Do You Need to Know How to Spell to be a Real Estate Investor?

Do You Need to Know How to Spell to be a Real Estate Investor?

Couldn’t help but notice this sign driving down Sheridan the other day.

Look closely.

Goes to show you that you don’t have to know how to spell in order to own a multi-unit apartment building.

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After seeing this sign, I started thinking…..what do you need to know to invest in real estate?

When I’m analyzing buy & hold investment properties I try my best to keep it simple (actually, I try to keep everything simple to avoid confusing myself).  For me, the main factor for any real estate investment is cash flow.  I want to see enough cash flow to cover all of the debt service, operating costs, and taxes, with room to spare.

Some investors will argue that cash flow isn’t that important because of the huge tax advantages.  Of course, the growing value of the property over time is also important.   You won’t find me arguing these relevant points, but the simpleton in me likes to focus on cash flow.

Let’s say I am looking at three potential rental properties in different areas of town and I want to know which one makes a good investment.  Oh, and let’s say I have to do this quickly because the properties just hit the market and I need to determine whether my client should make an offer.  For my quick cash flow analysis I will look at the ratio of the monthly gross income to the price of the property.  For example, a property selling for $100,000 that has gross income of $1,000/month would have an income ratio of 1%.  Is that a good investment?   Most likely it’s a great investment.  Here’s why:

Let’s take a closer look at that 1% income ratio property to see why the numbers work with the 1% income ratio.  I’ll assume for this analysis that my investor is getting a conventional loan for $70,000 at an interest rate of 5.5 %.  The monthly mortgage payment is about $400 per month.  I’ll also assume that the annual property taxes are $1,200 a year and my property insurance is $1,200 year (so another $200 per month combined).  With these numbers the monthly net cash flow would be $400 per month.

Taking this one step further let’s assume that the investor holds this property for 10 years and let’s assume that there is NO increase in the property values (I know, that’s crazy because values will go up in ten years, but let’s be super conservative).  After that 10th year, the  mortgage balance would be reduced to $57,000.   So, there would be $43,000 in equity in the property.  Meanwhile, the investor earned another $48,000 in cash flow over those 10 years (assuming rents NEVER increased).

I know, I know, the cash flow wouldn’t be a full $48,000 because  the investor, somewhere along the way, had some vacancies and had to do some repairs to the property.  OK, let’s just cut that $48,000 by 1/3rd for the sake of argument.   Now we have a deal 10 years down the road that has provided at least $32,000 in net cash flow and $43,000 in equity because the mortgage was being paid down.  The investor has made $75,000 from the initial $30,000 investment.   This is a 9.6% annual return.  Not bad right?   Now carry that investment out another 20 years when the mortgage is paid off and the numbers get ridiculous.   The $30,000 down payment turned into $144,000 cash flow and a home worth $100,000 for a total of $244,000.

Now remember, we assumed that $100,000 house would not appreciate a single dollar and the monthly rent would never go up in 10 years.  Recalculate those numbers with a small appreciation rate (like the historical 3% annually) and small rental rate increase (2%) and you will see that the 9.6% return is just the beginning.

I like this income ratio analysis for taking a quick look at properties because it’s a great way to weed out properties.    I will encourage my investor clients to take a second look at any property with an income ratio of .75% or more.   Of course this is just an quick barometer and lots of factors should be considered in the final analysis.  For example, In nicer neighborhoods with higher home prices you may have lower income ratios, but the home can be a great investment due to the annual appreciation of the home.

 

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