Real Estate 101: Running the Numbers

The following is a guest post by FMF reader Apex. He has been investing in rental real estate for more than four years and is authoring a Real Estate 101 series, posting every Friday, based on his experiences. (To read the series from the beginning, start here.)  The series is designed to give prospective investors the basic tools they need to succeed.

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 Numbers

• Purchase Price: $124,900
• Mortgage Balance: $93,675 (75% loan to value, 30 year mortgage with 5.25% interest)
• Closing Costs: $3,500

Monthly Revenue

• Rent: $1,400 ($1460 – 4.1% vacancy allowance)

Monthly Payments

• 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.

Comments

[Rick Franics]

Apex,

This is a great article and it shows the current potential of real estate investing. The ROI really shows the power of leverage... 9.1% is a very good rate of return but 18.4% is just insanely great.

Although unless you tap the home equity that is building up, wouldn't that 18.4% decrease toward 9.1% as your leverage decreases?

One number I did not see in the costs- compensation for your work managing the property. I don't think it is fair to not include some estimate- as you could be earning other income with that time.

Also, there will come a time at which you will need to hire help to manage additional properties and then it will be a real cost.

-Rick Francis

[FMF]

Rick --

You asked: "Although unless you tap the home equity that is building up, wouldn't that 18.4% decrease toward 9.1% as your leverage decreases?"

Yes. I am looking at these same sorts of numbers and this is exactly what happens.

But if you have a 30-year loan, the decrease takes place over all 30 years, and that's a long, long time.

[Manette @ Barbara Friedberg Personal Finance]

This is very informative. We are looking into purchasing a bigger house for our growing kids. We are also thinking of either selling this place or have it rented out. This article is definitely a big help in making our decision. Thanks!

[Bob]

association fee is almost half the mortgage?

[Apex]

@Rick,

All very good points.

Yes the returns do decrease over the course of the mortgage if you do not tap any of the equity that builds up. For the first 5 years or so the change is almost unnoticeable. But eventually if the property increases in value and the mortgage balance decreases, tapping the equity is a way to keep the returns higher.

As I mentioned in the article its also important to put the cash flow back into more properties if you want this return to compound. There is another measure of return called Internal Rate of Return (IRR) which accounts for all of these types of things. However it is far more complicated to calculate than the ratios I showed here and I don't think it helps me make any decisions anyway.

Some people think that making a real estate business profitable involves strict attention to the financial details. I disagree. Clearly you have to run numbers and that is what this column is about. But I have never tried to make these decisions by comparing numbers to the nth degree and deciding by having some kind of hard and fast cut off like I must make 16% ROI, or by deciding between properties based strictly on which one produces a higher return on a certain ratio.

The purpose of the numbers in my opinion is to make sure the property will perform well, will have margins of safety and will be a good long term investment. Once you have a handle on these numbers you can pretty much ball park them as soon as you look at a property. You have a sense for them and then you just run the numbers to make sure it still looks good.

As to accounting for labor put in, on a pure external investment basis this is true. However I am not trying to justify my time. I am trying to determine how much of a return I will get on my money. It is true that labor is a part of it so on a pure investment return basis you would have to subtract labor. It's a bit tricky to work that into the numbers because I don't put in much time doing labor and its quite variable. The argument that I could do something else with my time is true but that is an opportunity cost. I don't see returns on stocks discounted by accounting for the opportunity cost of investing them in something else.

The point of these numbers is to show how much will my money grow after I do this and they values here are an exact representation of that. It is understood that I will need to put in some labor to get that growth.

You are also correct that if I get big enough I will need to hire labor and then it is a real cost that will be paid with cash and it will by its vary nature reduce the returns. I do hope to get there some day. I have already thought about the size and numbers I would be talking about. The reduction will likely be pretty small because I can get pretty large before I need to hire help.

Again, I want to say that all your points are very valid. It's just not what I am trying to show with these numbers.

For example some people add in the tax savings to their ROI because they get to reduce some tax payments in ways that other investments do not. I don't do that with these numbers either because I also think that makes things messy and doesn't help for comparing returns. If I buy a stock that goes up 50% I pay no tax on that until I sell it so how do I account for that tax benefit.

My goal with these numbers is to say the following:

I had X dollars of cash that I invested in this business on Jan 1. How many dollars of cash and how much profit including principle paydown will I have on Dec 31. And will those returns be similar for the few years following this one. That's what these numbers show.

What the returns look like 20 years from now is what IRR is for but I am not actually that interested in that. Things are too variable for me to put too much stock in 20 year projections.

[Apex]

@Bob,

Yes the association fee is 40% of the mortgage. And it still makes these kind of numbers. Crazy huh?

I am sure you and maybe others are thinking why on earth is he buying townhouses with that association fee. Why not just buy houses.

Great question. I'm glad you asked. :)

In the area I am buying townhouses were over built in the 90's and 2000's. As such during the housing crisis tons of them were foreclosed on. This created a glut of them on the market which drove down price.

To buy a comparable house I would need to spend probably 20% more and it would be 30-50 years older and would probably rent for only a little bit more.

It would need more maintenance because everything would be old. I would need to pay for things like roofs, siding, driveways, etc which are covered by my association fee now. Most of the places that have these kinds of houses that are cheap enough to rent are in much worse neighborhoods than I can get these townhouses in.

There are always trade-offs and decisions to be made. If I bought one of those houses instead of these townhouses I could probably cash flow a bit more up front but as soon as the big expenses come it would eat up any extra money and I believe I would have a harder time finding the quality of tenants that I do find.

I could have gone inner city and bought dirt cheap houses for 40K. I know some investors who did and claim to be making very good returns. Definitely better than mine. There are multiple reasons why I do not want to do that.

[Apex]

One other thing I want to mention with respect to my comment to Rick.

I run these numbers for all my properties with updated values at the start of the year. Not so much to get the ratios anymore but to get the cash flow and profit projections for the next year.

At the end of the year, the actual numbers that I bring to my accountant are almost an identical match to what my projections were at the beginning of the year. This has been true every year I have done it.

These ratios and numbers tell me exactly how my properties are going to perform over the next year or two with respect to cash in hand, and total gain in equity.

[Venkat]

Apex,
Great info. Appreciate your effort and patience in explaining the ideas clearly.

[RichUncle EL]

Great article with detailed data one can use to calculate income figures on a future investment purchase.

[Mike Hunt]

Apex,

This is some great analysis and it all makes a lot of sense.

When I look at the market here (outside the USA) it seems like the Cap rates are only 3% or so, that seems quite unattractive, don't you think? Cap rates used to be in the 7-8% about 7 years ago when I purchased our residence.

-Mike

[Jonathan]

Rick and FMF -

While it is true that, all things being fixed, the returns would decrease over time as the mortgage was paid down, revenues aren't static. One great advantage of real estate which Apex didn't touch on in this article is that over time, property values will basically increase with inflation. So will rents. In 30 years, Apex may be getting $2,000 or more per month in rent. Also, and this gets deeper into time-value-of-money theory, at some point the original invested cash becomes irrelevant when you've been making money on it over time. At Apex's rate of return, he will get his cash back every 6-7 years on cash flow alone.

[Lurker Carl]

Beware of that community association fee. Expect it to rise accordingly with inflation and as the property ages. You will be assessed for community maintenance and repairs above and beyond the current monthly payment.

Attend some of the meetings so you'll have a handle and voice in what the association is considering. The cost of building repairs and upgrades in a condo can be quite shocking.

[Jonathan]

Apex - thanks for the great article (again!). My own experiences and numbers closely match your own. I have only ever really looked at cash-on-cash return and ROI, but I will look closer at the other two metrics.

I notice that your mortgage is at 5.25%. One great thing about the current interest rate environment is that you can refinance and make your numbers even better. A friend of mine has several properties purchased before the crash which are cash flow negative and have mortgages around 7%. He also has less than 20% equity despite having initially put 33% down. I showed him how, if he were to pay down his mortgages to get to 20% equity and then refinance to 4.25% (a rate we've been quoted for refinancing our own rentals), he could make as much as an 80% return on that "down payment" toward his equity and at the same time make his properties cash flow positive. You could refinance and probably save about $100 per month the same way (probably without first augmenting your equity).

[FMF]

Jonathan --

That is correct, but costs may rise as well (as Lurker carl points out). Houses eventually wear out and roofs need to be replaced, furnaces need replaced, paint needs updated, and so on -- much more than the basic maintenance we have in our annual budgets.

[Apex]

@Lurker Carl,

Very good point. I own multiple units in this association and am President of the board so I pretty much set the pace in this association.

The association fee will likely need to rise some over time (it was $198 when I took over and raised it to $210) but there will be no future assessments for maintenance. That is all part of the fee as we put money away for reserves. It is the law actually. It is true that many associations do not put enough away and need assessments to deal with it but I believe I have a handle on it and we will be prepared for future expenses.

One of the reasons why the fees are a little higher right now is that when I came into this association it was a mess. The units were nearly all investment owners all losing their properties (its a small association, 16 units and ever single one of them has now been foreclosed on now). The association was fairly new, fairly small and had no money. There was less than 9K in the bank when I came in and 1/3 of the units were not paying dues. We had little money and were going backwards. There was a risk of running out of money. 3 years later we have over 50K in the bank, every unit is paying dues and I have dramatically reduces expenses on things that were a waste of money in my opinion.

By the time we need to do any major replacements we will have more than a quarter million dollars in reserves.

One thing I want to note is that inflation is not unique to associations. Dues go up because things cost more. But if you own a house with a new roof, the cost to replace that roof in 25 years will be double what it costs to replace it today. Costs go up whether you are in an association or you own a house.

[Apex]

@Jonathan,

Very true on the refinance. However its not as easy once you get enough mortgages. I have about 6 mortgages right now so I have to fall under Fannie Mae's 5-10 rules. Those make things a lot harder. I can only find one broker who will even do them in my area and he lost 3 of the 4 institutions who would write the loans. If he loses the 4th I am going to have a lot harder time finding loans. He is so busy right now that he simply will not do refinances. So I pretty much have no option to refinance these loans at the current time. I certainly would if I could but sometimes you have to stick with good enough as much of a disappointment as that is.

[Apex]

@Mike,

I agree completely. 3% cap rate is horrible. I haven't given much thought to cap rates that low but I doubt I would find that an attractive environment to invest in.

Cap Rate isn't the real ROI if you are using leverage but if you can't get a cap rate above 5 it's hard to believe the other numbers will come out very well either. The numbers start to get good when cap rate gets up near 7 or so, like the numbers you mentioned that you used to be able to get.

A Cap rate of 3 sounds like a bubble to me. Something is not right with price to rent ratio when the cap rate is that low.

[Veronica @ Pelican on Money]

Apex, awesome post. I love how you break everything down and explain it all right below. I'm curious what you do with your cash flow from a property like this? Do you put profits towards another property?

[Apex]

@Veronica,

That is correct, I put it into more properties. I have lines of credit that I borrow from as well so I use extra cash to pay those down, then when I find another property I extract the cash from those lines to use as a down payment and get another mortgage for the difference.

[Jim]

Hey theres a good landlord tip : Get yourself elected president of the HOA for the properties you own. ;)

[Veronica]

@Apex, thanks for clearing that up. Hmm, I need to learn more about this!

[Rob]

When you are talking about mortgage payments, you want to use "principal", not "principle".

[Nicholas Casteel]

I am a local Realtor in South East MI and these kind of returns are available right now because home prices are still low from the market dropping, but rents never really went down. We see many people taking advantage of these opportunities and it will certainly pay of years from now. 18% return on investment with a built in long term savings account (home equity) seems like an awesome long term investment. especially considering with depreciation you only have tax ramifications for a portion of that income. Some stocks may do better, but certainly not with any amount of certainty. For the long hall it is really tough to beat real estate when these kind of returns are available.

[Apex]

@Nicholas.

That is a good summary of why this works now. These returns are basically locked in on these properties for the long term. What is also true is that these returns will not always be available on new purchases. There will be a time again when it will be difficult to purchase quality homes and make any return at all in the rental market. That's when people have to go to much less desirable properties to get a return.

If anyone is interested in considering real estate the time is now. The housing market is already starting to turn up. I do not know how long this will last but it could be shorter than people think.