All Forum Posts by: Frank Gallinelli

Hello Vlad -

Your computer's not broken. If you have no cash investment, you have nothing at risk. In other words, you have no investment on which to calculate a return and so it is not possible to calculate an IRR.

I wrote an article about this waaaay back in 2005:

http://realdata.com/blog/rate-of-return-on-no-money-down-and-other-tales-from-the-deep-woods/

Let me expand on @Jeremy Cyrier 's very good advice (and I am SO glad that someone is saying cash-on-cash return is inadequate because it fails to take time value of money into account)

In simplest terms, you need to project your cash flows over a reasonable holding period, and then perform an internal rate of return calc.

To estimate your year one cash flow, start with the gross rent and subtract an allowance for potential vacancy and credit loss (at least 3% but probably more since one lost month's rent in a SFR is 8%). Then subtract your expected operating expenses, such as property taxes, insurance, maintenance, leasing costs, legal costs, and any utilities or other expenses (e.g., water/sewer) that you may not be able to pass on to the tenant. Resisit the tempation to underestimate expenses.

That will give you your Net Operating Income. In a conventional income property you would apply a cap rate to estimate value, but that is unlikely to be helpful with a single-family, so move on to cash flow.

Next subtract your annual debt service and any capital costs (improvements) to get your first-year cash flow.

Then project the potential growth in revenue and expenses forward for each of the next several years to get your estimated future cash flows. For the final year, estimate the resale price, and subtract the mortgage balance as well as your costs of sale (lawyer, broker) to get the cash from resale. Add these proceeds to make them part of your final year cash flow.

Then do an IRR calculation on all the cash flows. Don't forget to include your closing costs to buy the property as part of your beginning-of-year-one cash outflow.

If IRR is not well into double digits, then consider looking at alternative properties.

In my previous post I expressed some doubts about getting financing on the terms you described. I haven't done a FHA loan since Nixon was president (seriously) so I didn't even think about MIP -- Brian and Joel are absolutely right to raise a warning there. And again, I wonder if lack of owner-occupancy will be an issue with the lender, either initially or if you occupy at first and then move out. The financing could be the deal-changer. I would re-run your numbers with conventional financing, and also (as Aaron suggests) with an allowance for third-party management.

@Jose Ramos -- I guess we were both scratching out numbers at the same time, -- I didn't see yours while I was doing mine. I misunderstood and thought you were buying for almost all cash.

Your calculations are essentially correct (I believe debt service would be a little higher -- 20,283, leaving cash flow a bit lower). And I would still urge you to raise your expense estimates a bit. Unless water /sewer is metered separately, you'll have to pay those. Typically a 4-plex would have a house electric meter for common area lighting, and you would pay that. I would still put a value on task like lawn/snow, even if yo do them yourself.

It looks like a good part of what makes this deal work is the high LTV (which I misunderstood before) and low rate. Financing is typically less favorable if the building is not owner occupied, so I would certainly double check to find out if the rate and term would be as you described if you rent out all the units. I would want to be sure about the availability of that financing before proceeding.

If everything falls into place as you describe, it does indeed look like the numbers work and you can have a positive cash flow.

Let me play devil's advocate and fill in some guesstimates for additional expenses, vacancy, etc.

Rent 40,080

3% Vacancy/Credit Loss 1,200

OpEx:
Advertising 300
Insurance (fire and liability) 1,200
Lawn/Snow 300
Repairs and Maintenance 2,400
Taxes - Real Estate 3,600
Utilities - Electricity 500
Utilities - Fuel Oil 1,200
Utilities - Sewer and Water 600
TOTAL OPERATING EXPENSES 10,100

NET OPERATING INCOME 28,780

Debt Service 802

CASH FLOW 27,976

Cash-on-Cash 7.44%

I must tell you that I'm not a big fan of cash-on-cash as a metric, because it doesn't take into account time value of money -- it assumes just the first-year's performance. So I made a few more assumptions: Let's say both rent and operating expenses increase at 3% per year, that you hold the property for five years, and sell it at the same 7.38% cap rate at which you're buying it. Your IRR for that holding period would be 8.75% -- which doesn't sound bad, but in reality it would be a little more than half of what most income-property investors would be looking for.

My bottom-line reaction: The property could make a positive return, but perhaps not one that would justify the amount you're investing. You're in a very strong position with 350k to invest. If that were in my wallet ;) I would be looking for a larger property, maybe commercial, and one that could provide an IRR in the mid-to-upper teens.

@Jose Ramos Jose -- I think you need to taken a harder look at these numbers. Even if the expenses you list are correct (and I would be a little skeptical about the minimal cost for maintenance), I believe there are a number of costs you may have overlooked:

Property insurance
Leasing costs (advertising and/or commissions)
Grounds maintenance (lawn, snow removal?)
Water and sewer charges
Electricity for common areas like hallways
Allowance for vacancy and credit loss

If I understand correctly, you would be carrying a very small (40k) mortgage, so with such minimal debt service you probably will still have a healthy positive cash flow --- but will it represent a sufficent return on 350k cash investment? Is there is strong upside in regard to the eventual resale value of the property for another owner-occupant? It could work, but I would urge you to take a more critical look at all the numbers before you decide.

Just a quick sidebar to a very good discussion here: Some investors (including myself, 40+ years ago) have received bad legal advice about forms of ownership. It is generally a bad idea to own real estate as a C-Corp, because that is not a pass-through entity like an LLC. If a C-Corp own, operates, then sells a property for a profit, it will have to pay a tax on that gain. However, the money is then stuck in the C-Corp. If you want to get it out of the Corp and into your hands personally, it will typically be taxed again. With pass-through entities like LLC, the LLC pays no tax but passes the income or gain onto its members.

Chad -

Just a couple of quick sidebar observations.

The typical commercial lender will use the lower of the appraisal (their own) or the purchase price, and will apply their loan-to-value ratio standards to that number to set to maximum loan they might approve.

They will also apply their standards for Debt Coverage Ratio (typically 1.20 or higher) in making a loan decision. That mean the property's net operating income needs to be 20% or more than the debt service. That's essentially what Joel is telling you when he says the bank doesn't really care if you make a profit, but they want to be sure you have enough, (actually, more than enough) cash to make the mortgage payments.

Finally, that appraisal is almost certainly going to be based on capitalizing the property's NOI, so you should recognize when making your projections that repairs and capital expenditures are not treated the same. Repairs are part of the NOI calculation (and are also deductible currently); capital expenditures don't affect NOI, and they cannot be written off all at once -- they have to amortized over the useful life of the building.

Frank

Hi Page -- Just a few quick thoughts:

First, I would not pass along an analysis prepared by a third party, especially someone who might have an interest not entirely in concert with yours. Always do your own analysis, after you do your own due diligence. Unless you take that approach, you won't really be confident that the facts are accurate and complete, or the reasoning in the analysis is sound.

Second, while I agree that the lender will have its own underwriting criteria and that satisfying those criteria is what matters most, that doesn't mean a good analysis and presentation are superfluous. You shouldn't take for granted that the underwriter has all the information he or she needs in order to apply those lending criteria, or -- again-- that the information is complete and accurate. You want to be part of the conversation, so demonstrate your own rationale for why the deal makes sense.

Finally, providing a clear and professional presentation delivers the message that you're no amateur -- you know how deals work and you know what you're talking about. Many times I've heard from folks I deal with or have taught that it was their presentation that tipped the scales in a transaction.

Even when it doesn't, it builds your reputation as a knowledgeable professional --- and that's what may seal the next deal.

@J Scott ...and thank you too. Yes, I remember meeting you in Denver -- it was a real treat to speak with you and a remarkable number of energized, intelligent investors. BP is great.