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Real Estate Investing – 4 Magic Numbers to Make You Rich and Wealthy!
When it comes to real estate investing, especially residential real estate, the likelihood of falling in love with a real estate asset is stronger than for other less tangible asset classes (bonds, stocks, pensions, etc.).
Many people fall in love with toxic properties that look good to the eye or feel good to the ego. But these kinds of self-indulgent asset purchases and self-drives can quickly turn into massive liabilities, eroding balance sheets and destroying income statements. Because? Because investing is an intellectual sport and your emotions must be put aside. You have to run your numbers first. When it comes to property investing, sometimes the ugly is beautiful. Ironically, sometimes the ugliest property has the best numbers.
Cash flow is always king in any business or property portfolio; much more important than capital appreciation if you ask me. Capital appreciation can increase your net worth, but cash flow will put cash in your bank account and keep you liquid! If I had to choose between positive net cash flow and guaranteed capital appreciation, I would have chosen cash flow all the way.
The challenge of real estate investing is to minimize your down payment (which will maximize your mortgage) while generating positive net cash flow each month.
Knowing the following 4 numbers will help you and should really be estimated to your knowledge before making any real estate investment.
1. Net rental income
I like to buy property assuming that natural capital appreciation will never occur (although of course it will). Generally, property value will double every 7 to 10 years. Note: This is a trend and not a one-way bet! Either way, we don’t want to wait for that natural appreciation to happen before we start building wealth. Therefore, we ideally want each real estate 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. Lots of estate agents will quote gross yield figures that is, the annual rent as a percentage of the price of the property. While this is a reasonable indicator of your potential ROI, it won’t actually tell you how much money you’ll make (or possibly lose!). So I prefer to focus on net returns and ultimately net income, which is how many net dollars a property will put in my back pocket each month.
Net rental income = Gross rental income – (operating costs + debt service)
In addition to debt service costs (i.e. the mortgage), the following are typical operating costs that you will need to deduct from your gross rental figure to get a net income figure: Management Fees, Property Taxes the City Council/City Council/State, Repairs/Maintenance. Costs, property taxes/land rents, insurance costs, voids (vacancy periods), utilities, etc.
As a general guideline, you should aim to achieve a gross rental of at least 150% of the property’s mortgage repayments to cover all operating costs and leave you with a net rental income.
Interest rates and market forces will affect your cash flow and net rental income figures. So test your cash flow forecast for a 1% or 2% increase in interest rates or a 20% or 30% reduction in rental income and see how that affects the net rental income figures.
The reason I like the net rental income test is that, in addition to the other numbers we’ll look at below, this income number will tell you how much cash a particular property will put in your back pocket every month (we’re leaving out taxed income for now). So a good question to ask yourself before even calculating your net rental income figure is, “How much net income would I need to get from this property to make it worthwhile?”
2. Cash back for cash
Many wealthy investors use cash return analysis as a sort of back test to establish whether a real estate investment is worth looking into.
Cash on Cash Return = Annual Cash Flow (before taxes)/Total Cash Invested
So, for example, you might buy a property for $100,000 and use $30,000 of your own cash as a down payment. Assuming the net cash flow (after all expenses) from renting the property was $700 per month, the cash-on-cash return on this investment would be $8,400/€30,000 =.28 (28% ).
I like to see more than 20% (and ideally closer to 30%) return on cash before I consider investing.
3. Net rental yield
Many estate agents quote gross yield rather than net yield. However, net return is the number you need to work with, especially if you’re investing in new geographic territories; you need to do your due diligence and calculate the running costs associated with that particular property.
Gross rental yield = annual rent/cost of ownership
So, using the same numbers as the example above, Gross Return = $950 x 12/€100,000 = 0.114, which is 11.4%
Net rental income = Annual rent – Operating costs/Cost of ownership
So, using the same numbers as in the previous example, Net Rental Return = $700 x 12/€100,000 =.084, or 8.4%
So when a realtor quotes you X% return on a particular property, ask them if it’s gross or clean. If you get blank stares, make sure you do your own research on property running costs. As a guideline, you can estimate 30% of rental income for operating costs, but again you would need to perform your own cost analysis on each property to arrive at an accurate figure.
After you’ve worked out the net rental yield for a particular property, you can compare it to the potential net rental yields of other investment properties to help you decide which one offers the best cash flow opportunity net positive
4. Capitalization rate
Capitalization rate = Net annual operating income/cost (or value) of the property
If a property is purchased for $100,000 and produces positive net operating income of $10,000 (the amount of income after deducting fixed costs and variable costs), the maximum rate for 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) to determine the maximum 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 top rate is 10% or more.
Indirectly, a cap rate will tell you how quickly an investment will pay off. A top rate of 10% tells you that it will take 10 years for that asset to fully capitalize, meaning pay off.
Your money is essentially a “capital asset”. As an investor, you should expect a personal rate of return on the use of your money. The maximum rate gives you this indication. If an apartment can be purchased for $100,000, and as an investor you expect to make at least 8% on your real estate investments, by multiplying the purchase price of $100,000 by 8%, you know that this particular property must generate $8,000 or more, annually, after operating expenses, to make it a viable investment.
Real estate professionals typically use the cap rate to value a property. So, for example, if you knew that a property advertised for sale generates a net operating income of $10,000 and, as a professional investor, you worked with a projected maximum rate of 8%, then the value of the asset (or the price you should consider paying). this property) is $125,000 (ie $10,000 /.08).
To sum up:
Just knowing these 4 numbers will put you way ahead of most newbie investors and could save you a fortune by eliminating any potential investments in negative cash flow properties that will only serve to erode your wealth. I only wish I had known these 4 numbers earlier in my real estate investing endeavors! Could have saved me a lot of money! Real estate investment is relatively high risk. Your job as an investor is to manage and minimize risk. By running your numbers first, you eliminate the #1 risk and cause of most real estate investment failures: negative cash flow. Review your real estate investing math before you rush out and buy any “investment” property. It could save you a fortune or make you a fortune!
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