8 Calculations you must learn to do when you invest in real estate

This morning I was thinking about some of the terms and calculations as a real estate investor I needed to learn. You may not use all of these calculations when analyzing a deal, but understanding each of these and when to use them is very important.

They are really not in any particular order, except for the first one.

Net Operating Income (NOI) is the most important calculation to use when it comes to analyzing a multi family apartment building or purchasing a portfolio of single family homes.

Also, Debt Coverage Ration (DCR) is a calculation that banks look at very hard when they are analyzing a multifamily property.

Learn how to make these calculations forwards and backwards.

A. Net Operating Income (NOI)
NOI is a property’s income after being reduced by vacancy and credit loss and all operating expenses. NOI is one of the most important calculations to any real estate investment because it represents the income stream that subsequently determines the property’s market value that is, the price a real estate investor is willing to pay for that income stream.

Gross Operating Income – Operating Expenses = Net Operating Income

B. Gross Scheduled Income (GSI)
GSI is the annual rental income a property would generate if 100% of all space were rented and all rents collected. If vacant units do exist at the time of your real estate analysis then include them at their reasonable market rent.

Rental Income (actual) + Vacant Units (at market rent) = Gross Scheduled Income

C. Gross Operating Income (GOI)
GOI is gross scheduled income less vacancy and credit loss plus income derived from other sources such as coin-operated laundry facilities. Consider GOI as the amount of rental income the real estate investor actually collects to service the rental property.

Gross Scheduled Income – Vacancy and Credit Loss + Other Income = Gross Operating Income

D. Loan to Value (LTV)
LTV measures what percentage of a property’s appraised value or selling price (whichever is less) is attributable to financing. A higher LTV benefits real estate investors with greater leverage, whereas lenders regard a higher LTV as a greater financial risk.

Loan Amount ÷ Lesser of Appraised Value or Selling Price = Loan to Value

E. Debt Coverage Ratio (DCR)
DCR is a ratio that expresses the number of times annual net operating income exceeds debt service (i.e., total loan payment, including both principal and interest).

Net Operating Income ÷ Debt Service = Debt Coverage Ratio

DCR results:

  • Less than 1.0 – not enough NOI to cover the debt
  • Exactly 1.0 – just enough NOI to cover the debt
  • Greater than 1.0 – more than enough NOI to cover the debt

F. Cash on Cash Return (CoC)
CoC is the ratio between a property’s cash flow in a given year and the amount of initial capital investment required to make the acquisition (e.g., mortgage down payment and closing costs). Most investors usually look at cash-on-cash as it relates to cash flow before taxes during the first year of ownership.

Cash Flow Before Taxes ÷ Initial Capital Investment = Cash on Cash Return

G. Cap Rate
This popular return expresses the ratio between a rental property’s value and its net operating income. The cap rate formula commonly serves two useful real estate investing purposes: To calculate a property’s cap rate, or by transposing the formula, to calculate a property’s reasonable estimate of value.

Net Operating Income ÷ Market Value = Cap Rate

Net Operating Income ÷ Cap rate = Market Value

H. Time Value of Money

Time value of money is very important to consider when you invest. What is your money worth today and what will it be worth in the future if you decide to hang on to it. This the calculation you must make when you are thinking about how to spend and invest your money wisely.

Time value of money is the underlying assumption that money, over time, will change value. It’s an important element in real estate investing because it could suggest that the timing of receipts from the investment might be more important than the amount received.

To your success and your future.

Contact me if you are looking to start investing in real estate.

Back of the napkin underwriting, the 50 percent rule.

It goes like this. “Yeah we were having lunch and we were just talking about some ideas and started writing them out on the back of a napkin. And now we have this multi-million dollar company, brand, or product.”

All you need to know is what is the rent roll for a given property. If you can’t get the rent rolls, you can look also look at market rents and do an estimation.

Again, at this point in the process you are just trying to see if this particular property fits the criteria you are investing for. Your criteria and strategy for investing is something we have talked about extensively and you need to determine before looking at any properties.

So if you have the rent rolls, you now know how much income the property will or should generate. Once you know this number. Then you just want to subtract 50% percent of it.

50% is very conservative by most people. But when you add up all of the expenses such as maintenance, utilities, property management, cap-ex, etc. Then the money you have left over must cover your debt on the property and any remaining cash flow, if there is any.

You can do all of this on the back of a napkin. If you determine that this property may be a good fit, then you can take the next steps in the underwriting process and get into the details even more by getting the real data on the income and expenses.

So you would need to see the rent rolls and the T12. The rent rolls are the rents that the building are getting on each of the units. The rent rolls should include the lease date of each unit as well and in most cases the tenants name and information, even though that is irrelevant at this point in the process.

The T12 (trailing twelve): Is the income and expenses a property has had the last twelve months. You could also, get a trailing six as well, which would be the last six months. But you get the point.

Now that you have these two documents you can take the back of the napkin underwriting to actually underwriting to see if this a good deal.

The back of the napkin approach is a way for you to look at more deals and sift through them much quicker.

I hope this was helpful as you are looking at deals. Also, when it comes to single family home investing the metrics are not as simplistic. There rents as many variables and they can vary widely. We will talk more about these later.

To your success and your future.

The criteria I used to create a million dollar portfolio with single family homes

As a new real estate investor a lot of questions may be running through your head. How do I know which property to invest in? What should I be looking at with each of the properties? And the list can go on and on.

To help you get out of your own head and get you on your way in to investing and accumulating wealth. I compiled a short list of things I thought about and still use in many cases, although my strategies have changed some, when I invest in income producing real estate and more specifically single family homes.

As we have discussed many times before. You first need to determine what is going to be your strategy for investing. Meaning, what are you looking for. Click here and you can learn more about each of these things, but I will quickly outline them for you.

Are you investing for cash flow, cash on cash return, appreciation, tax benefits, etc, or a combination of all of it. By knowing specifically what you are investing for it will help you to look at the right properties and stay away from the ones that don’t fit.

Early on in my investing my criteria was pretty simple:

I had a picture of the type of person or persons that would be renting the place. Typically a two parent household, making about the average household income, and either one or two kids. Or a single mother/father with two kids making less than average household income and could afford one of my places.

I wanted my properties to be in line with what it would cost them to rent a b-c class apartment (to learn more about classes click here), but what they really wanted was a house and would be willing to pay a little more than they would in an apartment to get one.

Specific criteria:

  1. The rent collected had to be double the amount of my mortgage.
  2. Back then and even for the most part now, I want the rent to be at least 1% of the value of the home each month. See here for more information on the 1% rule.
  3. The property had to be in an area that I wouldn’t be afraid of knocking on the door and collecting the rent.
  4. I wanted to be able to get my down payment to be paid back with in two-three years. Ex: If I had to pay $10,000 down, then I wanted to get that amount back before the third year was up.
  5. I preferred houses built on a concrete slab.
  6. No basements.
  7. 3 bedrooms and 1 bath was an absolute. These are way easier to rent.
  8. Not located on a very busy highway.

I had a few other less subjective things as well. Things such as nothing weird about the lot of the house or the layout of the house. I wanted it to be simple. You can be amazed how some of these older houses just have weird configurations or even things built in to the home.

I also preferred no very large trees close to the house. Trees can become very costly to manage and especially costly to get torn down.

Would I compromise on any of the criteria? Not really. Now you have to analyze each deal individually, but the purpose of the criteria is to help you not get paralysis from over analysis. You can’t look at everything. So by coming up with a criteria and a strategy it helps you, your realtor if you are using one, and lastly it helps you make decisions quicker.

As you can see by my criteria, I am really looking at cash on cash return. I want the downpayment back pretty quickly and the only way you can get that is with a great cash on cash return. With cash on cash return, I am investing for cash flow, not extreme cash flow, but I want it to carry my mortgage and all expenses with the property and actually have some cash left over to use.

I used this simple strategy and criteria for close to ten years of investing and I still use it when I am looking at single family income producing real estate.

If you are currently an investor, what is your strategy or criteria?

If you are new and haven’t bought your first property yet, what are you thinking?

Please share in comments.

To your success and your future.

Is the 1% rule still applicable in this market?

At 26, when I bought my first income producing rental property I wished I had known a few basic principles to investing in real estate. The only thing I knew was that everyone I had known growing up that owned real estate, which wasn’t anyone in my family, was rich to me.

This was the whole reason for me to like real estate and want to invest in it. Nowadays, knowledge on investing and real estate in general is everywhere, but 17 years ago, this just wasn’t the case.

Years later, I learned something called the 1% rule. The 1% rule in real estate investing means this. You should be able to rent a property that you purchase for at least 1% of the value of that property.

Example: Property purchased for $100,000 x 1% (.01) = $1,000. This property should be able to generate at least $1,000 a month in rent.

It’s pretty simple. If you put 20% down on $100,000 house. Your mortgage will be $80,000. Let’s say you have 5% interest rate on it. Your mortgage payment is roughly $450. Add in taxes and insurance, which might be another $150 a month. You are now at a payment of $600 or so.

Again, there are a lot of variables here. But you get the point.

I wish I would have known this when I bough my first property I mentioned earlier.

I am sure the critics out there are now saying is the 1% even feasible anymore in today’s market?

I say yes. With some caveats. Years ago I could buy properties in B- neighborhoods and easily get the 1%. However, in the last few years, I have had to downgrade some in to C- neighborhoods to get the 1%. These purchases were in areas I wouldn’t have considered before, but if you are committed to the 1% as a strategy then you have no choice.

However, my point here is clear. You have to come up with your own investment strategy. I have been telling people this for years.

I wrote an earlier post on all the ways income producing real estate makes you money. You can access that article here. Decide what your strategy is and then go look for properties that fit that strategy. Nicer places in better neighborhoods may not fit the 1% rule, but overtime they may appreciate more. And you may have less turnover in the unit and less maintenance.

So the question is can you still find properties that fit the 1% rule? I would answer, yes. However, they may not fit other criteria you may have. Like location and tenant base. Or they may be in other states than you are currently considering.

When it comes to multifamily properties does the 1% rule still apply? For me it does. Now, when I do a full underwriting of a multifamily property I will look deeper into the financials. But when I do a quick back of the napkin underwriting of a deal on whether or not I want to look at it deeper. I will look at what are they asking per door. And what is the rent they are getting per door.

If it is close. Then I will dig deeper into the deal.

One of my mentors says it like this. He says if you can find a property that gets .005% or a half a percent, he said buy all you can. Because it is worth it over time.

And if you take nothing a way from this post, I would say this.

Don’t wait to buy real estate, buy real estate and wait. Because it is the one investment that has proven itself over and over that it goes up over time.

What are your thoughts?

To your success and your future.

4 Ways Income Producing Real Estate makes you money

Are you still on the fence about investing your hard earned dollars in to income producing real estate? You can keep sending your money to Wall Street and be subjected to the highs and lows of your money constantly going up and down, and in many cases invested in to something you don’t know anything about. Even worse, it could be invested in a company that goes against your values.

Or you can control your own destiny and invest your money in one of the safest and surest ways of making you more money, which is income producing real estate.

Below I explain all the ways real estate can make you money, and in many cases all at the same time. You definitely don’t get this with your money when Wall Street has it.

  1. Tax Advantages

    I am not a CPA, so I am not going to provide you tax advice. However, I will tell you that when you own income producing real estate you are now operating a business. And businesses get tax advantages that an indovusal W2 employee do not have.

    The most taxed income you make is from a W2 job. When you have income producing real estate you can use some of the following to reduce your personal taxes.

    A. Depreciation: is the incremental loss of an asset’s value, generally due to assumed wear and tear. As a real estate investor that holds income-producing rental property, you can deduct depreciation as an expense on your taxes. That means you’ll lower your taxable income and possibly reduce your tax liability.

    B. Pass through deduction: Allows you to deduct up to 20% of your qualified business income (QBI) on your personal taxes.

    C. 1031 exchange: This is when you own a income producing property and you sell it. The money you make above and beyond what you paid for it, you wont have to pay taxes on it as long as you invest that money in another similar property within a certain time period. I recently did one of these myself. Very simple process. Just make sure you let everyone know at the very beginning what you are doing and then find an attorney that can assist you with it.

    D. Write offs: This is the biggest tax benefit. You get the opportunity to deduct any of the expenses tied to owing the real estate. All of the insurance, taxes, interest on the mortgage, maintenance, etc. Additionally, you can deduct any of the expenses accrued to operate the real estate business. Thing such as advertising, office space, business equipment, etc.

    All of these deductions lessen your taxable income from your W2 job.

    As i said, I am not a tax expert so please consult your CPA before purchasing income producing real estate.
  2. Principal pay down: This is the big one. If you buy the right real estate with the right terms the tenant will pay your mortgage each month. Which means they are paying down the loan for you.
  3. Market Appreciation: This is the one that is not talked about enough. Real Estate historically doubles every 20 years, and in the case of the last three or four years, this has been exponentially increased. Now, the last few years are historical highs for real estate.

    We all know that property values have and will continue to go up. Which means your wealth is going up as well. Because as you owe less, and the property is worth more than you paid. You make money.

    Typically the fed tries to keep inflation around 2% a year. Which means your real estate even if there is no market appreciation at all, will typically go up each year by no less than 2%, just because of inflation and the cost of everything has gone up.
  4. Cash Flow: In an earlier post (see here) I talked about cash flow and cash on cash return. As you can see above with the other ways income producing real estate can help you make more money or save you money, my hope is it is providing you additional income on a monthly and yearly basis as well.

    Different people have different strategies when it comes to owning investment real estate. I call it income producing, because I want it to provide some cash flow over and above the costs of owning it, in addition to the other benefits of it. However, some people will invest in an asset and in some cases may take a loss on a monthly basis hoping that the assets value will increase significantly making the losses the incurred early on in owning the asset is wiped out.

    Again people have different strategies for their investment goals. You have to decide them for yourself.

My mentor says it like this. “Don’t wait to buy real estate, buy real estate and wait.”

As you can see from all the ways above that real estate can make you money, it is not a get rich quick scheme. When you decide to buy your first income producing property, you must think long term especially in todays market.

Real Estate has created more millionaires than any other business.

What are you waiting for?

To your success and your future.

Why I will always rent the home I live in, unless I do this…

If you haven’t heard of Robert Shiller before, then my guess is you haven’t been watching the news or anything related to money or economics.

Shiller is the economist that predicted the housing bubble in 2006 that sent the world as we knew it into a tail spin for the next five years and I am not sure if everyone has yet to recover from it.

Shiller and his team did something ridiculously simple, yet effective. Shiller simply looked at U.S. housing prices dating back to 1890, stripping away inflation. He “benchmarked” the 1890 prices at a value of 100 and tracked relative housing costs through the lens of inflation-adjusted dollars.

Here is what they found:

  • A house in 1897 cost the same as a house in 1997, adjusted for inflation.
  • If you benchmark 1890 prices at a value of 100, you’ll notice that U.S. housing prices have stayed within the 100-120 range over the past century.
  • In 1950, for example, the index stood at 105; in 1996 the index stood at 106. Real estate didn’t make any gains (other than inflation) during that 46-year timespan.
  • Starting in 1997, an unprecedented bubble began forming.
  • Every housing ‘peak,’ or bubble, is followed by a tragic, painful, ugly fall.

Shiller and his team have created the Case Shiller Home Price Index.  Below is the image of the current one.  This index is created quarterly.  If you look at the most recent spike.  Right before the recession hit.  You can now see why he was able to predict the housing bubble.  What is even scarier.  Is that you can see a current one is being formed as I type this.

 

So you are saying right now Brian, you are silly.  A home is an investment.  Over time, this appreciable asset can be sold for more money.  Everybody makes money on real estate.

Well, let me tell you a few other reasons why I will never buy a home again as my primary residence.  First of all, I own five homes.  They are all rented out and make money each money.  Matter of fact they are very profitable.  But I rent where I live. And here are some other reasons why I will always rent, other than the fact as you can see by the chart above it isn’t a very good investment.

The only time I will not rent is the day I can write a check for the place I want to live in.  Meaning I don’t take out a loan.

My other reasons.

Mobility:  I don’t plan on staying put.  I stayed put in my hometown from birth until age 38.  I am not doing that anymore.  I want to move.  I want to see the world. I want to see the United States.  My plan is to move at least every three or four years or so, or maybe sooner.  Look, I get bored easily.  I like new things.  I want to move around and see new things and be in new areas.

Assets vs. Liability: The lie you have been sold is that a home is an asset.  Its not. It is a liability.  It doesn’t make you money every month.  It costs you money every month.  I know, so does rent.  And unless you plan on staying in a house for more than five years, and depending on price, it doesn’t make sense to buy a home unless you plan on staying in it over five years.  Which is not the case for a lot of people.

An asset is something that can provide you cash flow.  If it doesn’t provide you cash flow, then it is not an asset. Simple definitions, an asset makes you money every month.  A liability costs you money every month.

But I am getting the gains from appreciation?  What is the point of appreciation if you can’t do anything with the money?

Costs:  The average down payment of a $150,000 home should be, $30,000, 20%.  If you invest that $30,000 into a home, you have to think about opportunity costs associated with that 30K.  Which means, since you invested your 30K into this home, it means you can’t invest it into something else.  Like a mutual fund, a business, or some other kind of asset that can provide you a return.  So this money is tied up.

I, like you have been sold the “American Dream”, whatever that is.  I think most would say, home ownership is the “American Dream”.  I subscribed to that thinking growing up as well.

But to me the “American Dream” is “Ultimate Freedom.”  Freedom from doing anything I don’t want to do.  Freedom from any debts or obligations to others.  Freedom to come and go as I please.  Freedom to live off of my own assets that I have accumulated.  Freedom to travel and live where I want to live.  Freedom to get up on a Sunday and not have to worry about cutting the grass.

If you like to cut the grass, good for you. I don’t. Life is too short to spend one hour a week  cutting grass.  I have better things I want to do.

In 2006, I bought my first rental property.  It was a $175,000 dollar duplex.  At the time, I was renting a great apartment/duplex in the best area (in my opinion) in my city at the time. That duplex gave me cash flow every single month that helped me establish a love for real estate and a love for seeking pure freedom in my life.  I am closer today to this goal than I was then.  And I get closer every single day.

If you are not sold, I would encourage you to do your own research instead of just taking my word for it.

At age 21, I bought my first house.  To live in.  At that time, that was considered to be the biggest achievement one could make, at least in my circles at that time.  Hey, I am not discounting it if that is what you want to do.  If this is one of your goals, and you do it, then good for you.  I am glad you set a goal and accomplished it.

But for me, ultimate freedom is the goal.  And conventional and traditional ways of thinking have never got anyone I know to this goal.

Also, if you looked at the above chart, this should be a concern if you plan on selling your home over the next few years.  We could be at the top of the bubble.

To your success and your future.

Chart:  http://www.multpl.com/case-shiller-home-price-index-inflation-adjusted/