5 Methods to evaluate your readiness for the money shift of our lifetimes
You don’t have to look far to hear people talking about the current greatest wealth transfer the country (perhaps the world) has ever seen. When the Pandemic subsides and the forbearances and eviction moratoriums are lifted, opportunities will abound, albeit differently.
Whether it is a single-family home, an apartment building a commercial investment like a mini storage unit or perhaps an office building, pending inventory levels are about to significantly rise. As you know when inventory goes up- prices comes down.
The great wealth transfer is underway. The question is: Are you ready for it?
The time to get better pricing and great interest rates may never have such a great alignment as it will have now. So you want to be prepared, educated and informed.
Luck
Remember the definition of luck: When preparation meets opportunity.
The investment you choose does not really matter as the analyses process is pretty much the same. Outside of the typical due diligence to check on the structure of the building you want to see how the property performs on your balance sheet.
5 things to identify when doing your due diligence.
Note when analyzing investment property you always want to consider items like closing costs and any lender fees. For simplification purposes the illustrations below are using easy numbers so you can quickly identify the process. When analyzing investments you want to incorporate any and all expenses and fee. Here is a calculator that will make this process easy
1. True income and expenses: true income is verified income. This is usually found on the seller’s income tax returns on Schedule E. Often a seller will state income to be X but report a different income on their tax record. Using true income is paramount. Income is all income the property generates (rents, vending machines, Laundry machines, etc.). Expenses are all expenses related to the daily operations of the property, taxes, utilities paid by owner, property management fees, landscaping etc. Note: mortgage payments are not included when identifying total expenses as many investors purchase property with different terms. Some pay cash some buy with 50% down payment as others finance up to 80% so each of these investors will have a different return on investment. For this exercise, we want to analyze investment that will give a true picture of the returns.
2. Cap Rate (capitalization rate): This is perhaps the most widely used formula for identifying the performance of a property. it is a simple formula NOI / purchase price. Exp: purchase Price $100,000 / NOI $90,000 = 9% cap rate. So what is a good cap rate? This will vary by city and by the market conditions. The principle is to determine what an average cap rate is for previous sales in your area. Determine if you have a good cap rate for your area or not. Most investors have a set cap rate floor they are willing to invest in. a common practice is to have a cap rate at least 2 to3% higher than current prevailing interest rates. This way if you were to fiancé a property you would have positive leverage.
3. Net operating Income: a simple process of adding all income together, all expenses together to get annual income and annual expense. Then subtract the income from expense to get Annual Net operating income.
4. Cash on cash return. This is the process of establishing how much return your cash invested into the property generates. If you buy with all cash versus buying with say 75% financing your cash on cash will differ. Cash on cash return is your total out of pocket expenses minus your net operating income minus any mortgage. EXP; Investor A buys a $100,000 property and pays all cash. The expenses are $10,000 per year. So the NOI is $90,000. His/ Her cash out of pocket is $100,000 so the $90,000 represents their return on their $100,000 cash investment. $90,000/$100,000 so their cash on cash investment return is 9%. Now investor B buys the same exact property only financing 75%. So their cash out of pocket is only $25,000. $90,000 / $25,000 = 36 percent cash on cash return. Often investors looking to increase cash on cash return will leverage their cash and buy multiple property allowing them to purchase and control more real estate
5. Cash flow: This is a first year look at the profit you make. NOI minus any mortgage = first year Cash on Cash Return.
Using above example the cash buyer has no mortgage so his/ her net operating income is the same $90,000 as his/her cash on cash return. Buyer B however has a mortgage so his/her cash flow is his NOI of $90,000 less his/her annual mortgage payment. (Let’s assume his/her annual mortgage payment is $10,000) $90,000 NOI less mortgage payment of $10,000 = $80,000 in cash flow
Here is where it gets exciting
You can see the importance of structuring a deal. Investor A has a hot button of getting maximum cash flow. He / She do not want to carry mortgage payments so he gets a whopping $90,000 in annual cash flow.
Investor B has a hot button of getting higher cash on cash return. He / She only put $25,000 of His/Her own cash in to the property so He / She gets a whopping 36% return on his / her cash.
“Good Debt”
Let’s assume Buyer B who only put $25,000 into this purchase actually had $100,000 cash to spend. By financing 75% this Investors cash flow is $10,000 less per year than the Cash Investor but if he / she used his/her $100,000 cash available to buy 4 exact properties like this one, he /she would now have 4 properties each worth $100,00 for a total of $400,000 worth of real estate appreciating in Value. He / She would also now have 4 properties generating $80,000 per year in cash flow (4x$80,000=$320,000) so 2 investors investing $100,000 each come out with 2 very different outcomes.
So you can easily see how different investors purchasing the same property can accomplish much different objectives. It is all in how you choose to structure the deal. This is the importance of creating your investment plan up front, knowing what your goals are and being purposeful with your investments.
Happy investing!
The author’s opinion cannot be construed as tax or legal advice, and may not represent the views of HTBUSA or its stakeholders. HTBUSA is not a legal service or professional tax service. As with any investment, there is an inherent risk in investing in real estate.