Don’t Invest in Real Estate Until You Do Your Homework

If you’ve read any of my previous articles you most likely know by now that I am a big fan of hard assets. Precious metals are hard assets yet buying physical gold and silver is not an investment! It is simply a wise move to help you and your family maintain your purchasing power when the government devalues the currency (and there’s sure plenty of that going on today!)  Keeping dollars in the bank (any bank) today is like putting your money under the mattress (some think it’s actually worse than that).

Real Estate is a hard asset however it may or may not represent a true investment. For years people who owned their own homes considered their residences an investment. Sure, it may have been the “cash cow” for the years prior to the economic Bust when real estate inflationary value was out of control. What most people called “property appreciation” the classic (not modern) economists were calling “a Boom in the making”. It makes me think of a client of mine, a formerly very successful builder, that was telling me how only a few years ago he was worth millions of dollars. Not anymore! His was simply an “artificial prosperity”. Artificial prosperity is created fast (usually during an economic boom) and lost as fast (usually during an economic bust).

Should you decide to invest in real estate take notice that your personal residence is not an investment. Your home is not generating an income for you…unless you own and live in a duplex, triplex, or any other kind of multi-family and you collect rents from your tenants. A real estate investment could be a house, an apartment complex, or a commercial property that provides a monthly cash flow for you. Nowadays I come across plenty of investors who prefer the small residential properties or apartment complexes. This type of investment satisfies one of the requirements for what I call “healthy investment” criteria. It’s a hard asset that provides housing to those who have no ability to own their personal home or have no desire to take on such a responsibility. In addition, there is a large influx of newly evicted homeowners which will most likely go up as more defaults are scheduled to occur in the next few years on the 5 and 7-year Option ARM loans (these loans are due to reset at higher monthly payments and had a negative amortization to start with.)

So, if you are a novice at this kind of investing, how do you determine in a few minutes if a particular property is an opportunity worth further investigation? Following are some of the things that I look at when evaluating a real estate investment.

1. The local economy. First of all let me just say that it doesn’t have to be a big city. I say that because you can invest in a metropolitan area with a large percentage of its population that is unemployed. So what good does it do to you to buy real estate at a bargain price in an area where people can’t afford the rent? Familiarize yourself with the local economy by doing research on the city’s unemployment, major employers, recent news, and crime statistics.

2. Condition of the property. There are four kinds that I can think of: fully renovated, average, poor, and dilapidated. The first kind is self-explanatory and after an inspection you can probably be assured that for the next 3-5 years no major repairs should be required. The average condition is what a thorough inspection should disclose: the work and its estimated cost during the next 5 years. The poor condition is the type where you accurately need to estimate a full rehabilitation; and the dilapidated is the kind that you buy to bulldoze off and rebuild from ground up. This is the case where you ought to know the value is only in land and there may be a while until it can provide you with cash flowing revenues. It takes time, building permits, and lots of headaches. Beside that the prospect of financing the construction is extremely limited at this time.

3. Return on Investment. I saved this for last because this is very important and it needs to be elaborated in more detail. This formula is based on the total amount of money invested and it differs between an all-cash transaction and one where leverage is involved. An all cash transaction will show a lower ROI rate than when leveraged but there are benefits that may offset the lower rate. The two that come to mind are the peace of mind that you own the property free and clear, and eliminating the interest you’d pay on the mortgage.

The way to calculate the ROI is by first subtracting the annual Operating Expenses OE (current and/or projected) and the vacancy factor VAC (5 – 10%) from the total annual rental income (GSI for Gross Scheduled Income). This first calculation determines the Net Operating Income (NOI). Once you have this figure you divide it by the total Purchase Price(PP) and the result is the ROI also known as Capitalization Rate (CAP Rate) in the commercial sector.

GSI – OE = NOI
NOI / PP = ROI or CAP Rate

As an example let’s say you purchase a property for $100,000. The annual rental income is $15,000 and all expenses are $5,000.

$15,000 (GSI) – $5,000 (OE) = $10,000(NOI)
$10,000(NOI) / $100,000 (PP) = 10% ROI or CAP Rate

Since there is no mortgage in this case the property’s NOI represents the annual cash flow. In ten years, Ceteris Paribus, this investment would be fully recouped. In other words based on a $10,000 annual cash flow it would take 10 years to fully recoup your original $100,000 investment. ($100,000 / $10,000 = 10 years.)

If financing is involved things change because you don’t invest your entire $100,000 and you’ll make mortgage payments. In this case here are the formulas you want to use.

GIS – OE = NOI
NOI – DS = Cash Flow
NOI / Capital Invested = ROI

Remember these are all calculated on an annual basis. The Debt Service(DS) is the monthly P&I (Principal & Interest) on the loan multiplied by 12 months. The Capital Invested is the down payment plus all other costs that you invested from your own pocket (such as the cost to renovate). In our previous example if the property was already renovated and if the down payment was 30% of the purchase price here is how the figures would look like.

$15,000(GSI) – $5,000 (OE) = $10,000(NOI)
$10,000(NOI)- $5,700(DS) = $4,300(Cash Flow)
$4,300(Cash Flow) / $30,000(Capital Invested) = 14.3% ROI

The DS was calculated based on a loan starting balance of $70,000 amortized over 25 years at an annual rate of 6.5%. In this case it should take you about 7 years to recoup your investment ($30,000 / $4,300). However, by using financing the property won’t be free and clear until the loan is paid off. After seven years you’ll still have about 18 years of mortgage payments (if you make the minimum required payments.)

What I have just described is a quick way to determine if an investment is worth exploring. If a preliminary ROI is at 8, 10, 12 or higher percentage, and if the other two criteria look good in your eyes it is possible that such a real estate investment may be a good opportunity. Also, because the ROI is higher when financing is used many investors prefer to leverage their investment when they have the ability to do so. One reason is that the $100,000 used to acquire just one property in an all-cash scenario could be used to buy two or more properties when loans are secured. And because many real estate investors view their investments as long-term the end goal is what prevails, and that is the number of properties $100,000 can buy today.

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