If you are holding deals close to your chest or not giving to your so-called competitors. You need to operate with an Abundance Mindset. Plus it’s no fun to do this on your own.
If I were starting out investing here are the Fab Four Books and Trifecta of Business Books that everyone should read before making a purchase:
It’s important to note that reading anymore is just overkill. Don’t be that ‘Shelf’-help guy or use the crux “oh I need to read and get more educated”. You need to step up and take action how many freaking books are you going to read? Many Fortune-500 Human Resources departments use the theory of 70-20-10 in developing employees which apply here. 70% is learned by doing, 20% learned from peers, and 10% is academic/book/classroom training.
Below is another rendition of the same theory. This also explains why after a few years of doing this podcast and helping others get started by modeling the way has accelerated my own growth.
Tim Ferris talks about the $100,000 MBA, where you don’t really go to school but you jump right in with your business/investment. This method may lead you to operate at a loss but you will have far more experience than getting that silly $100,000+ MBA degree from some brick and mortar school.
And a word on real estate training: Why would someone want to spend $20-30K on training when that alone is a down payment on a cashflowing property that you can learn through doing and make 300-400 a month cashflow. Heck, you could even buy an overpriced 2nd tier turnkey property and get your education that way too.
SPC GET ‘ER DONE PLAN:
- Read these books
- Keep yourself accountable. As Arnold says, “stop being a whiny baby [and Do IT]”.
Please note that some of the links found on this website are affiliate links. And at no additional cost to you, paid by the seller, I will earn a commission if you decide to purchase which helps pays for the various costs of running this website. Please understand that I have previously used these products. Do not feel the need to purchase these products but if you do please use these links. If you have any additional questions on how I optimize the use of these products please let me know.
Are you aware of Cap-Ex or Capital Expenses the big unknown in your deal analysis spreadsheet. Learn 3 ways to calculate Cap-Ex… So You Don’t Get Screwed a Year Into The Future
Blog article with all the charts. Sign up for the e-newsletter with your email to get the Cap-Ex spreadsheet.
Why the heck are we talking about, a board game?
When people in the very final stages of their life were asked, “what they regretted,” the response that often came up was that they wished they ‘played’ more. (Also in the top responses was a regret of spending so much time at work) The point is, although we are making investments and working hard, we should not forget to ‘play’ or have fun. I had a friend that played hours of video game baseball. Other than the fact that nobody plays baseball on video games, I always gave him crap. Now a little wiser, I realize that he was right… it made him happy and that was important (Side note: I do not condone mindless World of Warcraft addictions). Read on for the second lesson from this board game.
For the past decade, one award-winning board game called “Settlers of Catan”, has built up a huge, cult-like following, garnering hundreds of 5-Star reviews on Amazon and played by normal people unlike the Magic Gathering Card game or Dungeons and Dragons. In other words, females play this game and guys, who could probably save their lives by throwing a football play it too. If you have not heard of this game then you probably have never heard of BiggerPockets.com and you live under a rock. The strategy-intensive game, is intended to last less than 45 minutes. During that time, players collect resources and use them to build roads, settlements, and cities on their way to victory.
Check out this well made 4 minute documentary on the game.
The board game presents players with many decisions that parallel those facing many experienced real estate investors. In Settlers of Catan, there are 5 resources which include sheep, lumber, ore, brick, and grain. In the beginning of the game, sheep and wood are sought after, whereas in the dramatic ending of the game, ore is needed to lock in a win. Side note – I actually have a t-shirt that says “Nobody wants your F-ing Sheep” because as a typical occurrence in every game there is always one unfortunate player who is lagging behind and still trying to peddle their surplus of sheep.
The life cycle of an investor starts with typical equity building with rentals that utilize leverage (sheep/wood) and progress to larger deals (brick/grain). As the investor reaches the second half of their progression and surpassed the “critical point” where they have amassed enough equity build-up to live off their “dividends,” the investor will look to convert their portfolio to a more cash flowing portfolio via de-leveraged rentals, private lending, or notes (ore in Settlers of Catan). This stage is often called the end-game strategy. So often I see newbie investors with low cashflow/low assets with shiny object syndrome and want to get into notes or land contracts because that happened to be what Guru seminar they attended.
So if you don’t care about this fricking game and skipped ahead to the conclusion here it is. Whatever path you take in investing keep the end in mind… the end game… the goal. Have a series of if/then exit strategies in mind with everything you invest in. A few examples:
- A lot of people talk to me and say that they are tired of investing for appreciation and want to go for 100% cashflow to hold on to indefinitely. Having a few years of experience I realize that nothing is forever and things happen. Those investments that you bought, might have gone up in value 20% and it makes sense to cash out or you find another investment that is so much sweeter. But at the time of purchase, you did not think of these potential decisions when you bought the low 40k homes or a duplex/triplex/quad that are inherently harder to sell to a retail buyer as your exit strategy. Perhaps buying a higher price single family home would have been a better way to go (forgoing optimum cashflow).
- You have that meeting with a lawyer who sells you on this elaborate corporate structure but it might be a bit overkill since your dreams of building a 50 home portfolio transitions to other investments.
- You waste your time and money creating a small network of contractors to serve as part-time staff to service your 3 duplexes in the area. However, now it looks like you should sell and you wasted all that sweat equity in creating that system.
- You heard about the wonders of the Self-Directed IRA from a local Real Estate meeting and rush out to make the conversion and deploy your cash into a Real Estate notes. Now you realize that you have lost your leveraging ability but more importantly you are unable to use your IRA as cash reserves to get Fannie Mae loans.
SPC Git Er’ Done Action Plan:
- Don’t let this article give you an excuse for analysis paralysis, but inspire you to find that mentor who can help. You will never know all there needs to know by yourself.
- If you have implemented your Real Estate plan and looking for something fun to do, go out and enjoy life and buy this game! (Help support the site buy via Amazon affiliate link)
A lot of people have been asking for an expose’ of the turnkey investing world, so and here it is. Remember, buying the property is only part of the battle, but efficient operation and systems are what make it work. So please subscribe for good times and stories with SimplePassiveCashflow.com!
Passive Versus Active Investing
Turnkey Investing Defined
Turnkey investing is a form of passive investing. The definition of turnkey (TK) investing at the very least is buying a property from a seller called the Turnkey Provider (TKP) that is rent ready. The TKP typically does a rehab of the major components (roof, floor, plumbing, electrical, paint with sturdy tenant grade materials, such as no carpet, no garbage disposals, laminate flooring. etc). The TKP may purchase these at a discount with a part of their company made up of wholesalers or auction buyers to buy the properties at a discount. Also, the TKP may have property management in-house to manage it for a fee after the sale is complete. The TKP may fill the property with a tenant prior to closing the sale – although this verifies the market rents, there is no safeguard that prevents the TKP to just sticking a warm body in there. A lot of buyers like the fact that the TKP is vertically integrated because if the property does not perform you know who to go after. I personally don’t see the advantage of having a vertically integrated TKP as a clear-cut benefit since it brings up the potential for conflicts of interest. For example, if the TKP has a property management side, the property management can cover up shortcomings in the rehab.
“Hey, property management Paul, why is my property getting these 100 dollar repairs like every month?”
“Well, I don’t know it was an excellent rehab (done by my company) so it must be that dang tenant again.” says Paul.
My opinion of “vertically integrated” is that they do everything but also suck at everything… Rather than having a jack of all trades, wouldn’t you want an ace at every position?
How Do I Buy?
In every market (say Birmingham) there are typically two TKPs who are perennial good outfits. And that third TKP seat is constantly being indicted by some sort of FBI investigation… I’m just being funny. But this is where things get tricky from an outsider’s perspective. Who are the good guys and who are the fly by night operations? Good question! My best answer is to use references of disinterested parties – which are different from the uninterested friends/family/negative Nancy’s/nervous Ned’s.
Out of this pain-point, a middle-man layer called the “marketers” have arisen. These are the guys who typically do not live in the local market (most likely California) but do a good job at finding most of the reputable sellers. The marketers put on Meet-ups, podcasts, webinars, troll BiggerPockets, and find buyers who are looking for real estate in their portfolio. The trouble is, they are not doing these services for free, and you as the buyer will pay for it via a markup to the property one way or another. But overall the system works well. The TKP (small company) is good at what they do and are able to focus on finding distressed property and rehabbing. The TKP utilizes the Marketer to sell the inventory and create a profitable business based on volume.
There are some very reputable TKPs out there, but the trouble is sometimes they have so much demand for their product they can charge their buyers (you) a premium price. Pair this with the marketers bringing in lazy money in the form of inexperienced investor itching to get into real estate creates a micro sellers market. Some TKPs have buyer queues where you wait for a property and you have a limited amount to time to buy it or it gets moved on (to the next sucker). These scarce sales tactics are not a place you want to be. Another trick is that a TKP may require you pay cash for a property which basically takes away your ability to do your due-diligence on the property. I always buy with an appraisal contingency and inspection contingency to protect myself. Some will offer guaranteed rents or warranties which are seemingly good but could also mean that the TKP is just buying a $500/year insurance policy so you buy their property and they plan on just using the outside insurance to pay your inevitable claim. I’m going to stop there before I scare folks too much, but these are some of the pitfalls of working directly with the TKP seller (after all Real Estate is their profession).
A lot of folks jump on BiggerPockets and search or post on “Turnkey” and they will get bombarded by vendors being super helpful. I don’t know about you but I have never gone to the bar and been given free beers by other helpful patrons. Well if that’s the feeling you’re getting when you networking on BiggerPockets, make sure you background check who you’re direct messaging with. How are they getting paid? The folks you want to listen to (yes actually have rentals) and merely want to help out another Bro. I’ve used a marketer before but I did not get any value and I will not do it again, especially since it is not hard to find all the reputable sellers with a little bit of digging.
I mentioned two ways to buy a TK (TKP and Marketer) that both have their pros and cons. A third hybrid method that I have employed is to work with a licensed agent that helps you source properties and find your own construction crews to rehab the property. I have mixed opinions about this because it is a bit more work (especially being remote) and the agent is typically ignorant to what components make a good rental. An agent can find you a property that is priced well, however, they will not have the knowledge that an experienced rehabber or TKP will have (sturdy tenant grade materials such as no carpet, no garbage disposals, laminate flooring). So it’s a bit more risk/reward in the end if that’s your cup of tea or should I say Simple Passive Cashflow Latte. What has worked for me is not going with a marketer (due to absurd markup), but using a combination of off-market agents that have a Fiduciary responsibility to represent me and also working directly with the TKP for the best pricing once I had the experience of purchasing 3-5 properties and overpaying along the way.
Why the heck doesn’t the TKP just hold on to the property for themselves?
As stated earlier, the TKP does what they do well. They have the teams and market knowledge to do this efficiently. They could hold on the property but they have chosen to make profits on the volume business since they make their money by managing their multiple crews, essentially they are running a business. If you find a good TKP hopefully you get to partake in some of these efficiencies. But don’t be entitled as a TK buyer. You are not doing any work and frankly you deserve the market rate.
Which class, property value range, would be best to put on the buying list?
This is ultimately up to your investing strategy and criteria. For me to tell you what is the best is irresponsible and against what I believe because you should understand the macro (not micro) concepts for yourself and make your own best individual strategy. With that disclaimer out of the way, I personally went (my strategy changes per my overall portfolio) after B/B+ properties that rented for at least $1000 per month and had at least 3 bed and 2 bath. Some things to think of when finding your strategy/criteria:
- Although I have full intention to hold on to these properties indefinitely for cashflow, recognize that things change and perhaps I might want to trade in 1 “goose that lays the golden egg” for 2 or 3 “geese that lay the golden egg” or 1 “big ass goose that yea you get the point”. To say “I’m making cashflow” is a fallacy… what do the numbers say on the bottom of the spreadsheet and compare the two situations you are evaluating. You should always be making moves to optimize your return assuming it warrants the transaction costs.
- I was using Fannie Mae loans which are those sweet government subsidized 30-year fixed loans. At the time of this writing (5/2016) the most one person can have is 10 to their name. Your plan might be to only get one or two homes and sail off into the sunset but your plan might change and you have to change your plan for the “if” in life. To acquire a conventional Fannie/Freddie non-owner occupied property requires 20-25% down payment. There are also lender costs which I typically estimate at $5000 +/- $1000. Parts of the lender costs are variable such as an origination loan (basically it’s their fee to have to deal with you and headaches you cause them) that is a certain percentage (~1%) of the final loan that changes from lender to lender so this is something you are comparing. Other parts of the lender costs are fixed costs such as inspection costs, credit reports, and appraisal fees. It is these fixed costs that are the same whether you buy a $40K property or a $140K property. This is one reason I personally went after a more expensive property.
- By buying 50K properties that rent for $800 you’re like “Hey that’s awesome that’s a 1.6+% Rent to Value Ratio”. But I suggest reading my article about the nuances of the RV Ratio and property classes.
- Remember the goal is to maximize the profit which is the rent minus expenses. Folks get wrapped around all these metrics but do not forget the goal.
- This is totally my strategy but please think for yourself: When I was getting started I went for the higher priced properties (Not the A properties cause there is no cashflow in those). I went for properties that rent for 1100 that I could get for 100K. I would say these were B+ properties (Note: do not take the seller’s definition). My strategy was to find low hassle properties that had better tenants and properties that I could easily liquidate because they were close to the median home. There is a bit contradiction here because yes they were safer in terms of tenant quality and exit strategy but the cashflow buffer was less so I had less ability to lower rents in a market downturn. Now that I have a stronger base in terms of teams, money, and knowledge I try to go for more C properties because I feel I have the experience and risk tolerance for it (although I stated that these could be safer in terms of the buffer in the cashflow).
I am selling my home for 600k, I want to invest out of state for cash flow 200/month cash each door?
Before you do anything make sure TK investing is for you don’t just jump in cause I like it. However, I think that your per door $200 assumption is in line. There is a difference if you are buying $60K properties or $120K properties but either way, I think you will be beating the averages of the stock market and that is why I do what I do.
This is how it is going to work if you choose to sell and do a 1031 exchange. First, you sell the home for $600k (~10% will go to commissions etc) so you are left with $540K. This is how much you have to acquire or there are tax penalties so if you are looking at $90K properties you are going to need to pick up 6 of them. Your cash in your 1031 will be $540k minus your remaining mortgage. You can bring cash out of pocket to make up any shortcomings. Check out this article for more info on some 1031 issues and strategies.
Other Passive Investing options (REITS & Crowdfunding):
Passive turnkey (TK) investing is a slow way to building long term wealth. My track record in the macro sense is to put down $30K to control a $100K property that rents for a tad over $1000 a month. From that $30K down, I create about $200-300 a month in cashflow or $3000 a year per property. If those of you at home are plotting the day when you leave your job and take over the world, 20 homes would get you about $60K in passive income a year (tax-free) which would require about $300k of down payments.
A lot of smart people dabble in REITs or Crowdfunding deals, but typically it is the operator taking most of the profits off the top. Ideally, if you have the ability to, you want to be in control and be the operator if the numbers make sense. REITs and Crowdfunding deals are just like stock/mutual funds- you do not own the hard asset, and you are at the mercy of the operator to run it like a business and not take business trips to Las Vegas “Conventions” as a business expense. Moreover, most of the time, you also miss out on the tax benefits, such as depreciation. Isn’t this the reason why you want out of the stock/mutual funds in the first place? Plus who the heck knows how Stocks are priced? As if that wasn’t enough, most crowdfunding platforms (at least for now) require that you be an accredited investor. Most of you starting out won’t qualify.
Here are a few of links with actual portfolio analysis of these Crowdfunding methods in action:
Why go through all this trouble of a rental?
As in the above Crowdfunding links, the returns range from 6-12%. These returns suck. I mean it’s good for an institutional investor or someone with a gazillion dollars, however, I look for cash-on-cash returns of ~10% and total gains, or IRR (Internal Rate of Return), of ~20-40% per year.
For my info on total gains see this article: How We Make Money with Real Estate & the Hidden Returns
Here are some questions I often receive from readers:
- Are you visiting these locations at any frequency and for the initial purchases, or are you able to have enough trust and working relationship with other professional resources at those locations?
- I’m interested in a few out of state markets while trying to better understand what acquisition and management options are realistic. Ideally, I’d prefer not to travel.
- Hey, can you help me get started? Can you give me your providers?
I could do that, but that would be doing you a huge disservice because you will not be properly educated. Use these people as your educators.
Here is what I would do:
Find at least 6-10 turnkey dealers via googling turnkey rentals. You can also look online at Bigger Pockets, as many, though not all, turnkey companies have a presence there. Call each and every one of them, and get a dialogue going. Then, ask them the following questions (but not all of them… don’t be a machine, build a relationship:
- Can you break down the structure of your company for me?
- Tell me how your process works from start to finish.
- What does “turnkey” mean with your company?
- Will there be a tenant in place before I close on the property?
- Can I use the financing to purchase the property?
- Do you own properties close to the one you’re selling to me?
- Is the home required to pass inspection and appraisal before I close?
- Can I hire my own appraiser before closing on the property?
- Do you use other companies to help you provide turnkey properties?
- What is your role in the sale of the turnkey properties?
- Who owns the homes?
- Who rehabs the homes?
- Am I expected to pay for the rehab?
- Who are the “boots on the ground” in these areas? Are you talking to the actual guy who manages the crews or just their sales person who never leaves the
- Who manages the properties after the sale?
- How long have you been in business for?
- Is their a warranty on the property after the sale?
- Can I see a scope of work with expenses for one of your rehabs?
- How many properties are generally in your inventory month by month? (The more properties means better economies of scale but can also mean more bloat and more competition from other buyers)
- What sets you apart from other turnkey companies?
- What are some mistakes you make when you started out, and how are you doing those things differently now?
Why Screw Around with Rental Real Estate when I can just do REITS and those really cool crowdfunding sites? Because these REITs are middle men. Work directly!
The Biggest Kept Secret – Hidden Returns of Rental Real Estate
SPC Git Er’ Done Action Plan:
- Sit down, take 10 minutes, and create 60 day action plan.
- If you are a bit overwhelmed I made a simple Excel Gantt chart showing the steps to purchase a property with all the due diligent checklists. I’d like to share it, so take a screenshot of your itunes review and email me with your 60 day action plan and “Gantt Chart” in the subject line. Lane@simplepassivecashflow.com
Do not buy properties all cash. I don’t care even if you are in the endgame part of your strategy. The real risk in having so much equity in your properties. The real security is having cashflow.
When I am looking at potential investment properties the rent-to-value ratio is the very first metric I look at with evaluating an investment. To calculate this metric you take the monthly rent divided by the purchase price/value. For example a home that rents for $1000/month that costs $100,000 has a rent to value ratio of 1% (1,000/100,000=1%). The higher the better. I typically look at a huge list of properties so using excel to make this calculation is the best practice. It’s sort of like using the dating app Tinder… but with a filter…. I’ll stop there… you get the point, a lot of options, how do you best narrow them down. In the spreadsheet if you are so inclined to use conditional formatting or spark charts to flag the best ratio values… well, no wonder you are bored at your day job. If you create a bunch of Macros to do this, wake up! You are seriously being underutilized in this world.
I actually don’t care about how many bedrooms, square footage, if it’s Victorian era, made out of bricks, in a hurricane zone, or if Heath Ledger grew up there. I’m not interested in any of it yet because I am just checking out if it hits the numbers first. Dummy Alert: Just because it meets the 1% threshold does not mean you have a winner. For example, I can find homes all day that is $50k and rent for $800. You’re probably thinking “Wow, that’s so rad it has an (800/50k) 1.6%+ Rent to value ratio”. But in reality, those homes typically have lower quality tenants who screw up the property and have more vacancy. In some places, you might have to carry a gun to pick up the rent. I personally like to find properties that are right in that 1% zone but are also the most expensive (highest class), e.g. a $145k property that rents for $1400/month.
There are similar metrics such as the Cap Rate or Gross Rent Multiplier, but these are typically not used in the non-commercial realm of Single Family Rentals. Using such vernacular can tip you off to an agent that you are either inexperienced or European… not that anything is wrong with being European except they do things ass-backwards like the whole Kilograms thing and drinking pints. ‘Merica! This is also an indicator for you that you are working with an inexperienced agent or one that is coming from the commercial world trying to “get rid of a few SFHs” as a side-gig. I am no one’s side-gig!
Figure: General Rent to Value Ratios w/ Classes in top Cashflow Markets
Note: Monthly Rents on vertical, Home Value on horizontal: Varies by market, this is simply to illustrate that this line is not straight
Nuances to recognize:
- The value and rent relationship would not be linear (straight line); instead it would be a curved line (see graph above) where you have aggressive returns in higher ratio rents in the beginning (lower class properties) and lower ratio rents in the end (higher class properties)
- As properties get more expensive the rent to value ratio typically decreases – see the graph above as the home value gets over 100k it gets flatter (horizontal).
- Just know that the rents per month in this chart are Proforma rents, which mean subject to real life – and if it’s coming from a sales agent – yup straight up BS. If you are totally understanding the graph above, note that the curve will flatten out (less bendy, straighter) as you transition to actual real life performance. Or in other words, you will have to pay a lot more expenses per income in the lower classes than higher classes because lower class tenants tend to be harder on the home. What the graph does not depict is your mental currency that you have to expend on “pain in the ass” (PITA) tenants. I personally try to minimize the PITA potential in all levels of my investing because I am lazy and my best and highest use is at my day job. I like real estate but I don’t love it enough to make it my full-time job. Remember – this is the investment that’s supposed to allow me to quit my job or free up my time for other things.
- If you want my input on my preferred class of properties (especially when starting out), I like to stay in the “sweet spot,” which occurs right before your rent to value numbers flat line – this is typical of the B to B+ range. You have to make your own judgment call here for your own strategy. Also, there is something to be said about being diversified in several classes. For example in Houston where blue collar jobs (C & B rentals) are suffering because of bad oil trends, it would also be good to have some higher class properties (B+ & A- rentals) with jobs tied to white-collar jobs despite the lower returns. Lots of things going on here and that is why real estate investing, although simple, is not for dummies. And now that you are confused and you don’t know what to think… someone told me that the 80% of the median home price (not average – which is typically skewed higher and a figure that is easily found online) is a key price point to try to be around because that is where most of your renting population will be. For example, if the median home in Birmingham is 120k (80% x 120K = 96K) the magic price point is 96K – hey that’s right above a B class property how lucky is that. Hey, it’s my blog so I pick the examples.
- There are many well-written articles on this subject and here is one of them:
Here are some of the numbers on a couple of my rentals:
My Rental #4 in Birmingham – http://simplepassivecashflow.com/case-study-birmingham-cindy/
My Rental #5 in Birmingham – http://simplepassivecashflow.com/rental-5-birmingham/
Learn more about other metrics to follow as a Sophisticated investor – Forbes – Three Financial Metrics Investors Must Monitor To Evaluate A Property’s Success
Make sure you are not making this mistake as an investor – Return on Equity
Here is a discussion that will hopefully put to bed the annoying quarrel that people outside of real estate just don’t get. I’m going to show you the hidden ways you make your money on real estate rentals that blow REITs, Crowdfunding deals, and Real Estate Notes out of the water. There are potentially better investments (risk divided by reward) backed up by a hard asset, however, those deals are not obtainable by the average individual who does not have access to a rich and powerful network of people (not this bottom feeder one) and who does not have a net worth exceeding $1-million. These are the deals that happen behind closed doors in the country club crowd, but that’s not what we are here to talk about today. If you’re wondering, I too am Tiny Tim peering into that window of that exclusive party. The simple rental is something that is accessible to everyone and today we are talking about the math behind it. So put on your propeller hats, because we’re about to talk numbers.
“Hidden Returns of Rental Real Estate – 30%+ ROI a year smokes the pants off stocks/mutual funds”Continue reading
“We are almost paid off our property and cashflowing like crazy!” – an Unsofisticated investor
Don’t take it from me take it from a Forbes article – Three Financial Metrics Investors Must Monitor To Evaluate A Property’s Success
Download the worksheet to calculate the return on your deployable equity.
Wait I thought Seattle/San Francisco was a hot market with double-digit appreciation and an up and coming tech market?!? Return on Equity = Profit (Cashflow) / Total Deployable Equity if your sold (Don’t forget to include selling commissions)
“every month that goes by you are losing $300/month per $25k you have of deployable equity”
As a real estate investor or any investors consider your Return on Equity (ROE) as a means to evaluate the highest and best use for your capital and to be able to make adjustments to your portfolio over time.
The saying “buy and never sell” will work but “buy and evaluate your ROE prudently” will yield high returns and safer capital preservation.
There are many metrics that Investors use to quantify the quality of their investments. COC, ROI, ROE, are to name a few.
Cash on Cash Return on Investment (COC Return)
The pre-tax year-end cash flow divided by the actual amount of original investment you have invested.
COC is used to compare your investment with other options excluding factions such as the use of leverage (mortgage), taxes, appreciation over time, and mortgage paydown over time. As time goes along and your investment goes well due to your tenants paying their rent as they should and the home going up in value due to inflation and market appreciation, COC becomes less relevant.
For example, if you purchased a property with $22,500 down payment, $5,000 in closing expenses, and $2,500 for some touch-up paint and new carpet, you are all-in for an original investment of $30,000. If at the end of the first year with your rental property in operation that you are able to profit $10,000 from cash flow after all operational expenses and debt service were paid, your COC return would be $10,000/$30,000 or 33%.
Sophisticated investors compare COC with other investments to determine the highest and best use for their liquidity going into an investment whereas ROE is used once the investment is owned. COC for mutual fund and stock investments have been known to have been in the 8-10% COC range.
Annualized Return on Investment (Annualized Return)
Annualized return is used to evaluate an investment’s performance over time. Real estate is not a get rich scheme and many times if rehab is done to the property it will require a few years to complete the construction and stabilize the rents for the next buyer to feel comfortable and pay a higher price for the investment.
Annualized return takes into account the cash flow returns received during the hold of the property and the sale or refinances of a property that takes place at the exit. The annualized return is often used to compare syndications (private placements) with different business plans but similar lengths of ownership.
For example, if you received a 8% COC return for 5 years ($8,000 per year on a $100,000 investment for each of 5 years = $40,000). And then you exited the property via a sale at end of year 5 for a gain of $60,000. Your annualized return would be a total of $100,000/5-years or 20% a year. This is calculated with $40,000 in cash flow plus the $60,000 due to the general appreciation of the property.
Return on Equity (ROE)
One of the few downsides of real estate investing is that your investment is illiquid unless you sell or refinance the asset.
As you hold on to investments you are increasing you equity position over time via the following:
- Mortgage paydown
- General appreciation from the market
- Forced appreciation from any property improvements
Say you had a great investment kicking off 20% COC a year. Your return on equity shortly after purchase on a $100,000 home that you used $20,000 to acquire is making you $4,000 profit a year. In this case, your ROE would be 20% ($4,000 divided by $20,000).
But say a couple years go by and with a hot market the property is now worth $160,000. You return of equity on the $160,000 home that you used $20,000 to acquire is now making $5,000 profit a year. In this case, your ROE would be only 6.25% ($5,000 divided by $80,000). Note: This does not include mortgage paydown.
For the minor headaches rental property ownership brings 6.25% would not be worth it. I personally believe that when you ROE dips lower than 10-15% you need to look to make a change in your portfolio via 1) Cash out refinance, 2) 1031 exchange or, 3) simply selling the asset.
There is one intangle metric that we did not talk about here which is your Return on Time (ROT). I don’t believe this is an official term but something that is near and dear to Simple Passive Cashflow Followers. At some point, you need to transition from higher returns and higher headache investments to more scaleable investments where you investing passively.
After purchasing a couple rentals in the Seattle market and being the beneficiary of some nice appreciation, I evaluated the property’s performance with a ROE or Return of Equity metric. On of my rentals had appreciated all the way to $450k and my mortgage that I owned was $200k. Therefore, I had about 250K of “lazy” equity. If you kids are at home with you calculators that 250k goes in the denominator of the calculation. The numerator is the annual cash flow which was about $4K a year. Therefore my return on equity was less than 2%=4k/250k. Frankly, 2% is very poor compared to stocks (~8-10%) or properly leveraged Real Estate (~20-40%).
Calculate how lazy your current rental investments are with this spreadsheet: Link
Video: If your interested in seeing a A-Grade rental in Seattle that does not cashflow (poor cashflow investment)
I am sure someone somewhere is trying to invest in something similar and fooling themselves that they are making money on the project. But you are smart and you subscribe via RSS feed to this blog and podcast 😉
Long story short, I decided to sell these rentals to unleash this “lazy money” and get it working again with prudent leverage. This is what separates sophisticated investors who look at the numbers and your mom & pop investors who go by warm & fuzzy feelings of “hey I’m making cashflow, life is good”. Yes, Mom you are cashflowing but that is because you are halfway to 100% cash in the deal and you are taking on all that hassle and risk for a microscopic return.
A couple graphs for the engineers.
SPC GET ‘ER DONE PLAN:
- Arrange all your properties on a spreadsheet and calculate ROE, Cash on Cash Return, etc.
- Look for the “Lazy Money” to trade in for a better performing investment.