Cash-Flow and Rates of Return | PREI 005
In today’s episode we discuss the importance of understanding and calculating a properties cash-flow and rates of return. Specifically we look at capitalization rates, cash-on-cash returns, and the total return on investment (ROI).
A good understanding of these numbers are required to make smart investment decisions and to be able to properly compare one investment to another.
We also take a look at a real world example available today from www.NoradaRealEstate.com.
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Cash-Flow and Rates of Return
Welcome back to Passive Real Estate Investing. I’m your host, Marco Santarelli. This is the show where busy people learn how to build substantial passive income and create wealth for the long term. If this is your first time here, welcome. We’re glad to have you. If you’re returning, welcome back.
Today’s show is about cash flow and rates of return. This is something that every investor needs to know. It’s important to know how your properties performing for you. Or if you’re analyzing a property because you’re looking to purchase, then it’s important that you know how to analyze that property to know what the rates of return are and to be able to compare property to other investment options that you have. This is a very important topic today. I’m going to break this down into two main sections, cash flow and then rates of return. Both are equally important because the rates of return come from the cash flow of that property.
Let’s begin by talking about cash flow. Cash flow is loosely defined as the income from a property that’s left over after all expenses and bills are paid. That’s a simplistic definition and it’s not exactly correct. Let’s break it down. Income is obvious, it’s the gross rental income that comes from a property. If you have a property and it rents for $1,000 a month, that is your gross rental income. Now, assuming that comes in every month, that will be what is collected by you or your property manager and from there, you would deduct expenses.
Sometimes you’ll have other income coming in from a property. It’s not that common but it is possible to have late fees from tenants who miss a payment or are late on their payment because rents are generally due on the first and late on the fifth. There may be a $50 or more late payment fee that will be charged and that’s added income for you. Not all that common, but on larger properties and sometimes on fourplexes, you’ll have income from a washer and dryer. For the most part, the income is made up of the gross rental income from that property.
When it comes to expenses, there’s a long list of potential expenses but there are few that you can’t get around. The largest expense you typically have will be property taxes. Property taxes will vary from state to state, county to county. They’re usually the highest expense and you can’t get around them. Property taxes will vary from about one percent to as high as five percent. Texas, for example, will average somewhere around 2.2%.
At the end of the day, property taxes are a mandatory expense that you will have. Some people are under the false belief that if you invest in a state or a market where property taxes are high, that may not be a good deal or it should be avoided because it cuts into your cash flow. That’s not true because taxes are relative to the income.
In most cases, again I use Texas as an example, you will find that even though you have higher property taxes relatively speaking, you also have higher income or rent. That income that your tenant is paying is going to make up for those higher property taxes. I say “higher” because again, it’s all relative.
The next most common expense, and I will say it’s a mandatory expense, is insurance. You have to have property insurance on your property in case there a fire or some other catastrophe. You always have to carry property insurance. Insurance is a commodity. It varies greatly from provider to provider. You could shop it around all day long. You’ll probably see $40 to $60 per unit.
Sometimes, if you’re in a FEMA flood zone or you buy a property near the water, let’s say the coast of Texas, you may be required to cover your mortgage with an extra policy called flood insurance. This is not always needed. Some people require it. It’s not mandatory in some cases but if you’re in a FEMA flood zone and you have mortgage financing, they may insist that you have flood insurance on your property.
Some properties on occasion will have a home owners association or what’s known as an HOA. Those HOA fees or association fees will vary greatly. If you’re in a market like California, they could be well into the hundreds of dollars. But in a state like Texas or the mid-west, you may not even find a property with an HOA. It’s great if you don’t have a home owners association, there’s no cost or expense for that.
Once in a while, you’ll have what I’ll call a light home owners association. They’re really not providing coverage and overseeing your property as a whole, like you have in a condo, but you may have a single family detached home in a residential neighborhood or an area that has a community home owners association. There may be a $10, $20, $30, $50 per month fee just to have that home owners association there.
They’re really just keeping the community clean and cohesive. They’re looking for people doing odd things like painting their house pink and whatnot. You can’t get out of that HOA fee but in some cases you’ll still find great opportunities and great investments that actually have an HOA fee. That’s nothing really to be worried about but it is an expense.
Next on the list would be your property management fee. Again, this does vary. What you might call a street rate would be ten percent. A lot of property managers will charge ten percent if you’re just walking in off the street and you have one property for them to manager. That just seems to be the going rate.
I’ve seen that management fee vary greatly. From as low five percent a month to ten percent or twelve percent. I’d say a normal range is between eight to ten percent. If you’re calculating and projecting or a running a proforma, use ten percent. If you know what those numbers are because you’ve already talked to the property management company, then you can go ahead and plug in that specific number, be it eight, nine or ten percent.
There may be some miscellaneous expenses that don’t necessarily show up on most rental properties, especially if you’re dealing with a single family home. But those other expenses would include water and sewer, which is often handled or paid for by the tenant. Garbage removal, gas and electricity, in other words, utilities, those are typically and often covered and paid for by the tenant. Snow removal and lawn care are, again, typically the tenant’s responsibility. This is especially true on a single family home.
As you get into larger properties like a fourplex or larger, you may have an outside company come in every two weeks to take care of the lawn or do snow removal. Those are miscellaneous expenses. You may or may not have them. If you have them, obviously plug them in. If you don’t, don’t worry about them.
There are two other expenses that I call soft cost. Everything I’ve just described so far are mandatory cost. You have to pay them. The bills come every month or every quarter or whatever, year, whatever the case is. There are two types of expenses that I call soft cost. They are actual expenses but you don’t have to pay for them on a regular basis, for example, monthly.
Let me give you an example. Let’s say you have a property and six months down the road, you have something break, something happens where you have to replace a fixture or the hot water tank stops working, it’s old, now you have to replace it. That expense has to be paid for and come out from your operating capital or from a reserve account.
If you don’t have a reserve account, which as a side note, I do recommend. If you’re not managing your properties that way and you’re actually just using your operating income to pay for expenses, then what you’ll want to do is budget something every month, whether it’d be four percent, six percent, eight percent. If it’s an older property and it had deferred maintenance, maybe you want to go as high as ten percent. You want to have a percentage of your income budgeted for future expenses. These are maintenance and repair items.
It’s good to budget something, whether it’s four, six, eight percent of your monthly income towards future expenses because it’s inevitable that you will have things come up. There will be other costs. You’re not paying for it this month, you may not pay for something next month, but at some point in time, it will come up.
The other cost that I call a soft cost is vacancy allowance or some people refer to that as a vacancy factor. Again, this varies. It’s very subjective. You talk to different investors, you’ll get different numbers. Some people will say budget three percent, some people will say six percent, some people will say eight percent. You could use a factor that’s one-twelfth of a year. In other words, one month. If you lost a tenant, you had a turnover, you’re basically budgeting one month’s lost income. Whatever you use, you have to budget something there.
Again, it’s not something that automatically comes out every month in terms of real dollars but it is something that you cover. If you do have a tenant move out or they lose their job or they have to get transferred and they have to break their lease and you’re going to be without a tenant for a short period time, at least you’ve budgeted for that vacancy. While your property manager is looking for a new tenant to replace your old tenant, you’ve covered or bridged that gap with that vacancy allowance.
Those are two soft costs that are mandatory to budget for. Obviously, if you don’t budget for them, you’re going to see those dollars that would have been there go straight into your pocket in terms of positive cash flow. The day will come where you’re going to need to cover some sort of maintenance item and that’s going to come out of your pocket. It washes out at the end of the day.
When you add up all of those expenses, what you have are your total operating expenses. When you add up all the gross income on your property and you deduct this vacancy allowance or this vacancy factor I was just talking about, you have your total operating income. When you subtract your total operating expenses from your total operating income, what you’re left with is known as NOI or net operating income.
That’s really the cash produced by your property every month or every year that is true profit. That is actually what your property generates as a standalone investment vehicle or asset. Put another way, if you purchase this property all cash, in other words, no financing, that property would generate that net operating income as income to you every month, every year.
If you have a mortgage, that’s known as debt service. That is a separate line item. It is not considered an expense even though some people refer to it as a mortgage expense. The mortgage or debt service is deducted from the NOI. What you have is your net operating income minus your mortgage expense, that leaves you with your annual cash flow or your monthly cash flow. That is your true cash flow from the property. That is spendable cash free and clear to you every month.
What you do with it is up to you. My recommendation, take that cash flow and purchase more investment property, or some people choose to accelerate their mortgage and pay it down quicker by applying that monthly cash flow back into their mortgage payment. They end up paying a 30 year mortgage in 25, 20, 15 years. You could accelerate that to as much as twelve.
I want to make a few comments about vacancy and repairs. Your property is not going to be leased 100% of the time. You will have tenants that will move out from time to time. They could stay for a year, they could stay for two, three years. I’ve seen and heard of tenants staying as long as seven years in a property. You have to be realistic and you should talk to your property manager about this. They can give you an idea of how long the average tenant stays in a particular area. They could also tell you how long it takes, on average, for them to re-lease a property based upon your property type and the tenant demand that they have.
You can get a number from them that you could use to budget for your vacancy allowance. Typically, you might want to use five percent, but you could use as much as eight percent. It just depends if you feel that property is going to turn over once a year, once every two years. Again, this is a subjective number. You can ask ten different investors about it and you’ll get ten different answers.
In regards to repairs, it’s inevitable. You’ll have repairs. Again, this is something you need to budget for and you may need to base that on the age of the property.
There’s also another type of expense or repair called a capital expenditure. This is your big ticket item. If you’re talking about heating or air conditioning unit or the roof, these are items that are known as capital expenditures or capex for short. Capex items need to be budgeted as well. This is something that you would into that one line item even though you could break it out into a separate line item. When you’re budgeting and forecasting what your repairs and maintenance might be, you want to factor in the lifespan of your hardware and your property, such as plumbing systems, the appliances and all that good stuff.
When you put this all together in terms of cash flow, you have your total operating income minus your total operating expenses, and that leaves you with your net operating income and then you subtract you mortgage expense or your debt service. What that leaves you with is your before tax cash flow. That is your true, in your pocket, spendable cash that your income property is producing.
When you map out all of your properties’ income and expenses and you put them into a statement, it’s referred to as an APOD, an annual property operating data sheet or data statement. The APOD is really just a breakdown in a spreadsheet format of your properties income and expenses and cash flow. That really is how you can take a quick snapshot or an analysis of a property’s performance especially in the first year of ownership.
When you own this property or you’re looking to purchase this property, what you’re going to do is plug in the actual numbers. That gives you a true picture of what the property will do or is doing at the current time. However, if you want to project that into the future, into years number two, three, four, etc., what you have is a proforma. What you’re doing is projecting a property’s income and expenses beyond the first year.
It’s the unknown but you can make some educated assumptions about where that is going. In other words, the APOD shows your income, operating expenses, net operating income, your debt service and cash flow in a very brief but comprehensive manner.
Let’s shift gears and talk about the return on investment. How do you know if you’re getting a good return on your real estate investment? Calculating the ROI or the return on investment on your income property is critical to knowing how your investment is performing. Or if you’re purchasing a property and you’re looking at one property compared to another property and you want to make a comparison, it’s the return on investment that’s going to show you how one property performs and compares to another.
In order to make that comparison successfully or to see how well your property is performing, you have to look at three specific numbers. The cap rate or capitalization rate is used to compare an income property with other similar income properties. It could be used to place a value on a property based on the income it generates.
One side note here, a cap rate is typically and commonly used with commercial properties. It is really not used all that often with residential properties. In fact, it really doesn’t fit well with residential income property. However, it is a simple metric to calculate, it is commonly used and easily understood. Real estate investors talk to one another about cap rates because it is a really simple measure and it’s easy to compare one property to another at a very superficial level.
The reason I don’t like the cap rate all that much is that it doesn’t take into account other factors about real estate that make real estate unique and really dynamic as far as an investment class. The cap rate is calculated by taking the property’s NOI or as you recall, the net operating income, and dividing it by the property’s fair market value. Obviously, the higher the cap rate, the better the property’s income. The cap rate’s very simple to calculate. It’s just the NOI divided by market value, that’s your cap rate.
The cap rate merely represents a projected return for one year, as if you had bought that property all cash, in other words, no financing. Real estate investors, we normally don’t buy properties with all cash. We like to borrow money and get a mortgage and leverage our investment capital.
You’re better off looking at a measure called a cash on cash return when you want to evaluate a property’s financial performance. The cash on cash return on investment, in other words, the cash on cash return as it’s known for short, is simply the before tax cash flow divided by the initial cash you invested.
As you recall, the before tax cash flow is calculated by subtracting your annual mortgage payment from the net operating income, which is simply the income from the property minus the operating expenses. Let’s take a simple example. Let’s say you’re purchasing a $150,000 property, you would need a 20% down payment, which is $30,000. I’m not including the closing cost into that, that might be a couple thousand dollars. If you really want to calculate this properly and thoroughly, you would want to include your closing cost.
For simple math, let’s just say you spent $30,000 towards the down payment on $150,000 property. Let’s also assume that this property generates $3,000 per year in before tax cash flow. What you do is you take that $3,000 before tax cash flow and you divide it by the $30,000 of down payment capital you put up. That gives you ten percent. Your cash on cash return is ten percent.
This is a rather conservative example. There are many investment opportunities through our network where the cash on cash returns are in the mid to upper teens. In some cases, even the 20% range. Another thing about the cash on cash return that is really nice is that it’s a simple calculation. Not only that, it allows you to show what yield your money is making today based on the cash flow alone. It ignores things like appreciation and amortization of loans. Everything else is just added value, added returns.
The cash on cash return is nice because it allows you to make a direct, immediate comparison to other investments such as mutual funds, notes, stocks and the stock market and it’s real time. In other words, it only focuses on cash flow and nothing else. The cash on cash return is a good measure of a property’s first year financial performance. However, it does not include additional benefits that are achieved through real estate such as the amortization of the mortgage and any future appreciation.
In order to calculate that, what you need to look at is the total return on investment. The total return on investment provides a much better and certainly a more complete measure of a property’s financial performance. That’s because it factors in amortization of the loan as well as appreciation that’s gained over time.
In order to calculate the total return on investment, you need to calculate your before tax cash flow for each year of expected ownership. Let’s hypothetically say you own it for ten years. You need to run a projection and say, “This will be my cash flow each year throughout that ten year period.” Then you need to calculate what your net proceeds will be if you were to sell that property.
That’s not implying that you need to sell that property or that you even will. You need to make an assumption that if you did sell that property at some point, whether it’s this year, next year or ten years from now. You need to calculate what those net proceeds will be from the sale of that property. The reason is you’re going to need that number in order to make this calculation.
Don’t worry about getting lost in all the math here. I know this is pretty thick for a lot of you. There’s spreadsheets and online applications and websites that can help you calculate this by simply plugging in numbers and it will just run a complete calculation.
In fact, our website does that for every single property that is on our website. All the numbers are there, all the calculations are made for you. In fact you can even go and change a lot of the numbers and the assumptions and it will recalculate for you to show you what your rates of return are and cash flows for all years, 30 years into the future. Don’t worry about having to pull out a calculator and you calculate all this. There are many tools and spreadsheets and websites that can help you in factoring this.
Let’s take our example and assume that we plan to sell it in five years with an average annual appreciation rate of four percent, which is a little bit conservative. It’s below the average rate of inflation so four percent is a good number to work with. After five years, our $150,000 property would be worth a little over $182,000.
At that point, our mortgage balance would be about $111,000, just a little bit over that. Remember that we started here with an 80% loan of $120,000. That’s 80% of the $150,000 purchase price. Again, don’t get lost in the math, just follow me through. I’m just trying to illustrate the numbers here.
We’re going to make a few other assumptions. Rather than go into a lot of detail here in this podcast, what we’re going to do is just take a look at how the numbers pan out in terms of your rate of return. I will also mention that you can follow along in this example by downloading our free report, it’s called The Ultimate Guide to Passive Real Estate Investing. You can follow along in great detail where I break this down number by number.
Using the figures above, our net proceeds from the sale of this property in five years would be about $62,000. Additionally, our before tax cash flow after these five years would total about $15,000. That’s assuming no annual increase in the rents or cash flow. If you just do the math, again, this is illustrated in the guide, you will see that we have 156% total return on investment on this property after five years.
That is what can be achieved with real estate as an investment class. Compare that to any other investments, see if you achieve that same rate of return anywhere else. Real estate is incredible.
However, the total return of investment still can be a little short sighted when you use it in isolation. That’s because the total return on investment does not measure the property’s financial performance as it relates to its tax benefits. Mainly, that’s the ultimate tax deduction depreciation. If you thought that was great, it gets even better.
There’s another metric I want to share, which is not exactly a rate of return but it is a quick measure that I like to use. It’s called the rent to value ratio or what I call the RV ratio for short. The rent to value ratio provides a quick measure of a property’s cash flow and income potential. It’s a litmus test and it allows me to quickly analyze a property without having to look at all the numbers in great detail.
I could tell if a property will be profitable or not just simply by looking at the RV ratio. It is conceptually similar to the price to earnings ratio that’s used to determine whether a common stock is over or undervalued. Our opinion is that an RV ratio of about 0.7% is the minimum with an ideal number closer to one percent. Obviously, the higher that number, the better.
How do you calculate the RV ratio? You simply take the gross monthly rental income and you divide that into the current fair market value of the property. For example, let’s say you have $100,000 property, that’s what it’s worth today. That property rents for $1,000 per month. You would have a one percent RV ratio. The thousand divided into the $100,000 gives you one percent.
That is a baseline, a floor, that is really what I look for in a market to find a healthy market that the numbers make sense. When you have an RV ratio of one percent, odds are the numbers on that property are going to look very good.
Of course, you don’t buy a property based on the numbers alone. You want to consider the market, the neighborhood, the teams that’s working with you, i.e. the property management company. You have to look at a lot of factors. This quick metric allows you to evaluate every single property quickly and easily before you even start doing due diligence on it.
It’s one of our many rules of thumb to quickly screen for potentially good properties and good investment opportunities. Try and stay above one percent. One percent is good, it’s the floor, and properties will work down to 0.7%, 0.8%. Obviously, you’re going to find a balanced market at the one percent range.
How do you improve your cash flow and your rates of return? The simple way and the most obvious way is to increase your rents. If you can increase your rents, you increase your returns and you increase your cash flow. That’s not always necessarily possible even though that happens with time and over time.
The quickest and the easiest and the simplest way is, if you’re looking for investment property, look at markets around the country where you have higher RV or rent to value ratios. When you compare markets around the country and you look at the RV ratios, it gives you an idea in a quick manner of where markets are overpriced in terms of property values related to that rental income and markets where they’re undervalued. The result is often lower cash flow and always a lower rate of return in markets where you have higher property values and higher property values relative to those rents.
If you take a look at a property in San Diego for example, with a median sales price of about $465,000 and a median rent of about $2,550, you divide those numbers and you’ll get 0.5%. That’s a very low rent to value ratio. Therefore, that property is going to produce a very low cap rate. You’re probably looking at a range of three to maybe as high as six percent. That’s low, it’s not good enough. You can certainly do much better.
If you look at other markets, you’ll find that you can find lower priced properties where you can buy more property for your investment dollar with higher cap rates, higher cash on cash returns. The same are better in terms of cash flow. Often you will see your cash flow increase by investing in markets that make more sense than a market that you may be considering because of its convenience to you or your proximity. Again, looking at a market’s rent to value ratio is a quick way to compare one market to another and get a good idea of its potential.
Let’s pull all this together and look at a real world example. This is an actual investment available today on our website in Indianapolis on Rouark Circle. In fact, let’s just call this the deal of the week. This four bedroom, two and a half bath house can be purchased for a whopping $103,000. It’s 2,200 square feet built in 1973. It’s only $47 a square foot.
If you think about that, if this house burned down, your insurance company would have to spend more than that $47 per square foot to rebuild this house. That implies that you’re buying this below replacement cost. It has a two car attached garage and it’s in a great neighborhood. It’s what we call a B+ neighborhood or B+ grading.
It has a tenant. That tenant is paying $1,100 a month. There’s $80 a month in property taxes, about $50 a month in insurance. It has a property management fee of about $88 a month, which is I believe eight percent. This property can be acquired with 20% down, which is about $20,600. All in, including your closing cost, you would have an investment that would take about $23,000 to purchase.
Let’s look at the numbers. If you deduct your vacancy allowance, your property taxes, your insurance, the maintenance reserve and property management, you would have a net operating income of $9,264 per year. Let’s assume you finance this with the minimum down payment of 20%, that would leave you a mortgage expense of $5,300 per year. That leaves you with an annual cash flow of $3,956. Let’s just call it $4,000 a year net positive cash flow. In other words, that’s $330 a month.
That’s talking about the cash flow. This is measured in dollars. Let’s look at this from a percentage point of view, in other words, what is the financial performance of this property? If you do the math, and this is on our website, you can go and take a look at NoradaRealEstate.com, the cap rate or capitalization rate is a healthy 8.6%. If you look at the cash on cash return, which is what you invested in this property divided into the annual cash flow, it’s a beautiful 17.1%. That is a great healthy and attractive rate of return.
Some people might not believe it, but when you actually amortize this loan a little bit because you’re making monthly mortgage payments and you factor in a nominal rate of inflation, in our case, we factored four percent, which is a somewhat conservative number. If you add up what your returns are from all the different factors of this property at the end of the first year, your total return on investment is 47.8%. That is absolutely incredible.
If you really want to take a worst, worst, worst case scenario, let’s just say this property performed only half as good as what these numbers show. These are actual numbers, by the way. Let’s just say, you had half of this. You would have approximately 8.5% cash on cash return and a 24% total ROI. Again, it’s still incredible. That’s what real estate is and has been the best and most historically proven wealth creation vehicle in I guess recorded history, I’ll venture to say.
That about wraps it up for this episode. I know that this episode had a lot of numbers and formulas and it might have been a little hard to follow or thick for some people. But understand that you really need to understand cash flow and why that’s so important because these are investments and they need to generate income for you. Also, rates of return of are important in terms of being able to measure the performance of your property and to be able to compare one investment to another.
Download the free report from our websites at NoradaRealEstate.com or you can go to PassiveRealEstateInvesting.com and download our Ultimate Guide to Passive Real Estate Investing. While you’re there, you can submit any questions or topic suggestions that you have.
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