HOW TO ACQUIRE REAL ESTATE TODAY:
3 Parameters to Assess a Property
Investing can be challenging and confusing. Where should I invest cash today?
Real estate investments have enjoyed nice returns through appreciation. But the market has been changing. For example:
Inflation is slowing.
Rent growth is slowing.
Interest rates continue to rise.
Inventory is low for single-family and multi-family properties.
We already know that real estate can be a great investment for building equity and cash flow. Changing market conditions can dictate a change in strategy. Rising interest rates have squeezed cash flow on new acquisitions and are putting downward pressure on multi-family prices. This raises some questions:
Should I sell any of my properties now?
Should I be trying to buy more properties?
Should I make improvements to existing properties in my portfolio?
The answers to those questions depend partially on where you are in your journey to build a portfolio with enough passive income to fund your desired lifestyle.
Let’s look at three parameters that help us assess how to structure a deal with prospective properties or what to do with an existing property. Please note that the examples are simplified for illustrative purposes. For multi-family investments you can add more zeros and do this with partners.
ONE. Cash on Cash
This one is fairly simple. “Cash on Cash” is the cash flow we receive on a property divided by the cash that was required to acquire it.
As an example, suppose we paid $200,000 cash for a house, including closing costs. Market rent is $2,000 per month. After paying for taxes, insurance, property management and repairs we have $1200 per month cash flow. That works out to $14,400 per year.
Divide $14,400 by $200,000 and you get 0.072, or 7.2-percent Cash on Cash return.
What if we decided to get financing and leverage our return? Like a $150,000 mortgage at 7.0 percent. A 30-year mortgage at 7-percent would have a payment of $997.95. Let’s round that to $998. So our monthly cash flow would look like this:
Cash Flow $202
That works out to an annual cash flow of 12 x $202 = $2,424.
Since our out of pocket investment was only $50,000, the Cash on Cash would be $2,424 divided by $50,000, or 0.04848. That’s 4.8-percent Cash on Cash.
Hmmm. I thought that real estate returns are supposed to be better with leverage. But as you can see, the financing needs to be considered.
Let’s try the scenario with a $100,000 mortgage and see how Cash on Cash changes.
Using the same interest rate of 7-percent and 30-year term, the principal and interest are $665.30. We’ll round that to $665.
Monthly cash flow after paying expenses and mortgage is $2,000 – $800 – $665 = $535. So annual cash flow is 12 x $535 = $6,420.
To get Cash on Cash, divide annual cash flow of $6,420 by our initial investment of $100,000. We get 0.0642 or 6.42-percent.
While Cash on Cash is a simple calculation, it does not account for the appreciation due to inflation and improvements or any equity buildup due to loan amortization.
TWO. ROI, Return On Investment
What if we want to take credit for appreciation and loan amortization? ROI, or Return On Investment, can be used.
Let’s take a look at the first scenario above and assume 4-percent inflation. Remember we paid $200,000 cash. At the end of one year the property is worth $208,000. We could project out further, but will keep this simple.
Our return for the year would consist of $14,400 in cash plus $8,000 in appreciation, for a total of $22,400. Our total ROI is calculated as Total Return divided by Investment, or $22,400 / $200,000. This amounts to an 11.2-percent ROI.
That sounds better than just the 7.2-percent Cash on Cash.
So what happens when leverage is applied?
Using the scenario with $50,000 invested, we still get the $8,000 gain with appreciation. Remember the cash flow from year 1 was $2,424. So the return is $8,000 plus $2,424 or 10,424. Divide $10,424 by the investment of $50,000 and we get a total return of 20.8 percent.
But wait. There’s more.
We have not yet accounted for loan amortization.
Using the initial loan amount of $150,000 above and the same terms, the loan balance at the end of year one is $148,476. So we had $1,524 in loan amortization that should be included in our total return. Now the total return is $8,000 + $2,424 + $1,524 = $11,948. The total ROI is $11,948 / $50,000 = 23.9 percent.
That scenario provides a greater total ROI but gives up much of the cash flow. What if we used the other leveraged condition with only $100,000 in financing? Let’s use the same loan terms.
The appreciation is still $8,000. Annual cash flow is $6,420. Loan amortization is $1,016. So our total Return is $8,000 + $6,420 + $1,016 = $15,436.
To find the ROI divide the Total Return by our initial investment and we get $15,436 / $100,000 = 15.436-percent.
Here’s a table to summarize our results.
|Cash on Cash||7.2%||6.4%||4.8%|
We can work with different financing options to decide how we should fund a project. Are we more concerned with cash flow and cash on cash? Or are we seeking total return to grow our portfolio? We might even be transitioning from a building phase in life to one with more cash flow.
The calculations can be carried forward to predict how an investment may do for five or more years into the future.
THREE. ROE, Return On Equity
After a period of time of significant appreciation or amortization the initial investment becomes less relevant. It may be better to look at the returns as a function of equity. What might that look like?
Suppose we purchased a property for $200,000 and it is now worth $250,000. We put $50,000 down and financed $150,000 at 7-percent for 30 years. The loan has been paid down to $140,000. Does this sound a little familiar?
Our Equity is now $250,000 less a mortgage balance of $140,000, or $110,000.
Expenses have gone up as have rents. Now the rents are $2,500 per month. We are grossing $30,000 per year with $12,000 in expenses. So we have $18,000 per year cash flow before the mortgage payments of $998 per month or roughly $12,000 per year. That leaves us with approximately $6,000 per year cash flow.
Appreciation at 4-percent on a $250,000 property yields $10,000 per year.
We are gaining approximately $2,200 per year in loan amortization.
Our total return is Cash Flow + Appreciation + Loan Amortization. This is $12,000 + $10,000 + 2,200 = $24,200.
The Return On Equity is $24,200 divided by $110,000.
So ROE is 22-percent.
Over time, as our equity increases, we may find the ROE decreases. At that point we can consider refinancing or selling the property. Or we could simply enjoy the increased cash flow with a lower loan to value on the property.
When we are in acquisition mode, we can run different scenarios with the three parameters above: Cash on Cash, Return on Investment (ROI), or Return on Equity (ROE) What happens if we pay all cash? What about 50-percent down? Or 25-percent down? Cash on Cash, ROI and ROE each have their place when analyzing different investment and financing options.
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Mike is a retired aerospace engineer with a passion for real estate investing and teaching financial literacy. He lives with his wife in Daytona Beach, Florida.