I recently went on vacation to the Outer Banks, a barrier island off the coast of North Carolina. It is a popular tourist destination, known for the wide expanse of beach front, state parks and unique history. Driving along the main road, a relative of mine, noted all the for sale signs on million dollar properties. I started wondering how many first time buyers had purchased these properties.
Perhaps these owners decided to purchase a property and then rent it out believing that the $8000 per week rentals would cover all their expenses and a mortgage payment. They may have expected to have a vacation spot without needing to pay any rent. When the property began needing repairs, maybe they realized that the rental season is too short to cover the real estate company's commission, the mortgage payments, utilities, and repairs.
What these potential first time owners discovered was that it costs more to keep the place up and pay the bills than the amount of rental income they receive. Ultimately, renting a place may be less expensive than owning. So these hypothetical owners put the house on the market, if they are lucky the property appreciated enough for them to recoup part of their cash outlay. If they aren't lucky and hit a down market (like the real estate market crash in 2009), they'll end up paying to get out from under the property.
Many of my clients ask me about real estate investment as a means to diversify their investment portfolio.
Real estate investments are easy to track and calculate net income compared to other business investment options and only require some upfront calculations to determine if they will be profitable.
Unfortunately, many real estate investors are first time investors who are emotionally devoted to finding their dream vacation home. In most of these situations this is a second home and not an investment. It’s important to not let emotions get in the way of doing the homework involved in real estate investing.
Emotions aside, the two key motives to own investment real estate are cash flow and capital appreciation.
A property generates a positive cash flow when the income coming in is greater than the expenses and debt service paid out. This differs from net income which excludes principal payments on debt, but includes depreciation expense.
Capital appreciation occurs when the property value increases above the original purchase price. Appreciation can have a high reward, but it comes at high risk. If you hit the right market at the right time you can make a lot of money on the appreciation. Yet, more times than not, the appreciation is not there once you consider all the money put in over the years.
Usually investors invest for one or the other. Finding a property that provides both can be difficult though very rewarding.
When I discuss real estate ownership with clients, I tend to stress cash flow over appreciation. Most clients can’t afford the risk involved in gambling on appreciation. Purchasing a property that cash flows can be a good investment for most investors since the risk is much less. For most of my clients investing for cash flow purposes is the right move.
The Homework required for Real Estate as Cash Flow investments:
Buying for cash flow takes some patience and some time to find the correct property.
The toughest part for most investors is to do a cash flow projection.
The first step in finding a property is to find an area where the rental market is strong or growing. It could also be an area next to a growing rental market as the rental units in the first area become scarce. Finding a property in an area that will rent for enough to cover ongoing expenses and the repair expenses that pop up can be a challenge.
Once you locate a property, you need to determine the rental market rates and put some cash flow projections together. Using an office building as an example, some of the questions you need to answer are:
What is the rental rate per square foot?
- There are publications in most areas that give the detail of rental rates for the different locations.
- Also, a real estate agent can usually give you information on rental rates.
- It is important to take a look at some of the buildings in the area when determing rates. A newly built building with many amenities will command a greater rent than an old building that needs some repairs.
- Compare the condition of the property you are thinking about buying with other similar buildings in the area and use that rental rate.
Consider the risk of vacancy.
- How many offices are in the building?
- Will there be one tenant or many tenants?
- More tenants with different lease end dates reduce the risk of vacancies affecting cash flow.
When will your cash flow start?
- Is it already rented or will you need to find tenants?
- If you need to find tenants, your cash flow will not start immediately and you will need to take this into consideration when doing your projections.
How much are the real estate taxes per year?
- Most counties have a real estate website that will tell you how much the property is assessed and the current taxes.
- If the assessed value is much less than the purchase price, you will need to adjust the potential annual tax bill based upon the purchase price just to be on the safe side.
How much are utilities per year?
- A real estate broker should be able to give you the previous owner's yearly expenses for the prior two years. From this you can determine the monthly cost for utilities, repairs, real estate taxes, etc.
How much are the maintenance costs?
- Again, a real estate broker should be able to give you the previous owner's yearly expenses for the prior two years. From this you can determine the monthly cost for maintenance, etc.
Are any major repairs needed?
- Is the roof new?
- Does the parking lot need to be repaved?
- Are there siginificant repairs needed before it is held out for rent?
- Gathering this data is where most investors stall.
The next step is to put some cash flow projections together
Figure out the monthly Gross Income:
- You have a 10,000 square foot building and you can get $12 per square foot rent, your annual rent would be $120,000 per year if it is fully rented.
- I usually recommend discounting this number by 20% to take into consideration potential vacancies. 20% equates to about a 2 month vacancy period, if the building is fully rented with long term tenants, this percentage can be reduced.
So your budgeted rent with a 20% vacancy is $96,000 per year or $8,000 per month.
Calculate monthly expenses:
- Real estate taxes will be $24,000,
- Utilities will be $24,000
- Insurance, Maintenance and a sinking fund for Repairs and Replacement, etc. will be another $12,000.
Subtract monthly expense from monthly rent
- This leaves you with $3,000 per month to pay the mortgage and accumulate a profit.
- You purchase a building for $400,000 and have 8% of closing costs, the total outlay is $432,000.
- The bank gives you a 3.5% interest rate over 20 years if you put 15% down, $60,000 (400,000 x 15%), this gives you a mortgage of $340,000 (400,000 - 60,000) and a monthly payment of $1,971.86.
- Your out of pocket expense is $92,000 (32,000 + 60,000) for the down payment and closing costs.
- Your monthly cash flow is $1,028 ($8,000 - $5,000 - $1,972) or $12,336 per year.
- Taking this cash flow as a percentage of your investment, you will have a 13% return on your $92,000 investment.
This differs from most return on Investment calculations in that we are deducting the full mortgage payment not just the interest portion.
Using the same information as above but paying cash:
- ...would put your outlay at $432,000 and your monthly cash flow at $3,000 ($8000 - $5,000).
- The annual cash flow would be $36,000 ($3,000 x 12).
- This would equate to an 8% return on investment.
This difference on the return is why most investors leverage the investment.
Last but not least, Negotiate!
Now that you know what you can afford to cash flow the property, you can negotiate with the owner to get the building at the price you need to make the cash flow work. If you can't come to an agreement, you need to be diligent and walk away from the deal. There will be other opportunities. If you get the building for the correct price, your return on investment can be substantial, if you don't it can be a drain.
I often see investors forget to work in a profit amount when they do their projections. Using the example above; this means they would be willing to use the entire $3,000 cash flow to pay the mortgage. I believe this is a big mistake for the following reasons.
- They do not know for certain if the property will appreciate.
- They will be tying up their investment for the 20 year life of the mortgage.
- If something goes wrong, like they need to put a new roof on and the sinking fund only has $5,000 in it but the roof costs $20,000, they will be out of pocket once again.
- If you're going to invest in real estate put your emotions aside.
- Use the cash flow approach! Unless you can afford the cash outlay needed for the appreciation approach the cash flow approach is the way to go.
- Do your homework! Real Estate can be a very rewarding investment if you do your homework properly.
- Calculate the potential cash flow before you make a purchase!