Friday, July 16, 2010

How Real Estate Investors Invest

This blog often deals with subjects that border on the abstract when it comes to the nuts and bolts of real estate investing. I recently viewed a spreadsheet used by a full-time real estate investor, one also used by many of this investor's acquaintances in the same line of work. This post is devoted to me explaining what factors they are using in their spreadsheet to calculate returns.

I will be focusing on a spreadsheet for the so-called "buy and hold" strategy -- buy, rent out, and hold indefinitely. We do not assume the property will be sold any time soon but, of course, capital appreciation comes in to calculating total return. So lets get into it.

(Note, I do not have permission to share this spreadsheet directly, however I will summarise how its calculations are performed as well as what inputs are used.)

Purchase Price

The first input into the spreadsheet is purchase price. We add into this closing costs and taxes, as well as any renovations that need to be performed before occupancy:

Total Price = Purchase Price + Closing Costs + Renovations

Revenue (Rent)

The major source of revenue for a property is rent. Here we use the anticipated annual rent from the property. There may be additional income sources, including: parking, vending, storage, interest income (e.g. on capital reserve), laundry, et cetera.

Operating Expenses

Operating expenses are the ongoing costs of maintaining the property. These would include property taxes, insurance, vacancy loss, advertising, repairs, management, strata fees, etc.

A big operating expense that is often overlooked by much of the analysis I see online is the so-called "capital cost allowance" which is effectively building up a reserve for capital replacement. This is, in the extreme, building up a reserve for building replacement but also includes large or small renovations that inevitably occur as the building ages.

Calculations

After determining our purchase price and costs, revenues, and operating expenses, we can calculate a few common values used by investors to determine their return. These are listed below:

Net Operating Income (NOI) = Revenue - Operating Expenses
Cap Rate = NOI/(Purchase Price) *
Gross Rent Multiiple (GRM) = (Purchase Price)/Revenue

* Note one can substitute Purchase Price with Total Price.

None of these calculations take into account financing. They are straight calculations on the investment's operations. They are also based on current, not future, operations; rent or operating expense increases are not calculated. GRM is analogous to the "price to rent ratio" that local commenters like to refer to. (A price to monthly rent ratio R would be equal to GRM*12.)

Debt Service and Financing

Financing is simply where the money to purchase the property comes from. It is either from the investor directly or through borrowing from a lending institution. Total debt servicing is an expense. Debt servicing costs are highly dependent on the interest rate. For longer term calculations, this interest rate may need to be modified to account for higher or lower rolled over financing costs.

Closing costs is the amount of cash required to complete the purchase, equal to Total Cost - Debt. A typical amount for closing costs would be, say, 25% of Total Cost, though other ratios are of course possible.

Capital Appreciation

Like most property, there will be some capital appreciation, usually expressed as an expected average percentage gain year-over-year.

Calculations after Financing and Appreciation

In a nutshell, a total return is comprised of: cash generation, debt repayment, and appreciation. After 1 year:

Cash on Cash Return (COC) = NOI/(Closing Costs)
Equity = (Purchase Price)*(1+Appreciation) + Cash - Debt
Return on Equity (ROE) = NOI/(Equity)
Total Return on Investment = Equity/Closing Costs - 1

NOI is annualised.

Stuff Not Done

As mentioned, there are things that are not calculated. Rental and expense increases, as well as debt repayment schedules are not calculated. There is a good reasons for this, in this particular case. The philosophy is that if the return after the first year is not positive, it generates no income for the investor. This is not sustainable without a large pool of cash to finance the shortfall -- these particular investors want to produce income.

Summary

Above are some of the formulas used by full-time residential property investors to calculate an investment's return. You can plug any property you see for sale on the market into these formulas into and come up with some typical figures, then play around with the financing costs and appreciation (both these have high sensitivity when it comes to calculating return). I'll go through a simple example next time.

These investors own property locally and are actively looking to invest in property in the current market. If you want to know who is looking to buy, it helps to understand what calculations and analysis they perform to determine a property's value and under what conditions they would buy.

10 comments:

Ray Barrett said...

Thanks! An example with all the parameters would be great.

david said...

I like the "stuff not done" part. That is basically the reason I think buying is a bad idea right now.

Sure, you will eventually pay off a place and when you do you expenses will almost surely be less than renting. It is also true that rents go up over time. But if 1 years rent is less than 1 year of paying mortgage interest, strata and taxes, then there really isnt much of a reaon to buy.

It is true that eventually rent would be more than mortgage interest, strata and taxes, but getting there means paying more than rent for 10-15 years. Why wouldnt I just save the difference for a bigger downpayment until the numbers make sense?

JimTan said...

I can immediately surmise that you haven't made many investments. Where's the risk calculation and premium?

The risk premium has to be factored into your cost of capital!

jesse said...

"I can immediately surmise that you haven't made many investments."

Re-read the post, Jimtan. These aren't my calculations; they are what others use.

JimTan said...

"I will be focusing on a spreadsheet for the so-called "buy and hold" strategy -- buy, rent out, and hold indefinitely. We do not assume the property will be sold any time soon but, of course, capital appreciation comes in to calculating total return. So lets get into it...

These investors own property locally and are actively looking to invest in property in the current market. If you want to know who is looking to buy, it helps to understand what calculations and analysis they perform to determine a property's value and under what conditions they would buy."

patriotz said...

Like most property, there will be some capital appreciation, usually expressed as an expected average percentage gain year-over-year.

There's the mistake. Capital appreciation is not an attribute of the investment. It's just the difference between what you paid for it, and what someone else is willing to pay for it, and cannot be assumed in advance. If you "expect" it, you are a speculator, by definition.

Have to assume you never sell it and compare the present value of cash flows to purchase price.

jesse said...

"If you 'expect' it, you are a speculator, by definition."

Which doesn't necessarily have to be a mistake, though I agree it's the dependent variable. I think there are more than a few mines to avoid in analysis, including, as JimTan alluded, avoiding doing some decent risk analysis.

buff_butler said...

@jimtan

Instead of just critisizing why not contribute? Maybe we can learn something; perhaps you can too.

Regarding risk analysis it depends what you want to capture and what risk you are comparing. Ex: Given JimTans post history might likely includes capital appreciation in his calculation whereas I wouldn't.

Most important is cashflows; I have found useful to outline at what interest rate points would present problematic. Also 100% revenue should not be quoted because this is best case scenario.

jesse said...

Note that adding provision for vacancy (say, 5% of gross rent) is another typical expense. Rachelle over at Landlord Rescue uses 22% of rent to provision for operating expenses for a typical property, with more if it's an older structure with deferred capital replacement.

takloo said...

good post...

there is yet another method (though rarely used) for real-estate valuation - hedonic pricing model which incorporates internal & external factors of the property under valuation

for e.g.- no. of bedrooms, distance from nearest station, swimming pool, etc...

its a very crude way but nevertheless used