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Updated over 8 years ago, 03/21/2016
How the deposit affects cash flow
I hear so much about how important it is to have positive cash flow when analyzing a property to buy and hold. What I don't hear is how the deposit you put down on a property affects the cash flow (by directly affecting the amount of money you need to borrow), and how that should affect your analysis.
For example, let's say I have $20,000 to buy a $100,000 property, but can qualify for a low interest FHA loan that only requires a 3.5% down payment ($3,500). Since my mortgage payment will be relatively high, let's say this causes my analysis to show a negative cash flow.
On the other hand, imagine if I had chosen to put the entire $20,000 as down payment. My mortgage payment would be lower, so let's say it's enough to provide me with positive cash flow.
So what's the difference? Should I turn down the deal just because I plan on only putting 3.5% down, just so I can keep extra cash on hand? Why does the deal suddenly get better when I tie that $20,000 as equity into the house? Whether my $20k is in cash, or is tied up in equity, why should that affect my decision based off of the cash flow rule?
What if I was paying 100% cash for the property? Of course the property is going to cash flow better than if it had a mortgage. But the deal may actually be terrible if you calculate it with a mortgage.
What am I missing here?
Originally posted by @Levi T.:
@Account Closed capitalization rate, is the ratio of NOI to property value, in this case what you paid, as everything else is assumption till otherwise, however a quick way of seeing if the property falls anywhere near what you want is to do, just run the gross earnings agents the asking price "gross cap"; Say someone called up and said they have a 2BR SFH for 100k, rents are 18k a year, which is a gross cap of 18%, so it would be a deal I would want to talk about, research, call the county, and run through my excel sheets to see what the cap rate is in the traditional since of NOI (What I'm calling "net cap"). Using this process lets me make deals dictions in the matter of seconds when people call me. If the deal falls under a 13% gross cap, it's a deal that will not workout once you take in operating expenses, so I can just turn the deal down and move on.
Seems your "gross" cap is basically a GRM. Why make up a process and term when GRM is already industry defined and understood?
But even then you are using the process in a backward manner that is killing deals for you. If the market GRM is 5 Then if this $100,000 for $18,000 Gross rent deal is offered to you then instead of blindly passing on the deal just make an offer at the market GRM of 5! 5 X 18000 = $90,000. See how that is easier to compute and keeps the negotiations open?
Gross Cap Rate is a common accounting term, nothing wrong with that. GRM works as well, you would lose out on the same number of deals one way or the other if the seller has no interest at reaching the GRM of 5, or a GCR (Gross Cap Rate) of 18%. So apples and oranges my friend.
Originally posted by @Levi T.:
Gross Cap Rate is a common accounting term, nothing wrong with that. GRM works as well, you would lose out on the same number of deals one way or the other if the seller has no interest at reaching the GRM of 5, or a GCR (Gross Cap Rate) of 18%. So apples and oranges my friend.
But this is a real estate forum and we are not discussing accounting. Seems best if we use the industry standard terms.
Using the GRM backwards has you making decisions based off an asking price. Doing it correctly immediately establishes market value from which you can make an intelligent decision. You will be in a superior position if you are negotiating from market value and not running in circles with asking prices.
Expand your view point man, there is more than one way to skin a deal, and just because the deal does not fit your target, it don't mean a price can't be reached. Besides who wants to always pay a GRM of 5. I'd personally like to get them for higher, or just get the property for free, but deals are deals, and you get what you can negotiate.
Accounting is accounting, even if the asset is real estate. For me, percentages are better as I'm not likely working in your type of business model. For example, my average deal is around 20-50 units in the $1 million - $2 million range, most times SFH, so if we are looking at a deal, or deals for the batch, and we know we want a GCR of 18%, but the owner is asking for a GCR of 13%, with a NOI of 8%. We now know a few things; first operation cost is 5% for the owner, we are also around 5% off targets. After that we can apply our own formulas and likely push the NOI down a bit further, before making an offer. For us it's about the bigger picture and spreads. So, nothing wrong with GRM, I may use it sometimes if it's something like one unit, but really it's just quick and easy for us to run the percent and look at the entire picture in one shot.
Originally posted by @Levi T.:
Expand your view point man, there is more than one way to skin a deal, and just because the deal does not fit your target, it don't mean a price can't be reached. Besides who wants to always pay a GRM of 5. I'd personally like to get them for higher, or just get the property for free, but deals are deals, and you get what you can negotiate.
There are different ways to analyze properties but doing it backwards should not be one of them. Don't you see that you are wasting time analyzing based on asking prices?
You say you want to get a property for a higher GRM. Why on earth do you want to pay more for the Gross rents? That is even more backwards. As far as the 5 GRM I stated that if 5 was the market than that would establish market value. Where I invest the GRM's would be in the 20's! If the market was only paying 15 then I would only want to pay 15 or less in that market. Why would you want higher GRM's? I don't think you understand the definition of GRM. Can you clarify?
Originally posted by @Levi T.:
Accounting is accounting, even if the asset is real estate. For me, percentages are better as I'm not likely working in your type of business model. For example, my average deal is around 20-50 units in the $1 million - $2 million range, most times SFH, so if we are looking at a deal, or deals for the batch, and we know we want a GCR of 18%, but the owner is asking for a GCR of 13%, with a NOI of 8%. We now know a few things; first operation cost is 5% for the owner, we are also around 5% off targets. After that we can apply our own formulas and likely push the NOI down a bit further, before making an offer. For us it's about the bigger picture and spreads. So, nothing wrong with GRM, I may use it sometimes if it's something like one unit, but really it's just quick and easy for us to run the percent and look at the entire picture in one shot.
Yeah my minimum price per unit would be about 10 times that but I'm not sure why you would prefer a percentage.
1. Where is this 5.5 (18%) GRM coming from?
2. The NOI is 8% of WHAT?
3. How do you define operation cost and how do you calculate it to be 5%?
4. The NOI for a property is determined by the market. How do you "push it down"?
No point, it's all outlined clearly in my last post, just like most your post try to insult people. GRM, GCR, or counting doors.. Whatever floats your boat to come up with evaluation model. Both work and both are used a lot, just because you don't agree with it don't mean it's wrong, I use it, and we are doing just fine.
Originally posted by @Levi T.:
No point, it's all outlined clearly in my last post, just like most your post try to insult people. GRM, GCR, or counting doors.. Whatever floats your boat to come up with evaluation model. Both work and both are used a lot, just because you don't agree with it don't mean it's wrong, I use it, and we are doing just fine.
But my point is that you are using metrics that even you can't define, or so it seems since you won't answer the 4 questions I asked. It's not a matter of me agreeing with them since you won't/can't explain them. If you feel insulted that's on you. I am asking you a few basic questions about what you are presenting here that you can't answer. Why is that?
In cash-flow markets running the numbers by assuming 100% financing will be the best metric but using 100% financing to analyze properties in an appreciation market will almost always result in negative cash flow. Does this mean investors shouldn't invest in appreciation markets? No. Bottom line is: know your market, learn what works for you, take action and repeat.
Originally posted by @Rob S.:
Does this mean investors shouldn't invest in appreciation markets? No. Bottom line is: know your market, learn what works for you, take action and repeat.
Yeah, like that makes sense. Oh wait, it does, nevermind.
But the big caveat that I'm expressing is that you also need to know the metrics you are using and their proper use. Thinking you have a deal because you negotiated 10% off asking price is not a winning method.
@Account Closed, do you invest in Honolulu?
Since 1978. Vegas & Bay Area also.
Bob I'll explain it again, last time:
1. Sellers asking price is 13% GCR, you want 18% GCR for all deals anywhere, for this example.
2. Seller is reporting a NOI of 8% on the asking price.
3. So... 13% subtract 8% is 5% current operating cost.
4. Buyer wants 18% GCR, so there's a 5% gap in offering and asking price.
6. Apply your operating model, NOI goes up or down, for the example it goes down, meaning it will likely be lower returns. lets say 6%, thus it's pushed down the net cap.
7. Buyer still want a GCR of 18% at minimum, so the seller has to clear the gap, thus the cap rate lowers, the buyers side of the GCR goes up, in this case 3% to make it 21%.
I know this is where your going to jump off and say it's backwards, or to many steps, but just hold that through..
This applies across any market anywhere, you don't need to get regional data. Right on the call someone can tell you they want 1m for a property that grosses 50k a year.. 50,0000/1,000,000 = 5% GCR. You already know that you don't want it at that price as your looking for 18% GCR, and can tell them just based on the gross income that they need to cut the price down to 250k, no math required to figure that out. If they can't play ball, done, move on.. if they can, open the excel and run your models on past data from all your other flips/buys, and send along a contract and some inspectors. All about moving fast at scale, I've been moving about 2 million a year in deals the last few years, plan to make it 4m this year, and 10m hopefully by end of next if I can.
Best,
- Residential Real Estate Investor
- Kansas City, MO
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The way we approach it is that a deal needs to cash flow fully financed for us to purchase it barring extraordinary circumstances. That being said, with FHA financing, that would be for a owner occupant only. If there's a lot of equity and you plan on living there, that does change things. The question I would ask is simply, can you do better than this property. What is your opportunity cost?
Originally posted by @Levi T.:
Bob I'll explain it again, last time:
1. Sellers asking price is 13% GCR, you want 18% GCR for all deals anywhere, for this example.
OK. One step at a time. Seller wants to sell at 7.7 GRM. 100/13= 7.7
You want to buy at 5.6 GRM. 100/18= 5.6. $100,000 Gross rents
Seller wants $770,000.
You want to pay $560,000, $210,000 less. Who is delusional and why? Convince me as the seller why your offer would be acceptable.
No one is delusional, it's perceived value. As a seller, you have to ask what is that value. For some, it's the peace of mind. As a buyer if you can find that value, you can close the deal.
I'm going to tell you a story;
A few years ago my wife wanted a new Honda Pilot for some reason, so she sent me to the dealership to trade in her ML350 Benz, they offered 15k for it, which was expected as we had it for many years, but I wanted 20k for it as the other car was around 40k. After a bit of talking, they agreed to give me 20k for the car, so we settled in to finish up the paperwork.
The agent asked me if I was getting a loan or not, and I told him I would, so he got the paperwork together. Anyone who has ever bought a car knows it's takes forever to buy a car. Even if your paying cash, it still takes hours to get in and out the door. After a while the day was coming to a close, and the agent was still running around with the closing department, financing, and management, making sure everything was just perfect.
Once everyone wrapped up, he passed me some paperwork that outlined that I would be borrowing 25k, and at that point I put down the pin and plainly said I was expecting to leave with only 15k in cost. He was shocked, he said that was impossible, but I told him I could not make a deal if it was not 15k. He called his manager, and with much fuss they ran around for an hour or so while making lower-and-lower counter offers, while I continued to say I would not buy it if I paid more than 15k. This keep going till finally everyone left, the agent sat down and started completing his paperwork for the day. 15 minutes pass, another 30 minutes passed, then his phone rang. He answered the phone, and talked to someone on the phone that was clearly higher up in the company. He said Yes, Yes Sr., I understand. Then hung up the phone. He leaned over, and shook my hand. He said Sr. you have gotten the best deal I have ever seen in my life. I had bought the car for 15k, which I promptly wrote a check for and went home.
Deals are made if you understand the value of making the deal.
Best,
Great question. Agreed on evaluating cash flow using a 100% financing. I am going to try that out as well. I also look at many different ratios and expected return measures in conjunction with cash flow. But just to be honest the only real estate I have ever purchased was my home, so I am new to this as well. In fact, this is my first post on BP so I hope it adds some value:
Have you ever heard of Net Present Value (NPV) and Internal Rate of Return (IRR)? These are also great calculations to add to your analysis because they will take into account the time value of money. NPV is a calculation used to estimate the present value of all future cash flows compared against the initial cash outlay. The IRR is the rate of return that would make the present value of all future cash flows equal to the initial cash outlay. The IRR is the percentage rate earned on each dollar invested for each period invested.
Many corporations will use NPV and IRR to compare projects with different capital requirements and cash inflows/outflows to get an apples to apples comparison. The same principals can be applied to real estate investing. There are pitfalls and assumptions with these calculations so be wary.
You can also add in scenario analysis to estimate worst case (e.g. unexpected cap ex) and best case (e.g. forget best case because it probably won't happen) scenarios.
Yeah, I heard a similar story like that from someone who paid about the price of a car for some Guru seminar. Still hasn't closed a real estate deal because he does not understand market value. Thanks for sharing.
Now back to this real estate conundrum. You Have a $210,000 difference here. You have provided absolutely no support for ANY market value but think holding firm to a 5.6 GRM will make the deal. And why 5.6? Since you're dreaming wouldn't 4.6 be even better?
Originally posted by @Levi T.:
Bob I'll explain it again, last time:
2. Seller is reporting a NOI of 8% on the asking price.
3. So... 13% subtract 8% is 5% current operating cost.
So at $770,000 asking the NOI at 8% is $61,600. That leaves $31,400 as operating expenses. You are saying operating expenses are 5% But that would be $38,500 or overstated by $7,100 (18.4%)! Seems pretty sloppy math. Did I misunderstand your figgering?
@Account Closed, I do now understand where you were coming from. Especially in value plays, I can see where a property may cash flow negatively in the beginning and become a cash cow after a while. Reserves and such are critical to success (and where many get into trouble).
That said, I shy away from appreciation as a strategy. Probably because of the market I am in and my strategy for investing.
Playing the appreciation market is probably safer than playing the stock market, but is still based and impacted by a number of outside forces over which I have very little control. One misspoken word by Janet Yellen and banks stop lending. A government body tries to reduce the cost of their water supply and you suddenly can't give houses away. A state stops paying its bills and one of the largest employers in the area, a college, lays off 700 people.
None of these events will do much for the buy-and-hold guy, either. But if you do buy it right and you do maintain it and you do plan for a worse-case scenario, at least you have a fighting chance of riding out the storm.
I guess it's a matter of preference, personal portfolio, and tolerance for risk. Also depends on where you are at in your investing lifecycle, too. Having a mix of different styles can help to hedge each other. But when you're just getting started it's tough to have several different styles all going at the same time.
I dunno, I'd give Levi the benefit of the doubt here and assume he's holding firm and doesn't care if he gets this particular deal or not. If he knows his market will support 5.6GRM and he runs into a seller at 7.7 they likely won't strike a deal until the seller realizes they're asking too much.
Would there be a better chance of making that deal if you go in with comps and a list of work that needs to be done to justify why your 5.6 GRM is the better number? Sure, but if you already have too many deals why go through the work?
Originally posted by @Ronald Perich:
@Account Closed but is still based and impacted by a number of outside forces over which I have very little control. One misspoken word by Janet Yellen and banks stop lending. A government body tries to reduce the cost of their water supply and you suddenly can't give houses away. A state stops paying its bills and one of the largest employers in the area, a college, lays off 700 people.
None of these events will do much for the buy-and-hold guy, either.
Exactly. What affects my appreciation rate will also affect your rent rate, vacancy rate, etc. My over 40 years of market analysis has shown the market to be very predictable in about 10 year cycles. 9-11% appreciation and 6%+ rent growth. I ain't gonna invest worrying about the zombie apocalypse.
Originally posted by @Wes Brand:
I dunno, I'd give Levi the benefit of the doubt here and assume he's holding firm and doesn't care if he gets this particular deal or not. If he knows his market will support 5.6GRM and he runs into a seller at 7.7 they likely won't strike a deal until the seller realizes they're asking too much.
Would there be a better chance of making that deal if you go in with comps and a list of work that needs to be done to justify why your 5.6 GRM is the better number? Sure, but if you already have too many deals why go through the work?
See Wes, Levi says 5.6 GRM works across all markets. Read above. You should know that is foolish. His problem is that he is negotiating from asking price without any knowledge of market value. Do you do that?
P.S. Wes Brand. The GRM is market derived. Any work needed to be done would be subtracted from the value AFTER the value was derived by the GRM.
Originally posted by @Levi T.:
I always run it as 100% financed, easy numbers to work with, and safer. Things I look at when doing deals:
1. At a glance; I want to figure out the gross cap. This at least lets me know if the income to property cost is right. If this don't work out, it's not worth learn more and I turn down the deal.
2. If gross cap is good. I dive into the net cap to insure it is cash flowing. Lots of times this is where bad management has run the rental into the ground. Don't expect to unload utilities or basic operations cost, however late pays, evictions, and run down units are easy to fix.
3. Finally LTV/Market value at closing without improvements. Leave plenty on the plate to insure you can get out if something goes sideways, plus that's your bonus profit after cash flow.
Buy and hold is like a slow flip, you want to earn at a higher rate than you can get on the stock market, then kick it the bonus earnings on exit.
*via my iPhone
You mentioned gross cap. Is a higher or lower gross cap better?