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?
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 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.