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Updated over 6 years ago, 09/05/2018

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Jamie Nacht
  • Real Estate Broker
  • Seattle, WA
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Balancing Cash Flow and Appreciation

Jamie Nacht
  • Real Estate Broker
  • Seattle, WA
Posted

What's preferred: (1) High cash flow, but low chance of appreciation, OR (2) modest cash flow, but high chance of appreciation? 

I had a discussion last week with a fellow investor, and we were debating the merits of either of these situations (assuming it is an either, or situation). I'd like to throw it out to the BP community to hear your thoughts. To put a little more color to it, let's assume the following:

Situation 1: Invest in a market where it's likely to get cash on cash returns of 12%, but the market the property is located in hasn't appreciated at all over the last 5 years

-VS-

Situation 2: Invest in a market where it's likely to get a cash on cash return of 3%, but the market the property is located in has appreciated at least 6% per year, during each of the last 5 years. 

Which one do you like more? Why?

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Antoine Martel
  • Rental Property Investor
  • Miami, FL
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Antoine Martel
  • Rental Property Investor
  • Miami, FL
Replied

Neither sound good to me. 

12% cash on cash return is too low, you should look to get over 15% if it is solely cash flow.

3% cash flow is terrible and you should never buy a property thinking it is going to appreciate. You're taking a lot of risk when you do that and there are so many market factors involved in that type of thinking. 

Buy for cash flow but set your targets higher or look out of state where 15%+ returns are possible. 

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It depends entirely on what your financial goals are. If you are earning money to put food on your families table I don't believe grocery stores accept equity as payment.

If you have deep pockets and are not interested in earning a income you may choose to park your unnecessary surplus cash in high potential appreciating real estate.  You are basically gambling that the markets will not turn and that you are not so unlucky that you die before you determine enough is enough and sell.

Cash flow is low risk, appreciation, also known as speculation, is high risk. Investor or speculator.

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Joe Villeneuve
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Joe Villeneuve
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Replied

Neither.  Normally I would say High Cash Flow because you can see that, but 12% stinks if that's what you are depending on.  That means it would take you over 8 years just to break even.  To me, that's not cash flow...that's cash trickle.

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Jamie Nacht
  • Real Estate Broker
  • Seattle, WA
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Jamie Nacht
  • Real Estate Broker
  • Seattle, WA
Replied

 @Antoine Martel

Thanks for your input. So you think zero appreciation, but 15% cash on cash, is better than using the power of combining leverage and a reasonable expectation of appreciation? To be the devil's advocate, let me play out those 2 scenarios: 

Assumptions: You buy a property for $250k, and you end up spending $100k to get it acquired and up and running.

Situation 1 (detailed above, but for 15% cash on cash): Year 1 you make $15k, Year 2 you make $15k, Year 3 you make $15k. The property doesn't appreciate. At the end of year 3, if you decide to keep the property, you've made $45k all together, if you sell the property, let's conservatively assume 10% of the price ($25k) for transaction costs. Now you've netted $20k over. 

Situation 2: Year 1 you make $3k, Year 2 you make $3k, Year 3 you make $3k. While that's happening, you get modest appreciation... call it 6%. So at the end of Year 1, your property is now worth $265k, at the end of Year 2 your property is worth $281k, and at the end of Year 3 your property is worth $298k. At the end of year 3, if you decide to keep the property you've made $9k of cash flow (realized), and $48k of appreciation (unrealized), for a total return of $57k on your investment. If you decide to sell, (same 10% for transaction), you net $27k, so a little more, and you get the option to benefit from using a 1031 exchange to drive up cash flow with a newer investment. 

Targeting markets with that type of historic appreciation, and fundamentals to drive further appreciation seem to make sense to me. Over the last 5 years, here's the average annual appreciation (CAGR) in the following markets: 

Portland, OR: 9.9% 

Seattle, WA: 14.9%

Denver, CO: 13.5%

Reno, NV: 13.3%

Bellingham, WA: 8.1%

Boulder, CO: 7.9%

I feel like writing this out, makes me think I have a strong preference for markets that show appreciation... So long as I set an investment up to have positive cash flow that protects me from any troughs the market may run through...

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Antoine Martel
  • Rental Property Investor
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Antoine Martel
  • Rental Property Investor
  • Miami, FL
Replied
Originally posted by @Jamie Nacht:

 @Antoine Martel

Thanks for your input. So you think zero appreciation, but 15% cash on cash, is better than using the power of combining leverage and a reasonable expectation of appreciation? To be the devil's advocate, let me play out those 2 scenarios: 

Assumptions: You buy a property for $250k, and you end up spending $100k to get it acquired and up and running.

Situation 1 (detailed above, but for 15% cash on cash): Year 1 you make $15k, Year 2 you make $15k, Year 3 you make $15k. The property doesn't appreciate. At the end of year 3, if you decide to keep the property, you've made $45k all together, if you sell the property, let's conservatively assume 10% of the price ($25k) for transaction costs. Now you've netted $20k over. 

Situation 2: Year 1 you make $3k, Year 2 you make $3k, Year 3 you make $3k. While that's happening, you get modest appreciation... call it 6%. So at the end of Year 1, your property is now worth $265k, at the end of Year 2 your property is worth $281k, and at the end of Year 3 your property is worth $298k. At the end of year 3, if you decide to keep the property you've made $9k of cash flow (realized), and $48k of appreciation (unrealized), for a total return of $57k on your investment. If you decide to sell, (same 10% for transaction), you net $27k, so a little more, and you get the option to benefit from using a 1031 exchange to drive up cash flow with a newer investment. 

Targeting markets with that type of historic appreciation, and fundamentals to drive further appreciation seem to make sense to me. Over the last 5 years, here's the average annual appreciation (CAGR) in the following markets: 

Portland, OR: 9.9% 

Seattle, WA: 14.9%

Denver, CO: 13.5%

Reno, NV: 13.3%

Bellingham, WA: 8.1%

Boulder, CO: 7.9%

I feel like writing this out, makes me think I have a strong preference for markets that show appreciation... So long as I set an investment up to have positive cash flow that protects me from any troughs the market may run through...

 I see how you are thinking. 

You only get the benefits of appreciation if all the variables go in your direction. If in 3 years the market has been going only up and you are able to sell it for the price that you want and if someone is there to buy that property from you for a now 2% cash on cash return. You also only get the appreciation IF you sell. What if you want cash flow and don't want to sell a property?

For just a couple thousand dollars over a three year period the cash flow model is the best. The cash flow model it doenst matter what the market has been doing. The market can completely tank and people still will pay their rent, and if you need to drop the rent then you are not underwater but instead you are breaking even. And even in the down market you can still sell the property for what it is worth. 

You're taking a lot of risk and banking on a lot of factors just for a couple extra thousand dollars. I like to think long term with my properties with 30 year holds. 

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Ned J.
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Ned J.
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Unless you are into pure speculation, you buy for cash flow and hope for appreciation.

The issue with the sole mantra of "cash flow is king" is that buying a 40k house that cash flows $200/month but will still be worth 40k , 10 years from now, then that "cash flow" isn't really as good as you think it is.

You do have to consider your exit strategy....... you may think you will hold it forever but sometimes other things come up and you need to offload a property or two and all that "cash flow" is lost when you sell it at the same price you bought it 5 years, minus the work to get it ready for sale and the commissions etc etc...

Appreciation is only useful if you sell at the right time and use the $$ in the right way, or 1031 it into something even better, or leverage it....otherwise its dead money..

  • Ned J.
  • Account Closed
    • Rental Property Investor
    • Everett, WA
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    Account Closed
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    Replied

    @Jamie Nacht I am in real estate to become wealthy. A couple thousand more dollars a year of cashflow is not going to get me there at the rate I am looking for. Buying property with some cashflow that allows me to reinvest in an appreciating market has allowed me to reach my goal year after year and tremendously grow my net worth over the last 5 years. Easy to say in a bull market, I know, I know. But while everyone was sitting on the sidelines we were picking up fourplexes left and right in Everett. We chose Everett because it had/has decent cashflow but also a significant amount of appreciation potential. 

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    Jamie Nacht
    • Real Estate Broker
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    Jamie Nacht
    • Real Estate Broker
    • Seattle, WA
    Replied

    @Account Closed I'm glad you chimed in. That's been my experience as well. I've had the benefit of investing in areas that have shown considerable appreciation. Those investments have turned $100k increments of invested capital into $500k over several years. I ended up parlaying that into other investments, and I've been targeting areas that (i) have demonstrated strong historical appreciation, and (ii) have the right fundamentals for me to believe that will continue (e.g. more jobs being created than housing being developed, government infrastructure investment, etc...). I also have always set up those investments so that I am both rewarded (at least moderately) for holding the investments  and considerably protected in the event the market undergoes turbulence. I know certain parts of the country are high cash flow, low appreciation, while others are lower cash flow, with high appreciation. My experience has fortunately been in the latter, and has guided my investing behavior. Certainly agree with you that it's easy for me to make that statement on the shoulders of a long bull market though. 

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    Jamie Nacht
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    Jamie Nacht
    • Real Estate Broker
    • Seattle, WA
    Replied

    All, I just wanted to say thank you for the various viewpoints everyone brought to this discussion. I really appreciate hearing from those of you who have investing experience in different parts of the country. It seems to me that if you have spent time investing in a market that is known for high cash flow (15%+), you may look at my assumption of 6% appreciation as outlandish. In a similar vein, I am surprised by the idea of 15%+ cash returns. It's just not an achievable target in my area of the country. I looked at the National FRED database, and was able to confirm my thoughts: housing prices in some of the high cash flow markets BP members have highlighted in the south east (Atlanta, Knoxville, Baltimore, Raleigh) generated average appreciation of 3% or less over the last 30 years. That does contrast with markets like Seattle, Portland, Denver, San Francisco or San Diego that each averaged between 5% and 6% over that same 30 year period. For a $250k house, that extra 2% to 4% of annual appreciation makes a big difference over time, especially as it compounds. 

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    Jeffrey Holst
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    Jeffrey Holst
    Pro Member
    • Investor
    • Chattanooga, TN
    Replied
    Originally posted by @Jamie Nacht:

    All, I just wanted to say thank you for the various viewpoints everyone brought to this discussion. I really appreciate hearing from those of you who have investing experience in different parts of the country. It seems to me that if you have spent time investing in a market that is known for high cash flow (15%+), you may look at my assumption of 6% appreciation as outlandish. In a similar vein, I am surprised by the idea of 15%+ cash returns. It's just not an achievable target in my area of the country. I looked at the National FRED database, and was able to confirm my thoughts: housing prices in some of the high cash flow markets BP members have highlighted in the south east (Atlanta, Knoxville, Baltimore, Raleigh) generated average appreciation of 3% or less over the last 30 years. That does contrast with markets like Seattle, Portland, Denver, San Francisco or San Diego that each averaged between 5% and 6% over that same 30 year period. For a $250k house, that extra 2% to 4% of annual appreciation makes a big difference over time, especially as it compounds. 

     Appreciation can make you rich but price corrections can erase that quickly.  The last several years we have all made money on appreciation in almost every market but cashflow keeps you alive and 3% is way to risky is there a possibility if a better return sure but a small decrease in rents and you are toast.  If you have high cash in cash returns you can sustain in good and bad markets with high vacancy you still can be cash flow neutral it slightly positive when rents go down you till make mortgage payments.

    Consider this year one you cash flow 3k house increases in value as you said year two cash flow - 3k and can't make mortgage payments and you lose 100k or you are at least forced to sell at a big loss.  That's not a scenario I ever want to be in.  We look for high debt coverage ratios in rent min 1.5 x. Which means if the payment is 1000 we better be cashflowing 1.5* that before the payment ie 1500-payment =$500.  To do this we usually need to be in high teens for a cash and cash return.  If we lose appreciation it's worth it because I know I won't lose the property.  Also we have seen reasonable appreciation inspite of this strategy ie 2.5 to 5% gains last few years and I some case much more with no property declining in value.

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    Tyson Cross
    • Investor
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    Tyson Cross
    • Investor
    • Portland, OR
    Replied

    It's funny to see people talk about getting 12% returns and say that is bad. Some picky investors out there. Look, ideally you want both right? Yes, everyone wants both. You should not focus on houses and instead focus on multifamily/mobile home parks. Specifically, I invest in MHPs. We get phenomenal cash flow AND you can force appreciation. At the end of the day, if you are investing in multifamily buildings or mhps that are 10 units and up (really only 5/6 units and up) its considered commercial and thus valued differently. I say 10 units because you want some scale. When you invest in these buildings its valued much more heavily on income vs market driven. Thus, if you can improve that income you're going to increase the value of the property (assuming cap rate/interest rates stay relatively the same). This is why I highly suggest investing in mobile home parks. There's just no asset class like it out there. I can get both. Now, apartments will traditionally have more appreciation than mobile home parks just because rents are more likely to increase at a faster rate depending on the market. The key is to make sure you buy right, don't over-leverage and be smart about the market you're investing in. 

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    Jamie Nacht
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    Jamie Nacht
    • Real Estate Broker
    • Seattle, WA
    Replied

    @Jeffrey Holst

    If I could ask you for clarification, are you saying that your net cash flow in that example is $1,500? In other words, your GROSS RENT minus ALL OWNERSHIP COSTS (mortgage payment, insurance, property taxes, current maintenance, deferred maintenance reserve, vacancy reserve, property management, and HOA's if any) provides you with net 1.5x your mortgage payment?

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    Neal Collins
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    Neal Collins
    • Developer
    • Portland, OR
    Replied

    Take out the example returns that @Jamie Nacht originally posted, and this is a great debate. I personally believe that the two pieces-- cash flow and equity build-up--are integral for a real estate investor, but are quite often mutually exclusive. For some people they may score big and be able to achieve both with the same activity or investment. Other times you will have to focus on which side of the equation you would like to focus on.

    In my market right now equity build-up and wealth building is an easy route to go. Value-add projects and marrying the right debt structure with the right asset enables the ability to grow equity quickly. But the cash flow side of things is nothing to write home about and the return on equity is dismal. The cash that is generated typically goes straight back into our business somewhere else. Unfortunately you can't live off equity.

    Cash generation, on the other hand, is critical to 1) keep food on the table, 2) enable you to borrow more funds, and 3) cover any unexpected expenses that invariably arise in life. This is why successful investors have jobs or provide professional services like a real estate agent or a lender. This keeps them in the game and boosts their cash earnings.

    Netting $100-200 per door and having a couple houses in a "cash flow market with no appreciation" is nice if you don't have to deploy much capital to get that return, but an extra $400 a month will only get you so far. I'd rather scale operations to put an extra zero on the monthly net amount, or focus on an activity that will generate enough cash to fund your life.

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    Dan H.
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    Dan H.
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    • Poway, CA
    Replied

    Just hoping for appreciation is for people who do not want to bother to study historical data, supply and demand, vacancy rates, income increases, cost of building new supply, population growth, etc. There are markets that in over 70 years do not have one 10 year span anywhere with a net decline. Some of these markets it costs >$100K to break ground on a new SFR. I can say with a lot of confidence that I can research a market and provide more basis for it having a higher RE value 10 years from now than a Midwest market can provide convincing evidence that their rents will not fall like Detroit did in the Great Recession. I do not consider investing in these types of markets any more speculation than investing in a Midwest cash flow market.

    As for getting money out ... You certainly do not need to sell. You can try to find Equity Line of Credit but they are getting more challenging to find on rental properties. however, as long as rates continue to be low a refinance works for getting money out of a place that has appreciated (either marked appreciation or forced appreciation). Refinance is a key R in the BRRRR process.

    I agree with the posters that indicated 12% COC is not enough in a 0% appreciation market. It is too close to the returns of S&P 500 to justify the effort. Because there is no compounding (i.e. the rent is unlikely to increase) my return on the S&P 500 (with compounding) will surpass the cash flow RE property given time.

    One thing to note that I did not see mentioned above is the 0 appreciation market typically has 0 rent appreciation. This in effect means that the return is decreasing by the inflation rate. The high appreciation market may have 3% COC upon purchase but if the property appreciation is 6%/year you can expect that the rent will appreciate. 5 years from now when the RE has appreciated ~34%(assuming the projected appreciation actually occurs) you can bet the rent will be higher than at purchase and that the cash flow will be higher than at purchase.

    I do not need cash flow from one property for my living expenses as I have my cash flow from previous RE purchases and my other investments.  I would take your scenario 2 every time.  Not only would I, I basically have.  Most of my RE investments have been in a high appreciation area that provides minimal cash flow (compared to Midwest locales) upon purchase.  I will add they cash flow outstanding today.  One purchase cash flows annually more than I invested at purchase and it was not a cheap property with a real cheap down payment; how is that for cash flow?

    I will add that even historical high appreciation markets have RE declines (typically less than 5 years from peak to new peak). Anyone who invests anywhere has to be prepared for market depreciation. If you have minimal cash flow you need to be sure that you are not relying on appreciation to meet your financial commitments.  Selling when the market is depreciated is the only way for investors in some of these high appreciation markets to have lost money.  Any RE investor needs to make sure that they are not so leveraged that they may need to sell when the market is depressed.

    Good luck

  • Dan H.
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    Jeffrey Holst
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    Jeffrey Holst
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    Originally posted by @Jamie Nacht:

    @Jeffrey Holst

    If I could ask you for clarification, are you saying that your net cash flow in that example is $1,500? In other words, your GROSS RENT minus ALL OWNERSHIP COSTS (mortgage payment, insurance, property taxes, current maintenance, deferred maintenance reserve, vacancy reserve, property management, and HOA's if any) provides you with net 1.5x your mortgage payment?

     No sorry I am saying that it needs to have a debt coverage ratio of 1.5 which means free cash flow excluding payments needs to be 1.5x payment amount which in my example means excluding payment it cash flows 1500 when you take payment out it actually cash flows $500 

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    Jeffrey Holst
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    Jeffrey Holst
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    Replied

    And yes that 500 is after all costs

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    Robert Herrera
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    Robert Herrera
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    Jamie Nacht I see you are GAMBLING on appreciation. You are looking at it as if it’s going to be appreciating forever. We saw what happened in 08’. If the property goes up in value for 3 years, then the market tanks... what is your strategy on these 2 scenarios?

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    Dan H.
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    Dan H.
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    • Poway, CA
    Replied
    Originally posted by @Jeffrey Holst:
    Originally posted by @Jamie Nacht:

    @Jeffrey Holst

    If I could ask you for clarification, are you saying that your net cash flow in that example is $1,500? In other words, your GROSS RENT minus ALL OWNERSHIP COSTS (mortgage payment, insurance, property taxes, current maintenance, deferred maintenance reserve, vacancy reserve, property management, and HOA's if any) provides you with net 1.5x your mortgage payment?

     No sorry I am saying that it needs to have a debt coverage ratio of 1.5 which means free cash flow excluding payments needs to be 1.5x payment amount which in my example means excluding payment it cash flows 1500 when you take payment out it actually cash flows $500 

    Interesting thought but I will propose something for you to consider: A class 4 BR/ 2 BA, 2000' in an A class area provides a 1.3X and a different 4 BR/ 2 Ba, 2000' in a class C area, class C property produces the 1.5X.  Both are geographically in the same vicinity.  The A class property has $1K "cash flow" (using your definition of cash flow) and the C class has $1K "cash flow".   So your criteria would have the class C being the one that would be purchased.  Which do you think is likely to produce the better actual cash flow?  Note in reality I am likely underselling the "cash flow" of the class A property because to produce 1.3X on an assumed much higher purchase price it would produce better than the same "cash flow" as the C property (otherwise it would not have achieved 1.3X).

    Many of the repair costs are similar for an A property versus a C property.  Basing maintenance/estimated cap expense on purchase price or rent price has flaws.  In general the A property will have better tenants likely reducing damage and wear and tear.  In additon the A class property will have nicer quality items providing longer expected life times (what is the life span on travertine tile: 50 years?).  The A class will require nicer kitchen, bathrooms, flooring, etc. so there is definitely an increased cap expense estimate partially offset by increased life spans.  However, items like plumping, hot water heater, foundation, structure, etc. are very similar regardless of the class of the property.

    BTW I did an analysis of my RE and only 1 property that I owned more than a year did not meet your criteria today.  I suspect most did not meet the criteria at purchase. 

  • Dan H.
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    Dan H.
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    Dan H.
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    Replied
    Originally posted by @Robert Herrera:

    Jamie Nacht I see you are GAMBLING on appreciation. You are looking at it as if it’s going to be appreciating forever. We saw what happened in 08’. If the property goes up in value for 3 years, then the market tanks... what is your strategy on these 2 scenarios?

    My strategy would be to hold it until at least the market is no longer depressed.  Try to never sell in a depressed market.  You try to purchase in a depressed market.   Most depressed markets have been less than 5 years in the high appreciation cities.  Do not over leverage and there will be no reason to sell in a depressed market.

  • Dan H.
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    James W.
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    • Minneapolis, MN
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    I would prefer strong cash flow with little to no appreciation at this time.  Apprecion comes and goes both ways as well.  A place with nice cash flow and minimal appreciation should be able to whether a storm better than a place where you need to time the market to get out and make a decent profit.  

    I'm currently in the process of buying a place with >25% cash return and will have minimal upside from an appreciation standpoint.  For me, if the cash don't flow, the deal's a no go!

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    Jamie Nacht
    • Real Estate Broker
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    Jamie Nacht
    • Real Estate Broker
    • Seattle, WA
    Replied

    Hi @Robert Herrera

    I neglected to address the fact that these markets that I like for price appreciation also demonstrate consistent rent appreciations (see FreddieMac Multifamily Outlook Report). I don't need the cash flow for my daily activities, so I structure the investments to reward me with modest but expanding COC returns (3% in yr 1, 4% in yr 2, etc...) but target those areas that have a high chance of appreciation. It is a gamble with an outsized one-directional payoff that I've benefited from considerably, and repeatedly. In a down market (like '08), I'm rewarded for holding the investment with an expanding return the longer I hold it. But when the market moves in my direction, I get an outsized upside benefit. Everyone seems to have balked at my 12% COC being too low, but nobody has mentioned my 6% appreciation. @Dan H. noted in his response above, an investor should do the research on the markets they are going into. If you do the appropriate research, and have a good understanding of what factors may likely lead to continued appreciation, that gamble seems like less of a true coin toss. My personal investing strategy is to set up a property so that it can sustain rent decreases of at least 25%, and vacancies of at least 4 months at the onset, and build even further reserves over time. I am comfortable with the amount of risk this mitigates. But going back to the appreciation, my investments have yielded average appreciation >10% per year in multiple markets. When leverage is used, that amplifies my returns and allows me to take huge wins on the upside, but allows me to clip my expanding return (or dividend) while I wait. The question is, can an investor justify and support the belief that over time, prices will go up and to the right, so to speak. I do agree with multiple people on this discussion that said "ideally you get COC and appreciation", but, so long as I'm not relying on this as my sole source of income, I'd rather position myself for upsides of 300% of my invested capital, and get paid just for making and holding the investment in the meantime.  

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    Jamie Nacht
    • Real Estate Broker
    • Seattle, WA
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    Jamie Nacht
    • Real Estate Broker
    • Seattle, WA
    Replied

    @James W.

    Thanks for your comment. Congrats on >25% COC! That's amazing. I looked at the Minneapolis market, but the property taxes seemed really high. Speaking with other investors in that market, that seemed to be their rationale for not seeing prices go up. Is that still correct?

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    James W.
    • Minneapolis, MN
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    James W.
    • Minneapolis, MN
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    @Jamie Nacht

    The property taxes are higher in some parts of the cities than others.  Sometimes I even wonder how prices vary so much from house to house in the same neighborhood.  

    Prices have gone up in the better areas and it is hard to find great deals at this time.  Housing prices were hit hard in 2007-20010 but have come back above their previous highs as other areas have. 

    The appreciation is nothing in comparison with what Seattle or other hot areas have been experiencing, but people that bought during the lows have had good appreciation.  For example, one home I bought in 2010 is worth double what it was then and I have done nothing to increase the value.  I have just kept it rented.

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    Mark S.
    • Real Estate Investor
    • Saint Paul, MN
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    Mark S.
    • Real Estate Investor
    • Saint Paul, MN
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    I would take modest cash flow with a realistic opportunity for appreciation any time. The combination of leverage and LTCG tax treatment when exiting more than offsets additional cash flow. But I am not relying on the cash flow to pay my living expenses - others may be in a different situation.

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    Jeffrey Holst
    Pro Member
    • Investor
    • Chattanooga, TN
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    Jeffrey Holst
    Pro Member
    • Investor
    • Chattanooga, TN
    Replied

    @Dan H. two quick thoughts one I am only saying what has worked for us. Having a healthy % based differential between loan and cash flow allows us to sleep well at night. Second, I dont think the A class = 1.3 necessarily is accurate. The debt coverage ratio is an equation. Where I = income, E = all non financing operating expenses, P= debt financing costs (a function of loan constant) and NOI= net operating income it looks like this.

    NOI = I-E (in other words net operating income is all operating income--probably just rent minus all operating costs --everything except for principle, interest and taxes on profits--property tax is an operating expense)

    NOI/ P= Debt Coverage Ratio

    Here's an example that might help

    2/1 SFH

    Purchase price $100,000

    Monthly rent $1200

    Annual rent $14,400

    vacancy allowance at 5%  $720

    management at 8%  $1152

    Cap ex at 7% $1008

    Tax and Insurance $2500

    Total expenses $5380  (720+1152+1008+2500)

    NOI= $9020 (14400-5380)

    If there is no debt then there is also no debt coverage ratio 

    No debt it cash flows $9020 per for a yield of 9.02%

    Now let add debt if you assume we can amortize over 30 years and get a rate of 5% it looks like this

    0% down loan payment = $537/ month or $6444 per year

    20% down loan payment= $429 per month or $5148 per year

    Now I know that 0% down is unlikely but lets just assume we can do that for this example. Then look at the DCR. Recall DCR=NOI/P

    So at 0% down DCR looks like this

    $9020 (NOI)/$6444 (Annual Payments or P)= 1.4

    which is to say I wouldn't do this deal unless I was confident that I could swing the payment for awhile personal and had a plan to increase rents or decrease costs to get it in line with my target of 1.5 but in truth Id probably pass,  However if I liked the property and had 20K to put down the deal is different

    At 20% down the DCR looks like this

    $9020 (NOI)/$5148 (P)= 1.75 DCR

    That easily passes my goal of 1.5 and I could justify this deal as safe enough that I dont have to worry about it. It doesnt really matter that much if its a b or c class the numbers are the same now obviously if I have a choice between a A class at 1.75 and a C class at 1.75 I take the A class but in my experience the NOI on an A class with lower expenses might be better by the purchase price is higher so I need a larger down payment to meet my DCR goal

    I dont know if I am doing a good job at explaining it but it works for my model. In truth we havent always been as particular about it and sometime we have wavered but I think its at least worth considering this before making a purchase. Banks always have a minimum DCR that require on larger loans so this process will prepare you for the big time.