What if before you purchased a stock, you could get a very close approximation of what kind of return you would get on it in the coming years? What if before you started a new business, you could make a close estimate of both your overall revenue and expenses to determine what your net profit would look like? Obviously that would make the decision to invest or start a business much easier to make, but unfortunately there is no crystal ball into that future.
With real estate, however, the future does have a crystal ball and it’s the present. The near future in real estate looks very much like the present. This is because rental properties are basically commodities. Similar properties in similar local neighborhoods will rent for similar prices and have similar expenses. Furthermore the supply of properties does not change much from year to year and neither does the demand. This creates a relatively stable environment that makes calculating how a real estate investment can be expected to perform in the coming few years straightforward and remarkably accurate.
If you research real estate financials you will find there are literally dozens of different numbers and ratios that you can use to measure the performance of the business. I am going to focus on 4 different ratios, which combine to give a complete financial picture of the investment. They are cap rate, cash on cash return, return on investment, and cash flow margin. These are all very straightforward to calculate.
You will notice that I do not account for appreciation in any of these calculations. Appreciation over long periods of time can improve return on investment significantly. The problem with appreciation is that it is difficult to project accurately, and it has no immediate cash impact on your business until you either sell a property or borrow against the increased equity to access more cash for future purchases. All things being equal you should favor a property that is more likely to appreciate, but in the short term your business will thrive much better on high cash flow properties than it will on high appreciation properties with low cash flow. As such we will focus on cash flow and profit calculations without factoring in appreciation.
To explore these calculations we will use real numbers from a property I purchased in June of 2011. This is a 4 bedroom, 3 bath townhouse that was built in 2007.
There will be two assumptions in these numbers. First is 1/2 month of vacancy per year, which is about 4.1%. My vacancy has thus far been much lower than this, because I have long-term tenants with long leases and have had almost no vacancy between renters. Eventually you will have some vacancy so it is important to make a realistic assessment of what your actual vacancy will be without underestimating it. Second is an allowance of 5% of revenue for unscheduled costs. This includes repairs, maintenance, and replacement. Normally this number would need to be much higher than this but since this is a townhouse most of my large expenses are covered by my association dues. My actual numbers have been far less than this number as well because of how new the property is, but they will eventually catch up when I have some larger replacement costs.
Here are the numbers.
- Purchase Price: $124,900
- Mortgage Balance: $93,675 (75% loan to value, 30 year mortgage with 5.25% interest)
- Closing Costs: $3,500
- Rent: $1,400 ($1460 – 4.1% vacancy allowance)
- Mortgage Payment: $517 (Interest-$410; Principle-$107)
- Association Dues: $210
- Taxes: $133
- Utilities (water): $35 (trash is provided by the association)
- Insurance: $10 (master insurance policy is provided by the association)
- Allowance for other costs (5%): $70
- Total Monthly Payments: $975
From these we will calculate some basic numbers needed by the financial ratios.
- Cash Invested = Purchase Price + Rehab Costs – Mortgage Balance + Closing Costs
$124,900 + $0 - $93,675 + $3,500 = $34,725
- Monthly Cash Flow = Revenue – All Payments
$1400 - $975 = $425
- Monthly Net Income = Cash Flow + Principle Pay down
$425 + $107 = $532
- Monthly Net Operating Income = Cash Flow + Debt Service (Mortgage Payments)
$425 + $517 = $942
While these numbers are needed by our calculations, they are valuable on their own as well. From these numbers we see that this property produces $425 of cash flow each month. This is real cash that is deposited in your bank account each month. It also produces $532 of net income or profit. This would be the amount you would pay taxes on except that you will receive a substantial deduction for depreciation and likely pay taxes on half of this or less. For instance my depreciation allowance on this property is about $330 per month. That means I gain $425 per month in cash, I have profit or gain in equity of $532 per month but will only pay taxes on about $200 per month. The Net operating income of $942 shows how much money this property would make if it were fully paid for. This is what your cash flow would look like if you purchased it with all cash or after you had paid the mortgage off.
From these numbers we can now calculate the ratios that will tell us how this property will perform as an investment:
- Cap Rate = Annual Net Operating Income / Current Value (Purchase Price)
$942 * 12 / $124,900 = 9.1%
- Cash on Cash Return = Annual Cash Flow / Cash Invested
$425 * 12 / $34,725 = 14.7%
- Return on Investment (ROI) = Annual Net Income / Cash Invested
$532 * 12 / $34,725 = 18.4%
- Cash Flow Margin = Cash Flow / Revenue
$425 / $1400 = 30.4%
The cap rate is 9.1%, which is a solid number. This is the return you would get if you purchased the property with all cash. You will find that if you use more cash and less leverage you will get lower overall returns on your investment but higher amounts of cash flow.
The next two numbers show us how this property will perform using the financing terms we have chosen. By using 75% leverage this property’s cash return on the money invested is increased from the 9.1% cap rate to a 14.7% cash on cash return. This is a 60% increase in cash for every dollar invested. The Return on Investment (ROI) which accounts for the portion of your mortgage payment that went to equity in your property comes to 18.4%. This is the more than double return I had mentioned during the benefits column that can be achieved by using leverage over cash. These two numbers show the actual return you are going to get on this property. Cash on cash return shows your cash in hand return and ROI shows your total profit return.
These two ratios are dramatically affected by how much leverage you use. Because of that the cleanest way to compare one property to another on a pure performance basis is the cap rate. It’s worth pointing out that if a property is purchased with all cash, then the cash on cash return and the ROI will be the same as the cap rate.
Cash on cash return and ROI work together to tell you how well this investment will perform. Cash on cash return is important because this tells you what percentage of your investment is being returned to you in cash each year. This can be used as income or as capital for future investments. There is one danger with looking only at cash on cash return however. You can affect this number by changing the financing terms. Different amortizations and payment terms can make this number look better than it is. For instance I have some loans that are interest only because they are lines of credit. They appear to perform vastly better on a cash on cash return basis because the loan payments are only interest. This is why ROI is also important because when comparing ROI the loan term differences are accounted for and the returns look more similar. ROI is also your true total return on the property. You want to be sure you are not convincing yourself something is a better investment than it is by focusing too intently on a single measurement of performance, and you want to avoid making short term financing decisions based solely on numbers that may not be the wisest choice for a long term investment.
Finally we see the cash flow margin is 30.4%. This means you are able to keep almost 1/3 of the rent you collect after making all of your payments. This is an important measurement because you want to make sure there is a margin of safety in your cash flow numbers. 30% is a very safe cash flow margin.
Overall these numbers show that this property performs quite well as a real estate investment. Since it is a townhouse with association dues involving overhead, a single family house or a duplex can often produce even better numbers depending on the purchase price.
This property turns out to be ideal for the current investment strategy that I have. It is in a very good neighborhood. It is almost brand new. It attracts high quality, stable, long-term tenants and as such my real numbers are actually higher than what I am showing here because the allowances I am using are higher than I am currently experiencing. Because of the quality of tenants I can attract my tenant issues are minimal. Since it is a townhouse my maintenance demands are reduced because I only have to deal with inside issues, the association handles everything external. The intangibles of this property are very high. Those intangibles are very important to my strategy so I am pleased to get such solid numbers on a high quality property. It tends to be the case that the higher the quality of property the lower the overall numbers because the sales prices tend to push up on better quality properties and the increased rent usually can’t keep pace with the higher sales prices.
I would like to be able to conclude this column with specific targets for these measurements. Unfortunately it’s not possible to give universal targets. Different areas of the country will produce different numbers. Different eras of real estate investing will drastically affect the kind of numbers one can achieve. We are in an era where the returns are at the high end of the range. These numbers won’t always be achievable. Also different types and qualities of properties will produce different numbers. Older duplexes will probably produce better numbers than newer single family houses. But newer single family houses may produce better future appreciation, less maintenance, and depending on location may result in higher quality tenants. There are far too many variables to say what any of these numbers should look like.
I will, however, offer two pieces of guidance. The first is around cash flow. Because of how critical cash flow is, any property you buy should always be able to produce some reasonable cash flow. If your cash flow margin is in single digits it’s getting uncomfortably low. Preferably cash flow margin should be in double digits and certainly not below 5%. This target is easily attainable in this market.
The other guidance I would offer is to examine your ROI and decide if that number is something you think is worth the effort and worth your investment. If you get a reasonable cash flow margin by using more cash but at the cost of a low ROI perhaps that is not a sufficient return to justify the investment in real estate. Personally I would like to see ROI that is in double digits. You could accept high single digit ROI on an all cash deal but once ROI was down near 5% the return is probably not high enough to justify real estate over alternative investments. With the use of leverage double digit ROI is also easily attainable in this market.
With these 4 ratios you can effectively compare every property you are considering to determine which ones give you the best returns and which ones do not. Remember that these numbers do not account for appreciation so over time your return will exceed these numbers. However, for the purposes of making the initial investment, these 4 ratios will give you all the information you need to make a well-informed decision.
To read the next post in this series, see Real Estate 101: Making an Offer.