Capitalization Rate (Cap Rate)

This is probably the most common metric used by investors. Sellers will drastically understate expenses. Ask for copies of original bills. If they refuse just move on and find a more honest seller.

    Gross Operating Income Ė Expenses = Net Operating Income (NOI)
    Net Operating Income/Purchase Price = Cap rate

Lets talk about expenses. This includes bills such as natural gas, electricity, water and property taxes. This calculation also includes a percentage for maintenance, property management and vacancy allowance. Those expenses are what sellers leave out. This is your safety margin and believe me you will need it at some point.

When deciding what to offer for a property youíll want to look at deferred maintenance both in the apartments and throughout the building. This is the list of stuff the previous owner should have done but did not.

Youíll also want to know more about the building. Was it a drug den? How do people like living there? Were there three murders in the building two months ago? What is turnover like? Have the tenants been there a long time? How is the street? What is the reputation of the building? For this youíll have to go back to the area without your real estate agent and knock on some doors.

Cap Rate Reversed

Youíll want to calculate the Cap Rate equation in reverse. This way you can decide how much you want to pay for the building.

    NOI/Cap Rate = Purchase Price

Lets assume you want to achieve a Cap Rate of 8%. Youíll want to plug in all your numbers for expenses to figure out the real Net Operating Income then do the calculation to figure out how much your final purchase price should be.

    $40,000 (NOI) / .08 = $500,000 (Purchase Price)

Cash on Cash Return

This calculation is more complex. Once you have figured out your NOI you calculate this important metric. This measures what the Return on Investment (ROI) will be on the cash used. This is how to operate this calculation.

    NOI Ė Mortgage payment = Projected annual cash return
    Down Payment + Closing costs + Deferred Maintenance Expense = Cash Outlay
    Projected Annual Cash Return/Cash Outlay = ROI
    Cash Outlay/Projected Annual Cash Return = How long it will take before you get your money back

Buying income property is NOT a POPULARITY CONTEST.

The only reason to buy an income property is to make money. The only way youíll make money is to buy properly. With income property, itís all about the cash flow. If you buy a property without all the safety margin numbers in place, you will end up putting more of your hard earned cash into the property. Month after month, year after year you can look forward to owning a cash-sucking cow of a property.

You should put in offers on property using your analysis. Feel free to show your math to the seller. Itís very likely you arenít informing them of anything. They want to get as much as possible for their property. Can you blame them? Itís not at all like buying a residential house. These properties are not very liquid and the only thing that matters is the income.

Return on Investment for Improvements

Once you have your property if youíre smart youíll want to figure out how to increase the income. Every time you increase the income by $50 youíll increase the value of your building and improve tenant quality.

How much is a $50 per month increase in rent worth to the investor?

    $50 x 12 months = $600
    $600/.08 (Cap Rate)= $7,500 increased value of building

Youíll want to figure out the payback on the improvement. How long will it take to get that money back? Increased building value is great but you donít get that money unless you refinance or sell the building.

If the improvement is painting the kitchen, putting new handles on it and installing a counter top. This will cost you $800 (assumed).

    $800/$50 = 16 month payback
    $50/$800= 6% ROI
    $7,500 increased value of the building.

Lets try to put the $800 towards a brand new kitchen. The kitchen is 15 years old and beat up. Letís try and get an extra $100 per month rent. Weíll spend $2000 on our kitchen. (assumed)

    $2000/$100 = 20 month payback
    $100/2000 = 5% ROI
    $15,000 increased value of the building.

The new kitchen is a better investment. At the end of the payback period you have replaced something old with something new that you get to keep. Your building value has increased by $15,000.

Final Thoughts

I urge every landlord/investor to use these calculations. Owning an income property is not the golden path to riches proclaimed in endless programs, courses and seminars. Like any other business you must make wise investments with solid measurable results. It is easy to spend money you donít need to on things that donít need to be done or that donít return any money. Donít pay foolish prices for income properties. Money must be respected. The numbers are your friends.

About the Author: Rachelle specializes in renting property on behalf of landlords and is the blogger behind Landlord Rescue, which is on the Million Dollar Journey blog. She also works with investors to find good investments in Toronto and surrounding areas.