by David | Dec 8, 2014 | Real Estate Basics
Valuating real estate investments can be complicated, but there are a few basic values that are important to understand. The two that we’ll focus on in this post are: capitalization rate and cash on cash return.
Capitalization rate (also known as “CAP rate”) is the ratio between the income of a property and its cost.
Cash on cash (or “COC”) return is the ratio between the amount of cash flow the investor receives and the amount invested.
Let’s look at an example of how to calculate these two valuations. A real estate investor purchases a property valued at $100,000 and uses a conventional 30-year mortgage, allowing her to put down 20% of the value of the house. She pays $20,000, and the rest of the $80,000 is paid with the mortgage. The monthly numbers for this house are:
| Rent |
$1,000 |
| Insurance |
– $40 |
| Property taxes |
– $130 |
| Management (10%) |
– $100 |
| Net operating income (NOI) |
$730 |
| Mortgage payment |
– $436 |
| Cash flow |
$295 |
If we multiply the NOI and cash flow by 12 we’ll see that, over the course of a year, the NOI is $8,760 and the cash flow is $3,528.
In order to calculate the CAP rate, we divide the yearly NOI by the value of the house (as defined above, the ratio between the income of a property and its cost). In this case, NOI ($8,760) divided by the value of the house ($100,000) gives us an 8.7% CAP rate.
To calculate the COC return, we divide the yearly cash flow of $3,528 by the amount the investor spent on the house ($20,000), which gives us a COC of 17.6%. Note that we’ll typically add closing costs to the amount the investor spent and also deduct maintenance and vacancy costs from the cash flow to get a more accurate COC.
So, now what?
When these ratios are useful
Calculating CAP rates and COC returns comes in handy when comparing two properties that have different costs and determining which one is a better investment. It’s really easy to compare two houses in the same neighborhood that cost the same. For example, if houses A and B are both priced at $100,000, and the monthly cash flow for house A is $150 while for house B it’s only $100, we can easily understand that house A makes for a better investment. But, if the houses don’t cost the same, then we need to use CAP and COC to compare them.
Let’s say house A costs $100K and house B costs $70K. If house A produces a monthly cash flow of $150 and house B produces a monthly cash flow of $100, we can use the cash on cash return to better understand which house has the higher return on investment. (We’ll assume that for both, we’re leveraging our money and putting 20% down.)
| House |
House A |
House B |
|---|
| Price |
$100K |
$70K |
| Down payment |
$20K |
$14K |
| Yearly cash flow |
$1800 |
$1200 |
| Cash on cash return |
9% |
8.6% |
So, in this example, our investor will receive a higher rate of return with house A.
Calculations are also useful when comparing different investment options, such as investing in a house vs. investing in the stock market. Let’s take another example: Our investor has $25,000 to invest. Her friends tell her that they’ve been getting an average of 8% return on their investments in stocks (in the case of $25,000, that will provide a yearly cash flow of $2,000). Her alternative to investing in stocks is purchasing a house by using the $25K as a 20% down payment and buying a $125,000 house. The house’s monthly cash flow is $200. So:
| Investment |
Stocks |
House |
|---|
| Price* |
$25K |
$125K |
| Down payment |
$25K |
$25K |
| Yearly cash flow |
$2000 |
$2400 |
| Cash on cash return |
9% |
9.6% |
*Doesn't matter for this example. Leverage is an important topic, but we'll save it for a different post.
So, in this case, we see that investing in the house will provide our investor with a higher return.
Apples to Apples
To conclude, the point of these valuations is to help us compare different investments in order to see which provides the higher return. Of course there are other factors to look at when comparing investments, such as the neighborhoods where the houses are located, appreciation, etc., but these are the basic values you need to know how to calculate.
by David | Dec 1, 2014 | Income Report
My main goal for November was to close on house #2, and that’s exactly what I did! After a little bit of trouble with getting the documents signed with a notary and wiring the money, everything has been closed and I’m now the owner of TWO investment properties. At this time, I have invested a total of $46,263 (down payments and closing costs) and my real estate portfolio is worth $131,400.
The cash flow breakdown for the month of November was:
| Rent |
$795.00 |
| Mortgage |
-$316.67 |
| Insurance |
$0.00 |
| Taxes |
$0.00 |
| Management |
-$79.50 |
| Total cash flow |
$398.83 |
The total cash flow this month comes out to $398.83, making the total cash flow thus far $1,427.30.
For the upcoming month, I’m planning on spending time setting goals for 2015 (I’ll write more about this soon) and searching for my next investment.
[For those of you who are wondering how much more money I have to invest… I mentioned that I investigated real estate investing for over 2 years and made sure to save money during that time (and before those two years). So my wife and I currently have around $60,000 left to invest. And, one of my goals for next year will be to continue and save for additional down payments.]
In regard to my performance meters, we’re green on both cash flow and passiveness! No problems with house #1, and I got 100% of the expected cash flow!
by David | Nov 26, 2014 | My REI History
In my previous blog post I mentioned that I found my second real estate property. Quick update that the process is now complete and I’ve closed on house #2!
The purchase price was $58,700, and I put a down payment of $23,480. The closing costs came out to $3,841, for a total amount of $27,321. The cap rate is 11% and the cash on cash return is 6%.
I learned a lot from the closing process, and I want to share some lessons with you…
- When signing the documents remotely, you need to use a notary to verify that it is in fact you who is signing the documents. Well, my wife and I are currently out of the country and needed to use a foreign notary. The title company recommended we go to the local US embassy since not all foreign notaries are accepted. When I called them, the nearest available appointment wasn’t until the middle of December! So, with some research, I found a local notary that would work. The problems with this:
- It was super stressful, as we hardly had any time to complete this process and mail the documents before the closing date.
- It cost more than I originally factored in the deal. I always like having all the facts and all the numbers ahead of time and I definitely don’t want surprises or additional costs at the time of closing.
- Keep full control of the process. You need to decide when you want to close the deal and, based on that, work back. For example, let’s say your turnkey company updates that the house will be ready on November 15th and that a tenant is moving in on November 17th. If you want to close on November 17th, make sure everyone knows this and have the title company prepare the documents well in advanced.
- Make sure you know how you’re going to wire the funds. For our first purchase, we paid using a check, no problem. In this case, with our being overseas, we thought it would be easier to wire the money. As it turns out, Chase has a limit of $25,000 on the amount you can wire per day. This meant I needed to break down the wire into two wires. And, since the first wire was for $25,000, it was blocked by the bank because they thought it was suspicious, which caused another delay since I needed to explain why I was wiring so much money. The bottom line is that you should know how you’re going to send the money and what limits your bank has, and make sure it’s all ready ahead of time.
Finally, as with everything in real estate, I recommend you always ask “why” or “what are the implications of that” regarding anything you’re told, and any options you receive. For example, since it was Thanks giving around the time we closed on the house, the title company updated me that they’ll be closed on November 27th and 28th and that we could either close on November 26th or December 1st. Beyond the fact that this would mean losing a few days of rent income from those last days of November, as part of the closing costs, the buyer needs to pay interest based on the number of days between the closing date and the last day of the month, which comes out to $7 per day. Closing on the 26th meant I would have 7 days of interest to pay as opposed to closing on the 1st which would mean 31 days of interest. I paid $35 instead of $217.
So, those are a few lessons for you… but the important thing is that we closed on house #2!
by David | Nov 12, 2014 | Thoughts about REI
One of the most common questions friends have been asking me is: how do you have money for down payments? They say things like “I don’t make enough money,” or “I’m still paying off my credit cards and student loans,” or “we barely break even between our paycheck and expenses.” And those are only some of the reasons (or excuses) people have for not investing.
The key to real estate investing is that anyone can do it–it’s just a matter of deciding that you want to and then making choices to help move you in the right direction. Some things help, like having savings. (Step 1: spend less than you earn.)
There are some great bloggers who write on the topic of saving money (they’re like “Jedi Masters,” whereas I’m just a “Jedi Padawan” in this area, so I’ll let them take it away). Here are a couple I follow:
- Afford Anything
- Budgets are Sexy
by David | Nov 6, 2014 | My REI History
I started the process to purchase my second real estate investment!
My second property is located in a middle class neighborhood in Memphis, TN. It’s a 3 bedroom 2 bath house with a big yard and car port, and the turnkey company I’m working with is currently renovating the property. The house is priced at $58,700 and the monthly rent is $725. If we deduct taxes, insurance, and management, the yearly net operating income is $6,558 which puts the CAP rate at 11%.
| Rent |
$725.00 |
| Taxes |
-$73.00 |
| Insurance |
-$33.00 |
| Management |
-$72.50 |
| Monthly NOI |
$546.50 |
For this purchase I’ll be paying 40% of the property cost up front (I don’t qualify for a 30 year loan at this time) and I’ll be getting a loan for the additional 60%. The loan is a 10 year loan with a 7.25% interest rate. This means that the monthly loan payment will come out to $418 bringing the monthly cash flow to $128. That’s a 7% cash on cash return on the down payment (slightly less, 6%, when including closing costs). This will be even lower if we factor in potential maintenance and vacancy costs in which case the monthly cash flow drops to $56 (a 2% cash on cash return). Not great, since I am a cash flow investor, but as I explained in the previous blog post this is worth it for me since my goal is to create lump sums of passive income in the next 10-15 years and not necessarily today.
| Rent |
$725.00 |
| Taxes |
-$73.00 |
| Insurance |
-$33.00 |
| Management |
-$72.50 |
| NOI |
$546.50 |
| Debt Services |
-$418 |
| Monthly cash flow |
$128.5 |
Now while you might be thinking to yourself that I’m totally crazy (and I might be…) for getting into an investment where my monthly cash flow is so low, you need to remember that after these 10 years, my cash on cash return will jump to 21% since the NOI will be my cash flow. In other words in 10 years (not as far away as you think it is) my cash flow will be $546.50 each month or $6,558 per year (and it will most likely be high since rent does go up with time).
Well there you have it, house #2!
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