Amortization

by David | Apr 10, 2015 | Real Estate Basics

Amortization is one of the most amazing concepts in real estate investing. It has to do with another amazing concept called OPM, which stands for Other People’s Money. Before we get to amortization, the idea behind OPM is that you don’t have to use your own money to purchase properties (or, at least you don’t need to use all of your money for the purchase). An obvious example for OPM is a mortgage. If there’s a property you want to purchase that’s valued at $100,000, you don’t need to have $100,000 in order to purchase it. With a conventional loan, you only need 20% of that price. In other words, if you only have $20,000 you can still purchase a property that’s worth $100,000.

That’s a simple example of OPM. Now, what is amortization? Amortization is the fact that, over the course of the life of that loan, you’re paying it down and slowly owning more of that property.

For example, the day after you purchase that $100k property with $20k of your own money and finance the other $80k from the bank, you own 20% of that property. Since you’re paying the bank a mortgage payment every month, you’re slowly paying back that loan. So after 10 years, you won’t own only 20% of the property, you’ll own 30% of it. And after 30 years (if this is a 30-year loan), you’ll own 100% of that property. In other words, you initially paid 20% of the price and after 30 years you’ll own the entire thing.

But, David, like you said, we’re making monthly payments to the bank to return the 80% back to them. That’s right, but the question is who is paying them back? If you’ve purchased the right property, your tenants’ rent payment should pay back the mortgage. You can see an example from my first home here. With my first property, the rent paid by my renters covers not only the mortgage but also all expenses! The rent pays for the mortgage, insurance, taxes, property management, and maintenance. In other words, my tenants are paying the bank back for the loan that I borrowed.

So, amortization is that slow increase of how much of the property I own vs. how much of it the bank owns. After 30 years I should own the additional 80% of the house without spending any more than my enitial payment of 20% of the property price.

Another example: Let’s say I’m able to save $20,000 a year for the next ten years, and every year I purchase a property with a conventional 30-year loan. After 40 years, I’ll own the ten houses free and clear (no more mortgages). So, in the first ten years I spent $20,000 per year, and after 40 years I’ll have ten houses for a total value of $1,000,000 (not taking appreciation in to account).

That’s how amortization is an amazing part of real estate.

Calculating Returns in Real Estate Investing

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:

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.)

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:

*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.