It seems like everyone in Chicago wants to be a real estate investor and judging by the number of 2 – 4 flats in the city it seems like plenty of people have realized their dream. I’m not sure what it is about real estate investing that appeals to so many. It might be the late night calls from angry tenants, or the collection nightmares, or the onerous eviction process, or dealing with vacancies, or the unexpected repairs, or the arcane rules around security deposits. Who knows? I suspect it’s actually the promise of some kind of vague financial reward. They might become the next Donald Trump.
The problem lies in the vague part. If you’re not sure what you are hoping to get out of a real estate investment then how will you know what to buy? So whenever a new investor client comes along the first thing I ask is what are their financial goals? Here are some typical responses.
Cash Flow Positive
This is probably one of the most popular financial objectives and it’s easy to understand. They don’t want to have to sink cash into the property every single month after collecting the rent and paying off the expenses, including the mortgage payment. They should, but they don’t always, factor in the tax benefits of the depreciation in determining the net cash flow.
This seems like a reasonable, basic criteria for an investment property. It’s producing some cash and, over time, the rent should go up so the cash flow should go up as well. In addition, as you pay off the mortgage you are building equity in the property. Of course you are also building equity by virtue of the fact that the value of the property is going up as the rents rise.
The only problem is that if you just look at the cash flow you don’t know if you’re getting a good return on your investment. Maybe you would be better off investing in a Chinchilla organic kale farm. More on this in the cap rate section below.
Cost Per Unit
This has always been a real head scratcher for me since it totally ignores everything that matters – like rent and operating expenses. It seems like $100,000 per rental unit is a popular metric. So I get calls from people looking for buildings with $100,000 units. It doesn’t matter what the rent is or where the property is located or what kind of condition the building is in or how nice the units are as long as they don’t pay more than $100,000 per unit.
Well, if you really know a neighborhood and you understand its economics and all the buildings are pretty similar then maybe you can sorta use this as a really rough initial screen. But that’s it.
This metric enables an investor to start to do a bit more sophisticated evaluation of investment opportunities. Basically it’s net income (rent – all operating expenses excluding interest)/ purchase price. Typical cap rates could be anywhere from 4% – 20%. So it not only takes into account the income the property will generate but also the total investment in the property. For those of you with a finance background it’s essentially return on assets and the nice thing about it is that you can use it to compare various investment opportunities – real estate or not.
Of all the metrics this is one of the least bad. However, the problem with this metric is that it simplifies the net income equation (more on that another time) and it doesn’t take into account the impact of financing, though it does tell you what the threshold should be for your interest rate – i.e. you don’t want to be paying a higher interest rate than your cap rate. And it doesn’t reflect the income tax impact.
The other thing that wannabe investors need to realize is that the cap rate is inversely related to the economic prosperity of a neighborhood. So cap rates are very low in Lincoln Park, very high in Englewood, and somewhere in between in West Town. That’s because investors need a larger incentive to invest in more economically depressed areas. Vacancies and rent delinquencies are higher there and the prospects of future appreciation are lower – until they are not.
Gross Rent Multiplier
They don’t want to pay more than X times the annual rent. (10 times is a popular multiplier.)
Well, it’s simple to understand but it totally ignores the expense side of the equation. However, if you think that all the historic expenses are bogus anyway (the seller is lying, they haven’t spent enough on maintenance, or they don’t track their costs closely enough) and all buildings should basically cost you X% of rent to operate then this basically becomes a proxy for cap rate. For example, an expense ratio of 30% on a building purchased at a 10 X gross rent multiplier essentially has a cap rate of 7% (rent – .3 rent)/ 10 rent = .07.
Cash On Cash Return
The basic concept is to look at the net pre-tax cash flow relative to the cash invested in the property. This is similar to the cap rate except that it includes the mortgage payment as an expense and the denominator is just the cash invested by the buyer (down payment + closing costs + needed improvements). The complete formula would be (rent – operating expenses – mortgage payment)/ (down payment + closing costs + needed improvements).
This is getting closer to a useful measure in that it tries to get at the return on investment. However, it’s still messed up in that it includes principal repayment as an expense and it doesn’t reflect income tax impacts.
Return On Equity
This is a refined version of cash on cash return. If done correctly it would be based upon after tax numbers and would not include principal repayment as an expense. It basically tells you what kind of economic return on your investment you will get – and after all that should be what you are after.
Of all the simple metrics I probably like this one the most since it really tells you what you need to know – assuming of course you factor in everything that really matters. However, as I will point out in a later post this number – in fact all these numbers – vary over time.
Net Present Value
They taught us in business school that this is the only acceptable way to evaluate any investment and that’s actually correct. However, almost no one looks at real estate investments this way because it’s too complicated for the average bear. If you are interested you will find a good overview of this technique from Wikipedia:
In reality there are as many metrics as there are wannabe real estate investors. Some people are focused single mindedly on the appreciation and others just want the properties to produce some kind of income. I’ve had people tell me that they will use all the cash from the properties to pay down the loan and they want to own the building outright in X years. Or maybe their goal is to live in one unit and rent out the others to pay their expenses. I totally get financial goals like this but the problem is that it’s difficult to compare opportunities on this basis and they really won’t know whether or not real estate investing will be any better for them than investing in that organic kale farm.
In a follow up post I will cover a real estate investing model that I created that helps investors evaluate multiple metrics simultaneously and also tells them what they really need to know.