Real Estate Investing 101

Real Estate Investing 101 -- Math

Real estate is dead which means that it’s probably a real good time to start thinking about investing in the sector. As someone once said, “There’s no secret to making money in real estate. You just sell when everyone else wants to buy and buy when everyone else wants to sell.” Right now the streets are full or will be soon with real estate assets for sale.

But before we can get into the pluses and minuses of residential versus commercial real estate and some alternatives to direct investment you need to have a grasp of the math needed to analyze a real estate investment.

Before you quit reading, let me assure you it’s pretty simple. So if your eyes rolled back in your head at the mere mention of the subject of mathematical analysis let me assure you that it’s not that bad.

First thing you have to do is figure out how much money the property you might want to buy makes. That’s pretty fundamental isn’t it? You would be surprised how many people screw this one up or fudge the numbers just so they can buy the property they fell in love with.

You start by calculating how much money you can generate from leasing the property. Naturally, that means you calculate the gross rent at the going market rent, make an allowance for vacancies (no property is 100% leased for 100% of the time), adjust for incentives for new renters and add in income from ancillary services (laundry room income for example in the case of an apartment building). Add it all up and you come up with what the pros call Effective Gross Income.

Next figure out what it costs to operate the property. Here is where people like to lie to themselves or forget the little things. So just to keep you honest, here’s a list of expenses you can expect to incur.

Management Fees

Advertising

Administrative

Cleaning and Maintenance

Property Insurance

Legal and Professional Fees

On-site Management

Repair and Maintenance

Common Area Maintenance

Supplies

Real Estate Taxes

Utilities (Water, Electricity, Gas, Trash)

Miscellaneous

Replacement Reserves

Pretty self-evident isn’t it. One word on replacement reserves. This is a non-cash item that recognizes roofs will need repair, air conditioners will break and lots of other capital items will indeed wear out. Investors like to skip over this little item since it doesn’t require cash upfront or on a monthly basis but do so at your own peril. You will be digging into your pocket to fix things.

Now you know the drill here. You just subtract the Operating Expenses from Effective Gross Income and you end up with operating cash flow. Once you have that number you can calculate the price you might be willing to pay based on the ROI (Return On Investment) that you expect.

For example, let’s say you want a 6% ROI and the property that you have your eye on has a price tag of $1 million. You do your calculations and figure out that it will generate cash flow of $100,000 a year and that you will have to invest $250,000 of your own money and can borrow the rest. The bank will charge you 6% interest on the loan. The yearly interest payment on the loan would be $45,000 which would leave you with cash flow of $55,000 per year.

As you can see, this is a screaming deal. Your ROI is around 22% and you need to jump on the property. There’s just one more calculation you need to make. You need to figure out the Cap Rate or Capitalization Rate on the property.

The Cap Rate is calculated by dividing the expected Net Operating Income or cash flow by the purchase price of the building. In our example the cash flow was $100,000 and the sales price was $1,000,000. That gives us a Cap Rate of 10.

So what you ask. Well, the value of the Cap Rate is that it allows you to compare the purchase price of your property with the price others are paying for similar properties. If, for example, you were buying an apartment building at a 10 Cap Rate and your real estate agent does some digging and finds out that the Cap Rate for similar apartment properties has been around 15% for the last couple of months, you would be overpaying for this piece of property. You could probably negotiate a better price and get an even better ROI.

When working with Cap Rates, always remember that higher Cap Rates mean a better deal for you. In other words, the higher the Cap Rate the less you are paying for the cash flow from the building.

There, I told you it wasn’t all that hard. In the next installment we’ll look at residential property versus commercial property and how you can employ these calculations to get the best investment deal.