The Magic of Income Property Math

duplex

duplex

How Income Math Is Magic

Owning income property is the key to magic money. Don’t believe me?

Think of it this way. Let’s take a small income property, say a fourplex. A quick way to figure the value of a fourplex or a duplex or triplex is to take the NOI [net operating income] and multiply by 10 or 12, the going rate here in Southern California.

So for example, a fourplex has four equal units and each is rented for $1000. Monthly income is $4000 and yearly income is therefore $48,000. The owner pays water and garbage collection for a total of $300 per month or $3600 per year. The taxes and insurance amount to $5000 per year and repairs about $2000. Subtracting these expenses from the income of $48,000 gives us the net operating income of $37,400. Multiply that by 10 and the value of the property is $370,400.

Rents have been going up all over the country and especially here in Los Angeles, so it’s time to raise the rent to current market rates.  Each unit will now rent for $1100. Yearly income becomes $52,800 and, assuming expenses stay the same, the NOI  $42,200. Multiply that by 10 and the value of the property is now $420,200. Magic. Pure magic.

For every extra dollar in increased rent, the value of the property goes up $10. This is truly magic math. Almost all the gains are passive. This kind of math is much more favorable than paycheck math, small business math or stock investing math.

More Magic

In the above example, the owners have not only increased the value of their property, but are also receiving a monthly income of $3500. If the property also has a mortgage, not included in the NOI, the tenants are paying that mortgage, not the owner. 

Many owners of income property fail to keep their rents at market rates. Now you can see why this is potentially catastrophic in the event that they wish to sell the property, take cash out of the property or refinance. Unless the rents are kept at market, the value of the property does not increase.

What Is The Best Investment Property? Part 2

Besides the considerations of Part 1 in  the previous post, price ,  tenants and condition, the investor has to investigate thoroughly before purchasing anything. In fact, the main job of the investor is not getting the money together, which, admittedly, can be  very tough, or running around looking at various deals, which does takes time and shoe leather.  No, the most important job for the investor is doing the due diligence.

We often hear that expression, “You’ve got to do your homework” or do the due diligence. For real estate, what does due diligence entail exactly? As might be expected with such a vague term, it’s complicated. To me, though, it can be simplified by dividing your due diligence into pre-purchase and during-purchase due diligence. Whatever happens, you don’t want your due diligence to happen post-purchase.

location_location_location

Location, Location, Location

Of course, that’s the most basic mantra of real estate and it certainly should be part of any investor’s pre-purchase due diligence. The location of the property will determine the rents and the quality of the tenants, so it is of utmost importance.

What is a desirable rental location?

Many would-be investors think that a newer building in their own suburb is an ideal investment. This may or may not be true. If the suburb is filled with homeowners, it’s likely that it’s not an ideal place for renters. Here are few questions to ask when considering location?

  • where do most residents work?
  • is public transportation handy?
  • is there adequate parking?
  • what is the area vacancy rate?

If most locals commute to the city, then renters will, too. That means most renters will seek housing closer to their work. Many renters do not have cars, so proximity to public transportation is a must. Whether tenants have cars or not, for most areas the building must have adequate parking. This means at least one space and preferably two per unit plus one or two extra for guests. Failing that, overnight street parking must be available. Make sure the vacancy rate is not above 5% as nothing costs a landlord more than vacancies, especially multiple vacancies.

Sometimes areas near a military base or adjacent to colleges and universities offer wonderful rental opportunities which are, nevertheless, different from “normal” rentals. Frequently, in such areas rentals are for six months or two semesters or a summer and then over and out. This might entail more work prepping the units more often,  but  the rents are actually higher. Usually, too, students and soldiers are not particularly fussy about their short-term digs.

cash-flow

Often, would-be investors start out looking for the “best” properties. That is usually a mistake. The best rental properties are usually in moderate to low-moderate areas which are not only more likely to attract renters, but which also offer what every investor should be seeking-immediate cash flow. Cash flow is the name of the game and more expensive properties in the best areas rarely offer it. Also, those moderate renters are more likely to stay put than the higher-paying renters with plenty of options. Remember: vacancies are a landlord’s bane.

Is Your Real Estate Investment A Good Deal?

Mortgage rates are the lowest since World War II.  Property values have hit bottom in most locales. Many now see the stock market as corrupt and manipulated.  Besides gold, silver and precious metals, all already hitting record values, real estate has emerged as the best place for an investor to place money.  Investors in mutual funds are passive participants in the process. Real estate investment is usually active. How does the novice investor recognize a good deal?

For rent

How To Value Real Estate

Traditionally, real estate investments generate value in two ways-through cash-flow and appreciation.  Simply put, cash flow is the amount flowing to the owner on a monthly basis after payment of the mortgage and all expenses. This calculation can and should be made before purchase. The second way to generate value, appreciation, is more tenuous as it refers to the future value of the property. No matter how good the deal, how wonderful the neighborhood or how solid the local economy, the future is always unknown, so appreciation cannot really be calculated, only assumed.  Never rely on appreciation alone in making a real estate investment. 

Calculating The Cash

cash flow

Cash Flow Calculation

That leaves cash flow. The serious buyer must always calculate the cash flow before jumping into any investment.  From my observation, though, it seems this crucial step is often skipped.  For simple cash flow, here’s what you need to consider.   The owner will also have to pay whatever is stipulated in the leases, such as water, trash, electricity, gas,  gardening, pool maintenance, snow removal, pest control and, possibly, property management and whatever other monthly expenses might accrue.  Subtract this from the rental income and that is Net Operating Income [NOI].

The purchase price minus the down payment equals the amount financed which, in turn, tells us the monthly mortgage payment.  For instance, on a $200,000 investment, the down payment might be 25% or $50,000, leaving a mortgage of $150,000 and a payment of  $1000, including taxes and insurance.   The NOI minus the mortgage payment is the monthly cash flow.

Cash On Cash Calculation

Another way to calculate a real estate investment is called the cash on cash return method. This time, the investor considers all the money invested in the property, including the down payment, to figure out exactly what is the return for every dollar invested.  the purchase price is still important, but more vital is the amount generated from the cash put out.

On a $200,000 investment, the down payments is typically 25% to 30% or $50,000 plus an additional  5% in closing costs, loan fees and rehab costs, another $10,000.  The total cash outlay is now $60,000 with a mortgage of $150,000.  Now, estimate that the rents generate $2000 monthly and the ongoing costs amount to about $500 [utilities, maintenance] leaving $1500 a month. This is the Net Operating Income. From that subtract the monthly mortgage cost of $1000 and that leave $500 a month, producing a cash flow of $6000 per year.

Divide that $6000 by $60,000 to get the cash on cash return. In this case, it is 10%. Considering that leaving money in a CD will generate less than 1% these days and even the stock market less than 5%, that’s an excellent return on money invested. But, real estate investment is an inherently risky investment, so the returns should be decent.