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 – https://simplepassivecashflow.com/case-study-birmingham-cindy/
My Rental #5 in Birmingham – https://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
Needless to say, there is a bunch of procrastination before the Podcast launch in a few days.
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
Check out the updated list here.
I promised real life properties and updates and here is the first one. For obvious reasons, the address will not be released for the tenant’s privacy but I am renaming the properties with the city name (Birmingham, Alabama) and the corresponding number that it was acquired.
This property was put into service in September of 2014 and was the successful beta test to prove the concept of remote out-of-state investing. I acquired the property from a marketer that makes connections with the rehabbers in certain markets and finds buyers such as myself who are typically located in low price to value ratio locations (this does not necessarily mean high-priced locations) such as California, New York, Hawaii, Seattle, Portland, and basically the coastal areas that all the cool kids what to actually live. Marketers have their place if the buyer is totally clueless but once you purchase a few of these properties the marketer really does not offer much value. The only thing I see that they would offer would be someone to be the bad guy role in a negotiation but many of the marketers are buddy-buddy with the rehabber because of their business relationship and won’t stick their neck out for you. As the buyer, you need to take ownership of the due-diligence process and negotiations because that marketer is not a licenced agent and does not have a fiducial responsibility to you.
“My Rental #4: Birmingham”Continue reading
Warning – Paradigm shift ahead! In the old Caste System people were split up in ranks to keep lower class people from rising up and keep those in power where they are whereas today, money/mindset is the real separator of the masses.
When I first got started in Real Estate investing I was lucky to have a good job and was able to skip right over the wholeselling/birddogging roles and go right into a buy and hold rentals with the conventional 20% down payment. Little did I know that I had just vaulted over about 80% of my local REIA members who had little money and not making any deals. To be in that 80% group was a terrible place not because of the endless books, seminars, training for the wholeselling/birddogging strategy but competition was fierce – imagine the start of a triathlon as the athletes jump into the first stage of competition -the swim, even the best athletes struggle to distance themselves from the pack as the pack pulls and sabotages those who try to distance themselves.
“Mindset of the best Performers”Continue reading
I’m going to take you back to high school math class for a moment. Remember the 4 Quadrants, they are labeled Quadrant 1 in the North East quadrant and Quadrant 2 in the North West…etc. The above graph only shows Quadrant I. To put it simply these markets in Quadrant 1, have median home Rent to Value ratios above 1% (a 100k property rents for more than 1000 per month – 1000/100,000=1%). These are the markets that investors like as cashflow investments because the income typically covers the mortgage and then some.
“The Real Cashflow Quadrant – Turn Key Rentals Heat Chart 4/2016”Continue reading
Capital Expenses (Cap-Ex) are the large items on your expense list that are not repairs or maintenance. I repeat, this is in addition (account another 10-20%) to your normal repairs/maintenance for minor components. Cap-Ex is for example roof, water heater, HVAC, flooring, paint, cabinets, landscaping, windows, etc.
“Don’t Forget! Capital Expenses “Cap-Ex””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.
Sophisticated investors re-leverage after their return on equity goes down
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.