Cash flow analysis.

[Mark Albano]

Hey everyone. I am new to BP and I currently do not have any investment properties. I plan to close on something this coming March. I have the idea of starting out with a single family or a condo/townhome for a rental property after living there for a year or so. I want to post a possible deal for second opinions. Even though I am not pulling the trigger on anything yet, I just want to know if my head is in the right spot or if I need to rethink somethings. So here is the kind of possibilities I am looking at. I plan on putting 5% down on anything I do. Also, how much should I ask off of the listing price? Thanks in advance.

Here is the description:

"Move in Ready two bedroom town home located in desirable area. Recently painted and new carpet in bedrooms make this the perfect investment property or starter home. Main level is complete with kitchen, dining area, pantry and great room which is perfect for entertaining family and friends. Two spacious "master-like" bedrooms in upper level with bathrooms. Home is located near shops, restaurants and entertainment."

 2bed 3bath 1254sqft condo.

Listing price :$124,500

HOA: $145

Build date: 2003

Mecklenburg annual tax: Approx. $1300

AVG. rent: $919 according to rentometor

[Mark Albano]

@Aaron Montague 

I answered my own question. I completely overlooked the very first thing you said...203k loan! I never considered one though. Also, that house in concord doesn't look worth any more than 40K.

@Ben Leybovich 

Yes I agree. The more I look into them the more it doesn't make sense to me. One place I look at has $65 HOA fees then the next place 10 miles down the road they're $165. That's not consistent at all.

[Larry Turowski]

@Mark Albano I think you had enough information that I wouldn't even bother to get the rest of the numbers and analyze it.

If you want to figure out why, use the calculator that @Hattie Dizmond linked to.

[Bill Gulley]

HOA, for those that don't know, is an organization to manage and govern a complex, the letters stand for Home Owner Assassins!

Ben's comment of being the ugly duckling could be made with more descriptive and stronger language.

While many will have limitations as to rentals, the folks living there own their homes. You have someone who bought their place then a rental pops up next door, they just lost money if they want to sell to a new owner, real or perceived their home has gypsies living next door, tenants who won't have the same pride of ownership attitudes as the owners do. Tenants may not even be admitted to the HOA meetings!

Your tenants can be snubbed, in the stairway, at the clubhouse at the pool or anywhere on the grounds. that doesn't make a happy tenant and can lead to a higher turn over and high turnover will lead to you selling and they will interject things to guide selling to a homeowner to live there.

There are all kinds of dirty little trick that owners can pull making things difficult, understand too that these owners are not real estate types familiar with applicable laws, so what they pull could be illegal, but that's the way things will be conducted unless you take them to court, more money out of your pocket. Even if you sue and win, your name will still be mud just because you sued all your neighbors!

I've cleaned up HOAs as an outsider, changing the board to get rid of control freaks, give some people power and they think they own the place.

I know we have LLs here who own condos with an HOA, they may believe things are fine but I feel sorry for them unless they control the voting rights of the corporation as sooner or later things will change. In some areas where there are more condos in the market that life may be better understood and accepted, that's not they way it is in this part of the country. :)

[Bram Spiero]

@Ben Leybovich You are right to insist that @Mark Albano use an analysis tool to help him decide if to go with a deal or not. That's not enough though. Just because you can now calculate NOI, Cap Rate and ROI doesn't mean you understand what these numbers mean. It is this understanding which will allow you to discover what your highest offer for a property should be in order for it to give you the returns you require. I even think that doing enough analysis will help you to better understand what it is that you require.

[Ben Leybovich]

@Bram Spiero - :)  Numbers mean nothing, which is why he should walk...

[Andrew Syrios]

A couple of points:

1) I wouldn't rely on Rentometer for anything other than a vague idea of what rents are. Direct comparables are much better (there should be other condos for rent in that complex you can call on and you can go onto Craigslist and use their map feature to find comps)

2) If the average rent is just $919, the rent to cost (given the list price) is only about 0.7% That is not very high and almost certainly won't cash flow.

3) Do you have any idea what the real value of the property is? That could change things a bit

[Sean Moen]

@Ben Leybovich @Bram Spiero 

The understanding of appropriate offer price is a point of contention for me now.  I believe I've identified a solid 8 unit that hits on all cylinders (under market rents, good area, big metro, value add opportunity on turn over) and I believe the cash flow is there to the point of being able to understand and justify what the offer price should be.

Given it's 8 units, offer price should be based on income generated so is it a 2-part calculation? Cash Flow analysis coupled with an offer price calculation? (My Calculated NOI * Cap Rate)?

[Scott Stevens]

I understand the pulling the trigger feeling. It may feel like everyone around you is buying homes and yes, that will be when the real learning takes place, but let me tell you why others have mentioned this home example used would not be good as a buy and hold. You may be thinking that after your mortgage, taxes, insurance, and hoa fees are paid each month, the extra money left over from the rent would be cash in your pocket right? Not quite. If you're going to hold it for a while, you have to factor in the life expectancy of items in the rental. At some point, most should fail. Let me list what you may have to update, fix, or replace:
1) Roof
2) Paint (inside, maybe exterior too)
3) Garbage Disposal
4) Carpet
5) Hardwood refinishing
6) Ceiling Fans/Fixtures
7) Garage Opener
8) Door Sweeps and weather stripping
9) Countertops depending on material and abuse
10) Cabinet hardware, touch up if they are nicked, scratched
11) Appliances (plus repairs when they come up)
12) Drains may clog
13) Periodic Caulking inside and out
14) Possible gutter cleaning
15) Air Conditioning and/or heating system
16) Pest Control
17) Turnover Costs between tenants (power, water, time expenses, handyman expenses, cleaning crew potentially
18) Bathroom Exhaust Vents
19) Electrical Outlets sometimes have connections burn off (repair expense)
20) lock changes between tenants
21) Updating of unit to keep it marketable
22) all others as this list is not all inclusive.

As you can see, there are alot of things that you may not have considered and that I certainly didn't when I first started. Add to that list the possibility that you have at first glance  a seemingly great property management company and then they take 4 months to rent the place. That happens. They just won't care about it as much as you would. You may say that you're paying down a mortgage agreement and building equity, and that could be true, but so were alot of people in Detroit who now have homes worth $1000.  Hope this helps.
Originally posted by @Mark Albano:

@Scott Stevens 

I see what you are saying and you make a valid point. I don't want to rush into anything. That is why my game plan is to buy this coming April or May. By then my lease will be up (I am currently renting a townhome) and I will have a good bit saved for a down payment. I study something new about investing everyday and have been for the past 8 months or so. I know I could never know everything I need to know in that amount of time, but I would think I would know enough to get started... I think. I know at some point I just have to pull the trigger on something. What is your opinion? Does that sound like a game plan? Is there a certain amount of time gaining knowledge before I buy?? I'm all ears. Thanks in advance.

[Ben Leybovich]

@Sean Moen 

1. Underwrite income

2. Underwrite expenses

3. Underwrite value add

4. Underwrite financing

5. underwrite market relative to cap. rate

6. underwrite costs of value add

7. Capitalize value based on current NOI - that's the winner if you can buy at this nomber

8. If not, underwrite stable NOI after vale add

9. Capitalize that thought desired CAP rate

10. Subtract cost of value add to arrive at purchase

Simple - there is much, much more to this.  But, this'll get you going.  Don't forget cost in your underwriting...

[Bram Spiero]

@Sean Moen 

Cashflow is not NOI. Value is not Price.

( @Ben Leybovich  I'm cribbing from you now.)

Imagine you buy a place with an NOI of 40k. If the prevailing Cap Rate is 10% it would value at 400k. Now let's assume that you manage to improve NOI to 50k, the value of the property will have gone up by 20% to 500k.

Question is, if your 8 unit was cashflowing at 1000 a year at a 40k NOI and at 1400 a year at a 50k NOI, would you really want to hold this property?

The price of the deal should be the discount you need on the value for it to work for you.

[Tapan Trivedi]

At first look this does not meet the 1% thumb rule. A rent ready house should gross atleast 1% of purchase price in rents. So for your 125k purchase price you should be getting atleast 1250 in rents. So it dosen't pass the test. Judging by the other responses it dosent' look like a good rental . 

HTH,

Tapan Trivedi

www.sacramentorealestateclub.com 

[Ben Leybovich]

@Sean Moen I assume you mean $1,000/month and $1,400/month - not per year.  If it were per year, I'd run as fast as my 2014 3.5L 290 hp engine would let me (60 in 6sec)...:)

Now - why would you only be able to improve the CF by only $400/mo (4,800/year) on an NOI upside of 10k. True, your % pro forma expenses such as vacancy, loss to lease, maintenance escrow, etc. would go up with higher top line. But, the difference shouldn't be 50%. On a 10k improvement to the NOI you should see at least 8k improvement to CF.

Now - if you really are talking about annual CF, then it makes no difference whether it's $1,000 or $1,400 - that's just so bad that it's a non-starter...

Makes sense?

[Sean Moen]

@Ben Leybovich 

I believe @Bram Spiero  was just providing an example.  Those aren't my numbers.  I should probably stop hijacking Mark's thread and post my own analysis and start the feedback process.  Look for a mention when I post it up Mr. Spiero & Mr. Leybovich.  Thank you for the refinement.

[Mark Albano]

Thank you everyone for all of the input! Bottom line, sounds like I am better off finding a single family to live in and stay away from anything with HOAs.

 @Aaron Montague 

thank you for pointing out the use of a 203k on a fixer upper. That got my wheels turning with new ideas!

@Scott Stevens 

That helped a lot. Thank you!

Looks like there is a debate going amongst yourselves lol

Anyway, thanks again. I'm sure I'll be posting another question soon.

[Bill Gulley]

Originally posted by @Bram Spiero:

@Ben Leybovich You are right to insist that @Mark Albano use an analysis tool to help him decide if to go with a deal or not. That's not enough though. Just because you can now calculate NOI, Cap Rate and ROI doesn't mean you understand what these numbers mean. It is this understanding which will allow you to discover what your highest offer for a property should be in order for it to give you the returns you require. I even think that doing enough analysis will help you to better understand what it is that you require.

Bram, sounds like you might have some formal training in the matter.

Not picking at you, but you say you need to understand what the ratios mean, what measurement you're actually looking at. So, lets pick one, the cap rate.

Cap is short for capitalization rate, to arrive at a valid cap rate you need to compare the rate to alternative investments to make a decision;

Picking a random ROI, say I just pulled 22% out of thin air, my investment requirement is to hit 22% or I pass on the deal. Then, I'm looking for a 22% cap rate after taxes, we all know I won't be buying many properties.

For your cap rate, you have inside of that a "managers rate of return" or the "Internal rate of return" arriving at that, bringing each dollar received in the future back to its present value, the beginning rate selected is that expected in the market compared to other investments requiring similar risk, costs of management and administrative expenses as well as tax treatments. So, what is that alternative investment to real estate? Most often it needs to be another real estate opportunity.

If I were to select bonds or stocks or insurance annuities as my alternative investment, then to have an apples to apples analysis I must consider the risks involved, mgt. required, admin. and market fluctuations and then adjust these factors to mirror those applicable to real estate.

Remember too, that $132 cash received clear on your opportunity investment, it goes through the similar analysis, that sum is reinvested for the best use of cash, otherwise you have a skewed view of the value of that annuity stream, what those payments are really worth. I can tell you (everyone) that trying to figure this aspect is impractical, as I mentioned the differences of option A and option B might be a hamburger at lunch. Alternative investments are very limited (keeping with liquidity considerations) for $132 a month. And, don't forget to bring the salvage or residual vale in the future back to its present value.

I'm addressing an economic cap rate, a financial cap rate, not simply investment/income as that is to accounting, not to investing.

For the 147th time, real estate is unique, it can not be directly compared to stocks or bonds or annuities or the manufacture of widgets. Because RE is unique you comparable investments need to begin as other RE opportunities. So, now, you're looking at other RE similar to the subject, if you don't own other similar properties you'll find it hard pressed to obtain a real cap rate on a pro forma basis or estimating future performance.

Doesn't take long to figure out, if you're doing things properly, that you're running in circles chasing your tail!

So, in your buy decision, trying to assess ROI, a true cap rate or a valuation of cash flow is pretty fruitless.

Now, after the purchase, you have historical numbers and you can then calculate actual ratios, that can be valid.

I admit, I learned the hard way, being a finance/accounting/economics type, I went through the same thing other students of RE do, trying to apply other business practices in this matter to RE investing.  I may have come to the realization of this reality since I taught the subjects mentioned, it became obvious that accurate numbers weren't possible and the reason boiled down to the uniqueness of real estate, it's a different animal as to investing. In terms of investing, RE is closer to speculation due to the unknowns to be faced in the future. I can tell you what you're going to be getting on a AA rated bond, I can't tell you what your RE investment will be a year or 5 years from now.  

Ben summed it up, numbers don't mean anything in reality, except ensuring that your horse isn't eating all the hay before you buy him. Trying to figure out how fast that horse will be is delusional and wishful thinking. Those formally trained in F&A are forgetting chapter one, use appropriate analysis required that pertains to the size, scope and type of investment or business. Wall Street is compared to Wall Street, RE is compared to RE, Insurance is compared to insurance, CDs to CDs, makes life easier and more valid in reality.

Yet, some will continue to run the batteries down in their calculator, projecting their expected wealth. Don't worry about it, work hard, work smart, go forward and it will happen. :)      

[Simon Campbell]

One of the questions that has not been touched on too much is the 50% rule. Investors use this as a guide to gauge whether an investment may be able to cash flow before spending the time to verify all the income and expense figures.

Generally speaking, 50% of the gross income will be spent on expenses. This is by far an accurate average. Of course some properties will perform better, but if it cannot meet the 50% rule, it is best to walk away.

The 50% expenses include vacancy rate, insurance, property taxes, repairs and maintenance, owner paid utilities and capital reserves. It does not include property management fees or your mortgage.