As I enter my last semester of Auburn’s Master of Real Estate Development program I wanted to use the blog of Developing a Developer partially as a series of “What I Learned.” The first post in this series has to do with real estate investment analysis.
As I entered Auburn’s program, one of my goals was to gain a substantial financial analysis platform that I could take with me long after my days at school. I can say that through a little blood sweat and tears (mostly tears) I feel that I have met that goal.
However, I can also say the following: most of the tools that I gained in this field of study are simply not needed to perform the majority of everyday deals that cross the table of the everyday real estate investor. While the “Back of the Envelope” method might not be sufficient in analyzing the purchase of a 50,000 sq. ft. office complex, or have you ready to sit for your CCIM (Certified Commercial Investment Member) designation, it will answer most questions about common rental income property.
So, you may ask, “What is this magical “Back of the Envelope” system and how complex is it to understand?” No, the idea was not named after the great financial guru Dr. Envelope. It actually is intended to be so simple that an investment can be proved as feasible with a pen, a little bit of paper, and some basic knowledge. No financial calculator, no complex Excel file, and no expensive real estate software such as ARGUS. So, lets start by asking two questions:
Q: What is the most important thing to an investor?
A: Cash flow
Q: How do you determine cash flow?
A: Income – Expenses = Cash Flow.
Wow, there you have it, what I learned over the past two years! Ok, ok, lets look at this second question a little more. Do you have your napkin ready? If so, lets start at the top. What numbers do we need to know?
- Gross Income (monthly)- This is simply what amount of rent you expect to receive
- Monthly Expenses
- Property Management Fee: If you are not going to manage yourself
(Note about expenses: Do not fudge on vacancy and repairs. I’m sorry, but you will not be the first landlord ever not to experience any vacancy or repairs on a property.)
3. Monthly Gross Income – Monthly Expenses = Net Income. If the number is positive, Congratulations, keep going. If the number is negative, throw the napkin away and never turn back!
4. Calculate Returns- We’re about to move from 1st– 2nd grade math to 3rd-4th grade math (Quick, open the calculator app on you phone.) There are two important numbers that you will need to focus on.
A. Cap Rate: This simple number tells you if you are buying a good deal.
Net Annual Income / Purchase Price = Cap Rate
(Note about Cap Rate: This is simply giving you a percentage number. Simply put, the higher the percentage, the better a deal. You have to decide how low you will go. Personally, I think you cannot go below 7% even in the best market. If the number is 8% or better, you are in the clear.)
B. Cash-on-cash Return: This number is the how much you are receiving on your actual investment. If you purchased the property with cash, this return will be the same as Cap Rate.
Net Annual Income / Total Cash Investment = Cash-On-Cash Return
(Note about Cash-on-cash return: Remember to include the mortgage payment since you are focusing on financing.)
Done! With these few calculations you should be well on your way to knowing if your next deal is a winner or a looser. Lets take a look at an example.
So, good deal or bad deal? You tell me…