||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
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
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
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
NOI Ė Mortgage payment = Projected annual cash return
Down Payment + Closing costs + Deferred Maintenance Expense = Cash
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.
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.
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.
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.