Thursday, July 29, 2010

How Real Estate Investors Invest Part 2

In the previous post in this series I outlined the basic inputs and calculations used by certain investors when determining the investment value of a particular property. In this installment we go through a simple example for a purpose-built rental building. A massive thanks to Rachelle over at Landlord Rescue for allowing me to publish a simple spreadsheet containing the calculations of an actual property in the Toronto area. (Toronto was used instead of Vancouver to avoid investors in Vancouver real estate from soiling themselves.)

link to spreadsheet (Note there is a bug with google spreadsheets; Click refresh if you get an annoying popup window and avoid dragging your mouse over the "anyone with the link" link. Should be fixed soon I hope.)

This is an actual real-life building in the GTA. We have the following inputs:

Purchase Price = $528,800
Closing Costs = $1,000
Deferred Maintenance (Renovations) = $0

Rent = 5 units totaling $3725/month

Taxes = $4759/yr
Insurance + Utilities* = $4974/yr
Property management** = 8% of revenue
Building maintenance = 10% of revenue
Vacancy allowance = 5% of revenue
TOTAL = $1668/month

* Rent includes utilities
** Property management fees can be a few % higher in Vancouver

NOI = Revenue-Expenses = $2057
Cap rate = NOI/Purchase Price = 4.7%
GRM = Purchase Price/Revenue = 11.82 (price/monthly rent = 142)

Here the investor is putting 30% down and assuming a 5% mortgage interest rate. With these numbers the mortgage payments just cover the NOI and is cash flow neutral, which is the goal of this particular investor.

Here we see the investor requires 30% down and 5% mortgage rate to make this property cash flow neutral. Also note the investor does not consider capital appreciation when determining the investment's value; it's all about the cash flow at what they consider to be a sustainable financing rate.

We can see right away the impact of lower mortgage rates on these investors' criteria for a cash flow positive property. They have no earnings, at least initially, save debt repayments. In time, the investor assumes, the rents will increase with inflation and start producing positive cash flow.

After some years there will be some added expenses as the building starts aging. This is partly, but not completely, accounted for in the 10% gross rent maintenance allowance. Significant overhauls may be necessary from time to time and this is accounted for through depreciation allowances, usually a few % of the purchase price on a geometric schedule. Though the spreadsheet does not explicitly cover this, one can expect in time some of the free cash flow to be diverted to capital replacement.

Also for consideration is the 5% assumed mortgage rate. Certainly in today's climate mortgage rates could easily stay at or below this level for some time. I have no doubt some investors are using even lower rates (even variable rates!) when calculating their monthly cash flow. Food for thought, though, that rates this low are borderline deflationary. It is unclear if the projected rental increases will be as large as anticipated if rates remain low.

With this in mind, there is a box at the bottom of the spreadsheet for calculating purchase price for a given cap rate. That is (at least in theory), an investment with revenues that generally track inflation should not vary their present value when inflation changes, therefore the cap rate will stay constant. What cap rate would be considered acceptable? Well the "acceptable" number used by this investor is 7% for that particular property, putting an acceptable purchase price in the area of $308,600. Food for thought.

So there you have it. A real-life example of a cursory analysis of a potential real estate investment. Certainly there is a ton more to consider when evaluating a particular property's investment viability but, following this investor's philosophy for what it's worth, having these numbers work on a particular property (at whatever values one considers acceptable) should warrant some additional investigation. Otherwise, it's probably best to spend one's efforts elsewhere.


Rachelle said...

The investor must have a spread between their cap rate and mortgage interest percentage to get any return on their cash downpayment.

For instance 5% cap rate and 5% interest on the mortgage = no return on your down payment.

6% cap rate and 5% mortgage = Return on investment

This example also included some allowances for property management, vacancy, maintenance. Real estate agents do not ever add these costs in when they do their cap rates. These real costs add about 22% to the expenses of the building. An investor buying a building according to a 9% cap rate as calculated by a real estate agent will actually end up with a property 11% negative cash flow!

Buyer beware indeed.

Thanks for the link Jesse!

patriotz said...

Thank you Rachelle and Jesse.

Being a landlord in Vancouver really hasn't made sense from a fundamental POV since the late 80's. Those who got in later were saved by falling interest rates and greater fools if they wished to sell.

Those lifelines will not be available going forward.

Anonymous said...

BC & Alberta's real estate prices will crash

Sudip Adhikari said...

Nice excel sheet indeed. The extra costs would really add up. Thanks for the insight.

Anonymous said...

the Cap Rate can be thought of as the cash return on investment... i.e. if you were to invest in a property for outright cash instead of financing it.

admin said...

I think a lot of people get confused by the cap rate. The first exercise tells you what cap rate you are earning at the current asking price, and the second is to determine what the real price is based on the fundamentals and YOUR cap rate.

Rachelle's spreadsheet is excellent. The only critique I have is that the mortgage calculation is not correct for Canadian mortgages. In excel the formula should be (1+interest rate/2)^(2/12)-1 to get the monthly interest rate.

michael said...

As a newbie in the real estate business, I'm very grateful that I read your article. It gives me more knowledge about this business.
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jesse said...

"In excel the formula should be..."

...corrected. Though the difference is small.

Hector said...

A Real estate investing is not a difficult task if calculated by determining the investment value of a particular property. This is very nice information to have with me. Excellent!

Kevin Matin said...

Great Information. That sounds great. Really helpful thanks for the Article, Great job, hope we can expect more articles like this. All the Best

Kevin Matin said...

Great Information. That sounds great. Really helpful thanks for the Article, Great job, hope we can expect more articles like this. All the Best

Micaela said...
This comment has been removed by a blog administrator.
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