Note: This is the latest post in my series of the ABCs of Buying, Selling and Investing in Real Estate. With each post, I select a letter (Y with this post) and write up a fictional advice column centered on the letter. The story is fake, but the advice is real(ty).
This post continues the story found in Three Yearnings all Real Estate Investors Have When Starting Out
It is always very pleasant when I run into current and former clients in the most unlikely of places. I was on a solo trip to Orlando where I was speaking at a real estate seminar. I had taken advantage of the Disney World tickets provided to me and was enjoying some great Beatles song covers in the England part of Epcot, when Yoko sat down next to me with a huge smile on her face. After we exchanged pleasantries and shock at running into each other, I asked her how her real estate investing was coming along. Yoko had started up her real estate business the previous year after years of thinking about doing it. Her hope was to be able to make enough passive income from rentals to retire from her usual nine to five job. She said she had been able to retire from her job three months prior due to the success of rentals she had acquired. I was very happy for her and asked her how she was gauging her the success of rentals. She blushed, which surprised me. She admitted that she had not been tracking it as well as she should have been doing, but knew she had enough coming into the coffers that she could easily pay her bills every month. She immediately asked me how other investors measured the success of rentals.
This is what I told Yoko….
I was gentle with her. I knew that many newbie investors had not been diligent in keeping their books. I had found that many really did not analyze the numbers as closely as they should to truly see how much money they were making on their rentals. I had worked with investors who told me that all that mattered was that they were seeing additional money in their checking accounts every month and that was plenty good for them. I told Yoko. “I think it is great that you have bought a few rentals and are seeing some cash because of them. However, if you don’t know how well your rentals are performing, how do you really know if your rentals are being successful?” Yoko muttered that she knew she should have been tracking the numbers better, but found it a difficult task to do daily, or even monthly. I told her to find a good CPA who was knew about real estate investing and work out a worksheet she could use to track her income and expenses. If that didn’t appeal to her, she could go to any number of sites on the web that would have some good spreadsheets(biggerpockets.com) she could customize to fit her own situation. No matter how she did it, she needed to have a very good grasp on her financials if for any reason for the time in April when Uncle Sam comes seeking for his cut. She looked alarmed at this last statement, and said she would look into it when she got back home. Feeling sorry for my terse ton, I immediately softened it and told her about three yardsticks investors use to gauge the success of rentals.
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2. Cap Rate – Let’s start this yardstick with a straight definition from PropertyMetrics.
What is a cap rate? The capitalization rate, often just called the cap rate, is the ratio of Net Operating Income (NOI) to property asset value. So, for example, if a property was listed for $1,000,000 and generated an NOI of $100,000, then the cap rate would be $100,000/$1,000,000, or 10%.
Cap rates are used by a lot of investors as a way to gauge the overall success of rentals. How high you want you cap rate depends on the area of the country you find your rentals. Here in North Texas, I have worked with investors who were happy with a cap rate of 5% or more. Their justification is that they would not be getting a better return with 5% on the rental than with other traditional investing tools like CDs or Bonds. Which expenses go into the calculation of NOI? It depends on the person. For example, some investors do not include the property taxes in the NOI as they feel this is an expense that stands outside of the normal expense while others include all expenses. If you ever want to have a lively conversation over a beer at the bar, ask this question of the guy sitting next to you. Everyone has an opinion.
3. Cash on Cash – This metric is defined by Wikipedia as “the ratio of annual before-tax cash flow to the total amount of cash invested, expressed as a percentage.” The cash flow is what a lot of investors will use to evaluate the success of rentals. If the investor is realizing a positive cash flow, then they consider it successful. Cash on Cash takes the cash flow one step further by evaluating it based on the amount of cash you have leveraged to obtain and maintain the rental. I have seen investors use cash on cash more frequently if they are investing via loans. It is a great way to guide your thinking on whether a loan is working on your behalf, or if is costing you too much and it might be ready to sell the property, or increase the rent to get a higher return.
Yoko had a pleased look on her face when I was done. She said she understood the importance of using cash flow, but there were additional metrics she could use to help evaluate the success of her rentals. Since she was using cash, she felt the cap rate was a better fit, but would consider the cash on cash as one more way to see how her rentals were performing. As she finished her statement, the band started up again, but she gave me a thumbs up that I had done well.