What financial metrics are most important for landlords?

Question

I'm wondering what financial metrics are important for landlords? Most landlords like to know the equity building on their property. After all, buy and rent out properties as part of their long term strategy. But there are others with no real intention to expand their portfolio and are satisfied with managing their property.

For the two types of landlords:

1) those looking to purchase more properties - what financial metrics would you use to assess your affordability ?

2) those happy managing their property with no intention to buy more - what financial metrics matter to you most?

Thanks.

Bill Gulley · Answer

Chanelle, your question would make a good chapter in a book or even a good book.  Not so much to ratio analysis but to the economic and financial aspects of asset management for small investors.

The financial considerations are the same for the two categories you defined, cash flow! Unless you are speculating in real estate you don't want any property that can't carry itself.

If it don't eat the hay, buy it. A property must do better than break even to address initial maintenance expenses, cost of production you might say, regardless if you want to hold 3 properties, 30 properties or 300.

Why are you investing in real estate is a better question. For income, tax advantages, growth, speculation for future development or for conversation at the club?

Your goals will dictate your analysis of a choice property, not a financial ratio, your ROI is a primary consideration in your expectations, for that you need to look at alternative investments which are difficult to compare to other investments such as stock or notes or cattle futures. RE is unique and therefore difficult to compare to other types of investments. .You may hear someone say I could have done better if I had invested my money in Apple, but if you drill down deeper, you must consider the risks, the management, the effects on your ability to leverage your assets, tax implications and the list goes on.

Bottom line, it's cash flow and the return on your investment after taxes being satisfactory rather than shooting for a killer return because you won't get killer returns. For a landlord, time is the key, holding long term.

Financial ratios become more relevant with larger portfolios that can be compared to other asset classes in similar sizes, asset and liabilities, earnings and asset performance become relevant only when there are other like alternative investments. Holding 6 homes as rentals won't give enough economic data (value of management, tax and appreciation, social values) to allow a true financial determination to compare your position.

Financial ratios are a measuring stick, they measure asset performance over short periods of time, monthly, quarterly and annually. You can look at long term performance but only historically and usually for only one purpose, to compare to alternative investments or use of funds as historic performance. It's fine to go through the number crunching if your ultimate goal is to give yourself a pat on the back and talk about your success at the club.

Holding RE is more about pro-forma predictions and comparing with a market norm than short term performance. Appreciation, population shifts, trends, social changes, market demand and cash flow after taxes than last year's ROI or IRR. For a small investor, playing with pro-forma statements or estimating the future is pretty much a waste of time, but it's entertaining to some. It's the cocaine that keeps you running, but you're not in reality.

Set your goals first, then look at the cash flow to keep you above water, select a good location for appreciation and growth, maintain the property to increase future market values and keep rents up with demand and market changes.

Those that really understand the financial, accounting and economic impact of ratio analysis understand that such is really irrelevant to small real estate investment portfolios with the exception of ensuring there is an acceptable cash flow so that you really have an earning asset. For a small investor historical evaluations are only good to make them smile or cry, they are holding the asset and RE is not a liquid asset. If you have a tax liability from your holding a property then you're making money, if not, dump it.

There are two times to evaluate your position, when you're leasing and at the end of a tax period. I found that crunching numbers over the past didn't make me any money.   :)

Giovanni Isaksen · Answer

@Chanelle Dupre  welcome aboard neighbor!

Cash FLOW is king as @Bill pointed out and many investors claim to understand that but yet don't know how much actually it costs to operate a property. Not just investors, but people who should know better too (cough Zillow cough) when they present cost of ownership ratios that seriously understate the cost of operating a property. See http://ashworthpartners.com/the-buy-vs-rent-meme-t... for more on that.

Many small investors (like many owners of small businesses) do not know their numbers well enough to even know if they're really making the returns they targeted because they run a lot of expenses out of pocket and ignore the value of their time. This is great if you're goal is bragging at the country club but if you're trying to build up or preserve wealth it pays to know your real numbers.

To do that imagine that you are the CEO of a large real estate company (or a singer/songwriter out on tour ;) and that someone has to paid a market competitive amount to perform every task associated with operating a property successfully on a long term basis. That includes managing the property, maintaining it and setting funds aside for replacing the big components when they inevitably wear out. Then add in the secondary costs, managing the managers, legal, accounting, etc. This is your true cost of operating the property and when you deduct these and the debt service from the actual Gross Operating Income you will know what the cash flow before tax is. Deduct for taxes and this is the true cash flow in your pocket.

Once you know the true cash flow, and presuming it is positive, you can decide how much it's worth to you as an investment. Cash on Cash Return is the first measure, cash flow in your pocket divided by your total investment in the property. It ignores the loan balance being paid down by the tenants and any appreciation that comes along but if the property isn't cash flowing enough you won't (or won't be able to) hang on to it long enough to enjoy those benefits.

The other measures such as IRR, DCF and NPV require that you correctly identify the selling price somewhere out in the future. The future is hard to predict as it has been said and so running these measure amounts to a guess at best. On the other hand if you can predict the future, I'd like to partner with you!

Good hunting-

Bill Gulley · Answer

I consider economic benefits rather than just cash, but cash on you cash is` suitable for most I'd say. COC, as Giovanni  mentioned excludes appreciation and principle reduction, it also ignores tax benefits.

If you cash income exceeds 133% of expenses you have increased you ability to borrow, what's that worth.....the present value of that amount over 30 years at street loan rate?

Can the equity be tapped by cross collateralization on the next deal? What's that worth, the investment income from that portion attributed to the additional borrowing?

What are the effects of your tax liabilities, carried forward or off setting the total liability?

Anyone consider social aspects of property ownership? There are social "assets" and "liabilities" or responsibilities. If you show up at a zoning council meeting and speak, do people listen? When you speak to a Realtor do they listen or if you were to tell a local RE attorney that there is an issue with the way something is done, do they listen and change what's being done? These social aspects and relationships are generally the basis for new opportunities and more business. You could be involved in one large transaction, perhaps a minor role with a major player, that catapults your business, did that major player allow you to play since you are in the business and have holdings with experience? Hard to tie such glancing positives to one property, but it depends on the property.

An example, buy an old warehouse in a district to be revitalized, you get to play since you own a property in that targeted area. I bought an empty building and pretty much left it empty except for my use just for the ability to have some say in a revitalization area and sold for a higher profit, yes that's rather speculative, but that's a consideration in buying.

Just saying, cash flow is important, but it's not everything. What will this property do for me if I were to own it? That's a better question, weigh the benefits and the drawbacks. :)

Terry Hershberger · Answer

Cash on Cash Return is KING in my eyes AKA Cas

Happy Investing!

Andrew Syrios · Answer

1. Rent to Cost

2. Cap Rate

3. Cash on Cash

and occasionally 4. Gross Rent Multiplier

I also still want equity, so a comparative market analysis is important too.

What financial metrics are most important for landlords?

Most Popular Reply