Real Estate Investments | The Cash Flow Approach
Many of my clients ask me about real estate investment as a means to diversify their investment portfolio.
Emotions aside, the two key motives to own investment real estate are cash flow and capital appreciation.
The Homework required for Real Estate as Cash Flow investments:
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!
- 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!