As a Realtor, I get to work with investors, some experienced, others just starting out. The experienced investors often have their tried-and-true ways to determine if a potential property makes fiscal sense for them. Some of my clients, both experienced and new, rely on me for help in this area. What I wanted to cover in this video is the process I go through with them, which, is also the exact same process when I’m looking for potential investments.
To determine if a property fits my investors’ or my financial goals, I run various calculations but the most important to me, is the cash-on-cash return on investment. Remember, cash flow is just one of the many benefits of real estate investing. Check out my video on all the other benefits of REI, I’ll leave a link in the comments below. Per Investopedia, the Cash-on-cash return is, “the cash income earned on the cash invested in the property.” It’s not rocket science, but it can be an artform, I just say that to make it sound hard, but it’s not. What I do is I take the annual gross rent, minus out operating expenses and mortgage payments, if there is a loan, to come up with my annual cash flow. I then divide this number by the total initial cash invested. Initial cash invested includes the purchase price, unless it’s financed, then it would be your down payment plus any fees and closing costs. Don’t forget to include any repairs and improvement costs needed to get the place rent-ready.
For the purposes of the operating expenses, I include property taxes, insurance, utilities, Association and maintenance fees, and property management fees. Don’t forget to include things such as landscaping, trash pickup and snowplowing (if you’re lucky enough to be in a place that snows). I also include a reserve for the vacancy and repairs and maintenance. So many of these expense types can be forecasted easily. You call an insurance agent and get a free quote. You find out the property taxes, that’s public information. Property management fees are determined when you go shopping for the management company. The vacancy rate could be challenging, but for lack of a better number, have your property manager help you with this one. In the area you are looking to purchase, find out how long tenants typically stay before vacating and find out how long it typically takes for the property manager to fill those vacancies. Make sure to see if there are additional costs like Lease up fees and admin charges for vendor repair projects, as these additional costs will reduce your ROI.
The main variable, in my opinion, that can make or break your cash on cash return on investment pro forma is the rent rate you are using to calculate the annual gross rents on. You want to get this number pretty accurate because if you’re off by a few hundred dollars you could drastically affect your return on investment. There are many ways to figure out the rent rate. Assuming your property manager is experienced and knows the rental market in the area, you can always use them. There are also a lot of online resources to corroborate or fine tune the number your property manager gives you. This also depends on what online resources the self-managed landlords use in your neck of the woods. You can try Facebook marketplace, Trulia, Zillow, and Craigslist. One site I often use is rentometer.com. This site allows a few free inquiries then you have to sign up and pay a monthly fee. If you need any reports, just email me, I can run them for you, as I have an account.
Once you get your cash-on-cash return on investment percentage now what do you do? Well, for me, I’m already shooting for a certain percentage target depending on where I’m investing. If I hit that target, then maybe that’s a place to consider putting an offer on. When you get comfortable with the calculation you can also run scenarios or sensitivity tests by playing with the numbers like increasing or decreasing rent rates. See what happens if association fees go up 7% in a year. Then you can see how much of hit you can take and get a better idea if income or expenses change. This may also help give you comfort or just the opposite, in case your estimates are inaccurate.
So that’s how I calculate my cash-on-cash return on investment for my clients and myself. Hope it helped. If you want to download the excel template I use, go to www.realestateofhawaii/roitemplate.
In the words of the late business leader, Peter Drucker, “Entrepreneurs believe that profit is what matters most in a new enterprise. But profit is secondary. Cash flow matters most.”
