How do you know if you’re making money on your rental property? How can you estimate if a potential deal will make you money? Here are three methods in order of complexity:
- Do you have more money in your bank account at the end of the year?
- When you filed your federal taxes did you have any taxable rental income? Check on your schedule E. I hope you didn’t lie.
- Is the cap rate - debt service a positive number? Is cap rate - loan constant / (loan /value) positive?
How would you evaluate a potential investment property? If you haven’t yet invested in a property then the first two aren’t possible. I’ll explain the third approach. It’s the only way to get a good idea of how cash flow positive your investment will be.
If the investment doesn’t have initially positive cash flow then you’re betting on price appreciation. Long term, historical home prices track overall inflation, no more. You really need higher returns than that to justify the investment and use of financing. And in the short term, as we know, prices can drop, putting you at risk when using financing. Negative cash flow in that situation can be financially fatal.
Beyond determining if your real estate can pay for itself when borrowing to purchase it, you should have a way to determine rate of return on your initial investment. Without that you can’t intelligently choose between two possible investments or know what a good deal looks like.
Simple Cash Flow
Let’s consider a simple case, the all-cash deal for an income-generating property. Even if you plan to finance any potential purchase, analyzing from an all-cash perspective is useful in ranking alternative deals.
With a cash deal you look at the cap rate (“cash-on-cash”) to determine if the property will be cash flow positive from day one.
cap rate = net operating income divided by property value
Obviously if your net operating income is positive you have positive cash flow. Getting an accurate estimate of the NOI is crucial; be careful when getting this figure from a seller. It’s possible to have a negative NOI after accounting for taxes and other expenses including vacancies.
Also, when you get a cap rate figure, find out what the “property value” denominator is: Purchase price or market value. It should be the price at which the seller is offering the property.
Once you determine the NOI is indeed positive, the real question in an all cash deal is whether the income will be enough to justify the price. Dividing by the property value puts that income into context: How long will it take to pay off the property with the income from it? If the ratio is 0.1 then it will take ten years, for example. Whether that’s good or bad all depends on how this rate compares to other investments.
If you decide on a cap rate – say five percent – as a minimum you can make an estimate of the maximum price you’d be willing to pay. For instance you might decide on a minimum cap rate of five percent because you would want the property to pay for itself in no more than twenty years in the event that property values don’t increase.
value = NOI / cap rate
A NOI of $50,000 and a cap rate of 5% = 1 million. So you would decide a million dollors is your maximum price. Mostly you use this estimate as a way to determine if rental property is over priced compared to other comparable properties in a deal where you don’t expect property values to increase. Often the cap rates will be rather low because part of the purchase price factors in the assumed growth of property values.
Since growth in property values is typical (though not certain as we know) the simple cap rate estimate is mostly useful for a short time horizon estimate of value. For longer term valuation you need to factor in growth in property values.
Before purchasing with all cash your biggest risk (assuming vacancy rates are low) will be inaccurately predicting the net operating income. Expenses can easily go higher than expected. After purchasing, your challenge as an investor is to keep evaluating if owning the real estate is the best use of the equity tied up in the property. Over time, with any luck the property values will rise or if you borrowed to buy (we’ll get to this scenario next) you pay down the loan and build equity.
Estimating Cash Flow and Market Value When Financing Real Estate
When financing part of an investment, determining if your property can be cash flow positive is a little complicated compared to analyzing all cash purchases. You have positive cash flow if cap rate less the annual loan constant multiplied by the loan to value ratio is positive.
Okay, what did that mean?
First of all, as I explained in the last section, the “cap rate” or “capitalization rate” means the percent of the value of the property the rent pays for each year: If you paid $500,000 for an apartment building and it brings in $50,000 after expenses, then that building has a cap rate of 10 percent.
It’s a way to measure the profitability of a property independently of how it may be financed, which won’t be known by the seller. They know their rental income and expenses and from those you can estimate the value as a business.
A cap rate of 10% for residential real estate is very good these days, maybe unrealistically good. A 6% cap rate is reasonable. Cap rate is also known as “cash-on-cash.” A high cap rate may indicate that the property is an area where property values aren’t expected to rise. In that case, ensuring a predictable amount of income is especially important.
Cap rate = Annual net operating income / total price (ignoring loan amount.)
NET OPERATING INCOME
Net operating income is total income from property minus expenses excluding finance costs. So you include the property taxes, insurance, management and maintenance in these expenses but not the mortgage or tax benefits or income taxes.
according to research these expenses average out to about 45% of rental income all across the U.S. Sellers may give you lower figures, but don’t use those. Assume fifty percent to be on the safe side. Here’s a fairly exhaustive treatment of the subject .
The annual loan constant gives a ratio of payments to loan amount; if you had a 0% interest loan for thirty years it would simply be 1/30 or 0.03333… For any loan with interest a thirty year loan will have a constant above 0.0333…
Annual loan constant = (Sum of annual principle + interest payments) / original loan amount
The LTV (Loan to Value ratio) is simply the ratio of the amount of money borrowed compared to the value of the property.
Loan to value ratio = loan amount / appraised value
This number should be under 1.0; values greater than 1.0 mean your property is “under-water.” “Equity” in the property (when you first purchase) is simply: current market value – loan amount. As you pay down the loan your equity is the difference between the current market value and the remaining principle on the loan.
Putting it together, you multiply the loan to value ratio by the loan constant and subtract from the cap rate. Initially this gives you: cap rate - (debt service)/ value since the loan amounts cancel out. A positive number means you have positive cash flow.
Imagine projecting this formula into the future. As the loan amount in the LTV decreases, and value of the property changes, you’re decreasing the term subtracted from the cap rate. Since the “L” in LTV initially decreases slowly according to most amortization schedules you won’t see the cash flow equation give you much different amounts from you’re initial purchase calculation; but as the years go by and equity is built up and gets paid off faster and faster, this formula becomes less useful.
After many years your cash flow will appear to be great, but that’s at the cost of locking up substantial equity. The above formula gives you a way to estimate return on initial investment. It isn’t meant to capture equity gained by paying down principle and cash flow; not return on equity (ROE.) It’s a modified version of the “Band of Investment” formula used by commercial real estate appraisers. In our case we subtracted the debt portion of the formula from the equity portion to get pure cash flow.
Band Of Investment
Appraisers use this method to estimate property values. In their case they have a cap rate an investor wants (probably determined by current interest rates) and an approximate interest rate and loan-to-value ratio (usually no higher than 75% for commercial real estate.) The missing term is the price, which they are responsible for estimating.
Here’s the formula:
over all cap rate = (1 - LTV) * (cap rate) + LTV * (loan constant)
They solve for the property value. To do this they compute an over all cap rate, plug in net operating income and work out what the value has to be. The value is the denominator in the over all cap rate. For instance, you could use these values for the variables:
Desired cap rate: 10% LTV: 75% Loan constant: 6.5% Net operating income: $15,800
Equity part, weighted by initial equity not covered by loan:
25% * desired cap rate
Debt part, weighted by the LTV, the part of the value covered by the loan:
75% * loan constant
Overall cap rate:
25% * 10% + 75% * 6.5% = 7.37%
Solve for the value that would yield a 7.37% cap rate:
$15,800 / 0.0737 = $214,000
This isn’t the best method now known, but it’s simple enough you can just about do it in your head. It’s decent for estimating your return on investment given an approximate sales price, or for estimating a fair sales price.
A more advance technique would give you information about your rate of return and allow for holding period as a variable. Two such methods are the Mortgage Equity Analysis and the Discounted Cash Flow Method
With the discounted cash flow method you can better compare real estate with stocks which can also be analyzed using DCF. Discounted cash flow is used to value the sales price of businesses in general.
Now we’ll “crunch the numbers” with a specific example. The crunching is easy. It’s getting accurate numbers to crunch that’s the hard part. The numbers in the following example were typical for the 2011 Minneapolis market, but ridiculously favorable by today’s standards.
From the example in the last post, borrowing 80% of $100,000 at current rates, (3.75%) your loan constant would be $370.49*12 using a conventional 30 year mortgage loan, divided by the loan , $80,000. That’s 5.56%.
Loan to Value:
If we assume the purchase was at market value the initial loan to value is 80%.
Net Operating Income:
From surveying rents in these areas for comparable houses we can estimate $1200-$1650 as a good range to expect. You need to expect up to 45% operating costs not including mortgage payments. This figure comes from a number of national surveys of apartment and rental housing managers.
So we get a possible gross income of $14400 to $19000. Subtracting operating expenses we have $7920 to 10450. The 45% expense rate includes accounting for vacancies, which is one reason the rate tracks so closely with the rental rate. Also, insurance rates and ammenities are roughly proportional to value of the property.
Now we can see the cap rate on the property will be between 7.92% to 10.45%. That’s $7,920 / $100,000 to a high of $10,450/$100,000.
The loan constant is 5.56%, so even in the case we get on the low end of the rent scale the property will be cash flow positive:
Low cap rate: 7.92% - 5.56% * 80% = 2.36% positive cash flow. High cap rate: 10.45 - 5.56% * 80% = 4.89%
If you simply subtract all expenses and debt service from the income you get $3475 to $6005 or so per year not counting income taxes and tax deductions for operating expenses and depriciation.
Return on investment would be pretty high at ($3475/ $32,000) to ($6005/$32,000) or 10.1% to 18.7%. The denominator includes the down-payment on the loan and the $12,000 of improvements needed before the property is rentable.
As the value increases (or decreases) and the loan is paid off, the cash flow becomes less important. You’re also going to care about the eventual sales price of the property and increases or decreases in income. And your equity increases as you pay off the loan. At this point afew years into the investment the question is, what is your return on equity? As your equity in a house grows due to paying down a loan and / or appreciation your return on equity drops. You would be better off putting the equity somewhere more efficient. This is why the discounted cash flow technique is useful for analyzing an investment. A rental proprety calculator can help you think through scenarios.
Taxes will change your cash flow slightly. An investment property can show (includes taxes avoided) you how this example will work out taking account of current tax law. You can deduct operating expenses and depriciation each year. On a cheap house depriciation isn’t much of a factor. Basis = house price - land price. Each year you can deduct Basis/27.5 from your income.
With the new 2018 tax law in the U.S. rates on pass-through business that qualify (if your real estate investing is in an L.L.C. it qualifies) will receive a twenty percent deduction on taxable income from the pass-through entity (or more if you have substantial income.) See this take. The income from the L.L.C. would now be taxed at a 25% rate; if the business had a lot of income – which previously would have been taxed partly at your personal bracket – your taxes might go down a lot. Incidentally it’s worth mentioning that REITs now will come with a tax benefit: 20% of their dividends are deductable.
Unless something changed, I believe the depreciation schedule is now twenty-five years instead of twenty-seven and a half.
The 1031 exchange is still allowed on real estate. A 1031 exchange allows you to avoid capital gains taxes when selling one property and buying another similar one.
Outside of retirement accounts, real estate offers you more ways to avoid taxation than other kinds of investing, unless you’re a hedge fund manager taking advantage of carried interest.
Taxes matter, but the bottom line is that the IRS won’t tax you on money you don’t make; changes in tax law will for the most part only change how much of your income is shielded from taxation. For one-off and small scale investors taxes shouldn’t be a large factor in your planning. If you invest long-term you will benefit from the 1031 exchange, but you would benifit almost as much by avoiding broker fees.