Saturday, June 26, 2010

Landlord Math – Cap Rate and Return on Investment: Million Dollar Journey



Landlord Math – Cap Rate and Return on Investment: Million Dollar Journey

Posted: 24 Jun 2010 04:30 AM PDT
This is an article from our regular real estate columnist Rachelle.
Every landlord should know some basic math. There are calculations that are indispensable to the business. I have seen plenty of fast and loose interpretations of these formulas. Remember when you are buying a property the seller is going to try to get creative to minimize expenses while you the buyer must use proper formulas to determine the purchase price for the property.

Capitalization Rate (Cap Rate)

This is probably the most common metric used by investors. Sellers will drastically understate expenses. Ask for copies of original bills. If they refuse just move on and find a more honest seller.
  • Gross Operating Income – Expenses = Net Operating Income (NOI)
  • Net Operating Income/Purchase Price = Cap rate
Lets talk about expenses. This includes bills such as natural gas, electricity, water and property taxes. This calculation also includes a percentage for maintenance, property management and vacancy allowance. Those expenses are what sellers leave out. This is your safety margin and believe me you will need it at some point.
Sample Cap Rate
A nice example of a Cap Rate calculation can be found here on CMHC's website.
The only item they are being shy about is the percentage for property management. You should calculate your property management at around 7% in my opinion. All things considered, the calculation is well done. You can find vacancy rates for different areas here.

Deferred Maintenance & Micro Analysis

When deciding what to offer for a property you'll want to look at deferred maintenance both in the apartments and throughout the building. This is the list of stuff the previous owner should have done but did not.
You'll also want to know more about the building. Was it a drug den? How do people like living there? Were there three murders in the building two months ago? What is turnover like? Have the tenants been there a long time? How is the street? What is the reputation of the building? For this you'll have to go back to the area without your real estate agent and knock on some doors.

Cap Rate Reversed

You'll want to calculate the Cap Rate equation in reverse. This way you can decide how much you want to pay for the building.
  • NOI/Cap Rate = Purchase Price
Lets assume you want to achieve a Cap Rate of 8%. You'll want to plug in all your numbers for expenses to figure out the real Net Operating Income then do the calculation to figure out how much your final purchase price should be.
  • $40,000 (NOI) / .08 = $500,000 (Purchase Price)

Cash on Cash Return

This calculation is more complex. Once you have figured out your NOI you calculate this important metric. This measures what the Return on Investment (ROI) will be on the cash used. This is how to operate this calculation.
  • NOI – Mortgage payment = Projected annual cash return
  • Down Payment + Closing costs + Deferred Maintenance Expense = Cash Outlay
  • Projected Annual Cash Return/Cash Outlay = ROI
  • Cash Outlay/Projected Annual Cash Return = How long it will take before you get your money back
Buying income property is NOT a POPULARITY CONTEST.
The only reason to buy an income property is to make money. The only way you'll make money is to buy properly. With income property, it's all about the cash flow. If you a buy a property without all the safety margin numbers in place, you will end up putting more of your hard earned cash into the property. Month after month, year after year you can look forward to owning a cash-sucking cow of a property.
You should put in offers on property using your analysis. Without offers no one will ever say yes. To do this you'll need a real estate agent. Lots of real estate agents will not want to put in the offers you want. If you're serious you might want to respect your real estate agents time by paying him or her something every time you put in an offer. You may have to put in 20 offers before one gets accepted. Why should the real estate agent spend his time and money working with an investor and putting in a bunch of complicated offers when they can go find a nice first time buyer, show them a couple houses and get a sale.
Feel free to show your math to the seller. It's very likely you aren't informing them of anything. They want to get as much as possible for their property. Can you blame them? It's not at all like buying a residential house. These properties are not very liquid and the only thing that matters is the income.

Return on Investment for Improvements

Once you have your property if you're smart you'll want to figure out how to increase the income. Every time you increase the income by $50 you'll increase the value of your building and improve tenant quality.
How much is a $50 per month increase in rent worth to the investor?
  • $50 x 12 months = $600
  • $600/.08 (Cap Rate)= $7,500 increased value of building
You'll want to figure out the payback on the improvement. How long will it take to get that money back? Increased building value is great but you don't get that money unless you refinance or sell the building.
If the improvement is painting the kitchen, putting new handles on it and installing a counter top. This will cost you $800 (assumed).
  • $800/$50 = 16 month payback
  • $50/$800= 6% ROI
  • $7,500 increased value of the building.
Lets try to put the $800 towards a brand new kitchen. The kitchen is 15 years old and beat up. Let's try and get an extra $100 per month rent. We'll spend $2000 on our kitchen. (assumed)
  • $2000/$100 = 20 month payback
  • $100/2000 = 5% ROI
  • $15,000 increased value of the building.
The new kitchen is a better investment. At the end of the payback period you have replaced something old with something new that you get to keep. Your building value has increased by $15,000.
I urge every landlord/investor to use these calculations. Owning an income property is not the golden path to riches proclaimed in endless programs, courses and seminars. Like any other business you must make wise investments with solid measurable results. It is easy to spend money you don't need to on things that don't need to be done or that don't return any money. Don't pay foolish prices for income properties. Money must be respected. The numbers are your friends.
Happy Investing !
About the Author: Rachelle specializes in renting property on behalf of landlords and is the blogger behind Landlord Rescue. She also works with investors to find good investments in Toronto and surrounding areas. Her passion is bringing multi res properties back from the brink and maximizing profitability. Check out some of her other real estate posts on MDJ.
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Normal is Broke

Living With A Chain

How to Get a Job when No One is Hiring

When the jobs are hidden

To get a job, you have to find the openings that no one's advertising, and really impress your potential employer.

By Jia Lynn Yang, writer-reporter
March 30, 2009: 12:31 PM ET

NEW YORK (Fortune) -- David Perry, a longtime headhunter, says you're wasting your time if you're looking for job postings online. And he should know: he's often the guy on the other side helping companies lure new talent. Perry, who's based in Ottawa, says that in the last 22 years he has accomplished 996 searches totaling $172 million in salary. And the bottom line in today's economy, he says, is you have to tap the "hidden job market."

Perry's also the co-author of "Guerrilla Marketing for Job Hunters" and he recently spoke with Fortune.

What's the "hidden job market"?

When companies say, 'We have a hiring freeze,' that doesn't mean they're not hiring. It just means they're not adding headcount. Every year there's 20-25% turn over. So in a 1,000-person company, 200 or 250 people are going to turn over, either through attrition, or someone moves. Those companies are still hiring but they don't want to tell you.

So how do you find these jobs?

What you have to do in a recession is map your skills to employers to where you know they have a problem you can solve. My advice to job hunters is pick 10 to 20 companies, no more, and pick companies you're interested in, and that you think you can add value to. That requires researching companies, and so that list may take you two weeks. If you're trying to crack the hidden job market and you know the job position you want reports to vice president, find that vice president on LinkedIn and look at his profile to see who else he's connected to and go ask them, 'What's this guy like to work for?' Do the research before you even pick up the phone.

How can you get someone's attention?

We can go into billboards, sandwiches - that stuff only works once. It's only for one person who figures it out once, once in a city. If you're looking for fun stuff, we have this thing called the coffee cup caper, 30% of the time it will result in an interview. You send an employer a coffee cup with a little $5 swipe card with a little note that says, I'd like to get together and talk with you over coffee. I'll be calling soon. And you send it by U.S. post two day delivery, and that gets registered. So when they've signed for it, you wait about 20 minutes and then you call them. And then you go, Hi, I know you just got my package.' You're proving you're imaginative and creative.

What something people should avoid during a job interview?

This drives me insane: I've seen people mentally deciding in the interview whether they want the job. That's the last place to decide. You go into an interview, and you sell like your life depends on it. You've got to get the job first. I've seen it thousands of times. There's this point in the interview, where people go 'Hmm, do I really want this? You can see their body change. The employer picks it up and it's gone. If the employer is telling you, 'I love you,' and you're not saying 'I love you too,' it's over with.

How about following up afterwards?

If you really like the opportunity, don't go home and write thank you very much. Go back and write a letter that says, upon further reflection of what we were talking about, here's what I bring to the table, here's how I see myself fitting into the organization, including a 30-60-90 day plan.

How can someone attract a recruiter's attention?

You have to go to ZoomInfo and LinkedIn and create a profile. All corporate recruiters and probably 20% of the headhunters in America have ZoomInfo accounts. When we start a search, companies aren't going to advertise. The headhunter goes to ZoomInfo, types in requirements that we need, like skillset, degree, city, functional title, and up will come anywhere from a hundred to several thousand people who fit that criteria. Then we go to LinkedIn and run the same search. If you're in ZoomInfo with a picture, we're going to call you first. Just reverse engineer what recruiters are doing so you get found.

How can you really impress a potential employer?

It hasn't worked in years just to bring in your resume, except only in the most junior positions. I concentrate on directors to CEOs, and the last interview for us regardless is always a Power Point presentation of what you've learned, pain points, and how you intend to fix that. Everyone talks about being a great leader and great communicator, so prove it. Don't go into an interview and treat it like it's just another business meeting. Your career is your biggest asset now - because it's certainly not your house. To top of page

From
http://money.cnn.com/2009/03/30/news/economy/yang_headhunter.fortune/index.htm

August 2008 Dave Ramsey on Barack Obama

This was aired in August 2008. So was Dave right???