The Simple Formula For Success in Real Estate

By | January 1, 2015

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Looking at the numbers in real estate:

Before you identify the several neighborhoods that interest you, you first must set your criteria on what type of rental property you want. Aside from the features of the neighborhood and amenities in the building, you need to treat this property as an investment and analyze the numbers much like purchasing a business or a stock. All of these investments throw cash flow to its owners/investors after deducting all expenses from revenue. Stock investors use the P/E ratio to basically show how expensive a stock is for the earnings the company produces. Much like this, rental property (especially commercial property), is valued on the rent it pulls every year times a market multiple. The higher the multiple, the more expensive it is based on the earnings it produces every year. I will start with the basics of an income statement of a rental property.

Let’s first look at the income statement of a rental property. This method of analysis is relevant no matter how many units the building has; from a single family house to a multifamily apartment.

The first item that you will account for is the income of the property.

Income (operational) involves your rents, change laundry income, application fees, and any other sources of income that the building generates

Expenses (operational) involve your property taxes, management, insurance, and maintenance

 

Income – Expenses = Net Operating Income (NOI)

 

Net Operating Income is your operational income and vital for your day to day business. If NOI is negative, then something really bad is happening and substantial changes need to happen immediately.

 

Net Operating Income – Debt service = Cash After Debt Service (CADS)

 

I will start with cap rate as it is one of the most widely used ratios. Cap rate is net income/purchase price. It basically tells you the return that the property is generating on an annual basis.

 

Cap rate:

Cap Rate = Net Income / Purchase Price

 

For instance, if a building is purchased for $1,000,000 sale price and it produces $100,000 in positive net cash flow (the amount left over after fixed costs and variable costs are subtracted from gross lease income) during one year, then:

 

$100,000 / $1,000,000 = 0.10 = 10%

 

Capitalization rates also show how fast an investment will pay for itself in net cash flows. In the example above, the purchased building will be fully capitalized (pay for itself in net income) after ten years.

 

Return on Income (ROI) = CADS/Initial Investment

This ratio tells your return on your initial investment, instead of the purchase price like in cap rates. This is generally a better measure of your return than cap rate because it takes into account, only the cash that you put in, and not any debt that you use. You can compare this rate of return to other investments to determine which gives the highest returns, and therefore help make your decision in what to invest in. You wouldn’t put your money in a savings account that gives only 1% if you invest in rental property that gives 10% yearly returns.

 

ROI tells you how much you can afford to pay as an investor using leverage/debt. Your ROI must be greater than the interest rate on debt.

 

 

Loan to Value (LTV) = Total mortgage/purchase price

This is just a ratio that tells you how much leverage you are using in terms of a percentage. Bankers often use the ratio when giving out commercial loans, and will require a down payment based upon the LTV that they are comfortable with.

 

You might be scratching your head with all of these numbers and formulas I am throwing out there. No worries, I have taken the liberty of creating my own property analyzer on excel which will automatically calculate key ratios outline in this chapter and will give you a visual income statement that you can edit.

 

I have asked many successful real estate investors on how they look at their properties and the first thing that they do is make sure the numbers work. What I mean is, making sure that the deal looks good on paper, and cash flowing enough money every month. This is what several real estate investors have drilled into my forehead: make sure the rental property follows the 50% rule.

 

The 50% Rule

 

The 50% rule states that the overall cost of maintaining a property over the long run is 50% of your rent. The rent would be an average estimate based on the location and current demand for the particular property. In order to figure out net income, you must subtract rent from expenses (Gross Rent – Expenses (50% of Gross Rent) = Net Income. The 50% rule excludes mortgage payments as well. In order to find out your cash flow, you subtract your Net Income to the mortgage payment. Since we are investing for cash flow, you need to make sure that the rental property is throwing off cash flow every month. A desirable deal would involve $100 a door in cash flow every month, or $100 per living unit (under the 50% rule).

 

You may be scratching your head and wondering why expenses are 50% of rent (sounds too high right?). The 50% Rule is nothing more than the historical average of operating expenses throughout the United States over the long run. It includes the typical expenses like taxes, property management, insurance, repairs, maintenance, grounds keeping, and advertising. It also includes gradual wear and tear of the building, new roofs, and installing new water heaters (to name a few bigger repairs). As you own the property over the long run, you will have to replace these higher cost parts to maintain the building. The 50% rule accounts for all of those expenses yet to be deducted.

 

The vast majority of the real estate properties that you see on the market will not meet this criteria. Although this rule is simple, the 50% rule points out a two specific things that you need to focus on initially. The two factors that determine whether a real estate deal good or not is rent and purchase price. It is important to have a market rent that is high enough to subtract 50% in expenses, then subtract a mortgage payment. Another variable that is crucial is the purchase price of the rental property. This is because it dictates how much you must pay a mortgage every month.

 

Several real estate mentors of mine have stuck to this rule, and have told me to obey it as if it were part of the ten commandments. If you want to be successful in real estate, you need to look at a lot of deals, and you need to be disciplined when you purchase.

 

It is important to leave your emotions out of the table. Do not fall in love with the property, and look at it purely from a numbers perspective. You should be asking yourself, does it cash flow according to the 50% rule?

 

This should be the first criteria on your list because it is one of the most important. I have met some investors that tell me the 50% rule is too rigid, and that their properties still cash flow despite not applying the rule. I even admit that my expenses for my rental property does not run at 50%. What I want to convey to you right now is to be picky. A good investor is picky when it comes to investments. They demand a high rate of return for the money that they worked so hard to save. I have had several investors tell me that it is normal for them to look at 100 properties before considering 10-15 potentials, and closing on 1. 1 out of 100; that is how selective a successful investor should be.

 

The 2% Rule

 

Another rule the you must consider is the 2% rule. Under the 2% rule, you must look for a property where the rent that it pulls in is 2% of the actual purchase price. Note, if you can find a property that follows the 2% rule, it will cash flow.

 

Both the 50% rule and the 2% rule work together. If you collect 2% of the rent each month, you’re collecting 24%/year. If expenses eat 50%, your NOI is 12% a year. Interest will probably run you about 8%. That leaves you 4% of the purchase price each year as profit. If you only collect 1% each monthly, and pay 50% in expenses, that leaves you an NOI of 6%. Interest is going to take all that and 2% more. If you have an amortized loan, you’ll have a bit less cash each month, but you’ll get that back when you sell.

 

Sometimes people say, well, I’ll put a big down payment on the property to try to make a higher price work. Say 50%, and assume 1% rent. You still have the same 6% NOI. But, now your interest cost is only half, or 4%. So, it looks like the property cash flows 2%. If you look at it that way, you’ve invested that 50% into an investment that returns nothing. Or, if you look at it as a cash on cash return, you’re 4% on your money. Less than bank CD’s.

 

Reflex, you say its impossible to find a property in your area that will cash flow using these numbers. I assume you really mean its very hard to find a property that meets the 2% guideline. True in many places, including right here. But, if you pay more, you won’t make any money.

 

Other Factors to Look at in Real Estate: Location

 

As you are searching for more real estate, you may notice that the 50% rules and the 2% rule works really well in areas that are less developed, and even dangerous. This is true in many locations because people are willing to pay a premium to live in places that are more desirable, and may fall out of range for the average investor if you do not have a substantial down payment. When looking for your first rental property, you may not be able to buy the best locations at the center of town. Your best bet is to look for neighborhoods with future potential for development.

 

Neighborhoods

Location is key in any kind of real estate. The three most important aspects of real estate is location, location, and location. This may be a very common statement in real estate, but it is very true. The type of neighborhood that you purchase your rental property in will influence the type of tenants you attract, and how often you face vacancies. For example, if you buy in a neighborhood near a university, the chances are that your pool of potential tenants will be mainly made up of students and you will have a pretty high turnover rate. Your property will be empty during summer, when students tend to return back home, and will be full during the fall semester with fresh tenants. You will want to be aware of the type of tenants you will attract. Will they be a blue-collar family making $40,000 a year? College students? Low income families? City-data.com can provide valuable information on the demographics, average income, and other key statistics to give you a general idea.

Jobs

Jobs are the lifeblood of any city. People go where the jobs are. Your ability to attract good, paying tenants depends on the employment rates of the area. Look for locations with growing employment opportunities. What kinds of big companies are in the city and employing people? If you notice news that a major company is moving to the area, then you know that the workers will move to the area. Jobs also have an effect on housing demand. If there are more jobs in a city, they will attract more people, and with more people comes more demand for housing. This is good for rental rates and housing prices.

Amenities

Check the potential neighborhood for current or projected parks, malls, gyms, movie theaters, public transport hubs, and other things that attract renters. Tenants will be attracted to these types of amenities because they will want to be near parks and have fun on the weekends. Areas with good amenities will command higher rents because there is a higher demand to live there. You can find this type of information through promotional literature that the city hands out (usually for tourists).

Property Taxes

Property taxes are not standard across the board and, as an investor planning to make money from rent, you want to be aware of how much you will be paying in taxes. High property taxes are generally associated with good neighborhoods, and not necessarily a bad thing. You can likely attract a good tenant who will want to stay in that neighborhood for a long time. Be sure to check the property taxes. Many real estate MLS listing websites will include the property tax information. You can also find this information at the town’s assessment office, or you can ask a Real Estate agent who works within the community to give you an idea of the property taxes. I will discuss property taxes in further detail later on my website. You can pay less in property taxes and even get a refund when you close on a deal if you know what you are doing.

Schools

Prospective tenants look for good schools to live around. They may have children or plan to have children, so schools are a key factor in their decision. When you have found a good property near a school, you will want to check the quality of the school as this can affect the value of your investment. If the school has a poor reputation, prices will reflect your property’s value poorly. Although you will be mostly concerned about the monthly cash flow, the overall value of your rental property comes in to play when you eventually want to sell it someday.

Crime

No one wants to live next door to a warzone. Go to the police for accurate crime statistics for various neighborhoods, rather than asking the homeowner who is hoping to sell the house to you. Websites like city-data.com can provide you with statistics on crime that could help to narrow down your search. Items to look for are the past crimes committed, vandalism rates, serious crimes, petty crimes and recent activity (growth or slow down). You will also want to ask about the frequency of police presence in your neighborhood. Crime is an important factor because you cannot really control the level of crime in the neighborhood. What happens when you receive calls at 4am that your house got broken into or vandalized. Avoid this at all costs, as constantly repairing all of these damages hurts your cash flow. You will lose money from this. Be aware of the level of crime in your area.

Future Development

New retailers or fast food restaurants spend a lot of money on research and marketing and have years of experience in knowing which locations have the most foot traffic or future growth. If there are new malls and commercial strips, why not use their marketing research for your own benefit? Usually when you see new projects and developments, that is a good thing for your property or prospective location. That means that other businesses think that this area is good and that there is potential for growth in it. However, watch out for new developments that could hurt the price of surrounding properties by, for example, losing parks and green spaces to condos/new housing. The additional condos and/or new housing could also provide competition for your renters, so be aware of that possibility.

Amount of Listings and Vacancies

Check out craigslist for apartment listings and housing. If there is an unusually high amount of listings for one particular neighborhood, this can either signal a seasonal cycle or a neighborhood that has “gone bad”. Make sure you are aware of the rental market in the area. Vacancy rates give you an idea of how easy it will be for you to find tenants. High vacancy rates will force landlords to lower rents, while low vacancy rates will have higher rental rates.

Rent

Knowing the rental rate of your key location will be crucial for you success in real estate. After all, the majority of your rental income will be coming from receiving rent from the tenant. You need to make sure that your rent will cover your mortgage, property taxes, insurance, property management, maintenance, and other expenses every month. I can wrote a whole chapter on this subject so I will cover this more in detail in the future. But it is safe to say that if you are charging the average rent, but cannot cover your mortgage payment, taxes and other expenses, then you have to keep looking. Be sure to account for what will happen in the next five years. If you can afford the area now, but major improvements are in store and property taxes are expected to increase, then what could be affordable now may mean bankruptcy later.

Natural disasters

Be sure to know if an area is prone to floods, tornadoes, or even earthquakes. Extra insurance is necessary and may eat up at your profit. My neighbor always had to pump out water from his basement whenever it rained really hard the previous night. You don’t want to buy a house with that sort of problem. Before you buy, check the property carefully by ordering a quality property inspection.
How to get information on your location and rental property:
Talk to tenants, real estate agents, property managers, and research online. They are the eyes and ears of a location so they know all the details of a particular area. Renters will be far more honest about the negative aspects of the area because they have no investment in it. If you are set on a particular neighborhood, try to visit it at different times on different days of the week to see your future neighbors in action. Check out the area at night and be sure to notice if anything strange happens (you can be in your car observing the neighborhood). A lot of neighborhoods may appear safe during the daytime but may turn dangerous at night.

 

So this is a general overview on how to select successful real estate investments. please like below if you found this useful and message me if you have any questions! Sam

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