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Rental Property Numbers so Easy You Can Calculate Them on a Napkin

by Ali Boone on January 19, 2013 · 114 comments

  
Real Estate Analysis

The numbers. In this industry, you must love the numbers. Love them like they are part of you. For good or for bad, ‘til death do you part, never leave the numbers.

One of the biggest questions I’m asked is how I go about a property once I find it. What do I do, what do I look at, how do I know if it’s “the one”? There are several things I do and look at with any new property potential, but the most important is the numbers. If the numbers aren’t good, I walk. Save yourself some time and before you do anything else, run the numbers and see if they work. If they don’t, awesome, you didn’t waste time on other stuff.

What numbers do you run? Well, what should any investor care most about? Cash flow. What determines cash flow? Income and expenses. Simple. People make running numbers out to be so complicated sometimes it’s a no wonder more people aren’t involved in real estate. In fact, the numbers can be one of the easiest parts of shopping for a property. Unless you are a trained psychic on the crystal ball, then predicting appreciation may be easier for you than estimating cash flow.

Ready?

Numbers for the Napkin

1. Figure out the Monthly Income (Gross Income): This will either be rent the current tenants are paying, the asking rent (confirm this number is realistic), or if you have neither of those you can  talk to a local property manager or real estate agent who can give you a market rent value for the property.

2. Calculate the Monthly Expenses: These include property taxes, insurance, property management fee (if applicable), mortgage or financing (if applicable), homeowner’s association fee (HOA) (if applicable), vacancy and repairs. Don’t forget vacancy and repairs! They are a real part of any property investment and they can drastically affect the cash flow. Yet so many people don’t think to include them in the expenses.

  • Property TaxesScreen Shot 2013-01-18 at 9.05.44 PM- Look on Zillow or another online source for the most recent annual tax amount and divide by 12.
  • Insurance- Get a quote from an insurance provider.
  • Property Management Fee- Usually around 10% of the monthly rent.
  • Mortgage- Use an online mortgage calculator to calculate the monthly payment. Confirm with your lender what your down payment and interest on the loan will be to ensure you are using accurate numbers for your calculations.
  • HOA- This can be tough to find sometimes. The seller or agent may know the number already, but if not you will have to call the HOA of the neighborhood. If you only know the annual fee, divide by 12.

Don’t skip out on finding out what the actual HOA is! The HOA can absolutely kill a property’s cash flow.

  • Vacancy- I conservatively estimate 10% of the monthly rent towards vacancy expenses. In situations where you have a rockstar property manager or your tenants are under a lease option, the actual % should be much less. I still use 10% no matter what just to be sure I have a conservative margin.
  • Repairs- Again an estimate but should not be left out. Just like with vacancy, I err on the side of conservative. If a house is a turnkey property or recently rehabbed and gets a good report from the inspector, I use 5% of the monthly rent. If the property is not in top shape, conservative could mean closer to 25%. Use your judgment on deciding what % to use for your estimate, but don’t overestimate the quality of your property and estimate too low.

3. Subtract the Monthly Expenses from the Monthly Rent (= Net Income): This is your monthly cash flow. Yay! Hopefully it’s positive. If it’s not positive, run.

4. Calculate the Returns: Two numbers I want to see on any property I evaluate are the Cap Rate and the Cash-on-Cash Return.

  • Cap Rate- This gives you an idea if you are buying the property at a good deal. It basically compares the return on investment (ROI) to the purchase price.

The Cap Rate equation:

Net Annual Income / Purchase Price = Cap Rate

NOTE: I don’t include the mortgage payment in this calculation.

The lowest cap rate I would ever want to see for any property, whether residential or commercial I don’t care is 6%. The lowest I would want to see on a residential rental property in this market is 8% and even then, there better be a good reason it’s that low (property in a “sexy” market, highly desirable area, etc.). Anything over 8% and you are doing well in my opinion.

  • Cash-on-Cash Return- This number is how much return you are getting on the money you invest. If you pay all cash for a property, this number will be the same as the Cap Rate. If you are financing, this number is the most accurate way to see the actual return you are getting on your cash-in and the leverage. Here is the equation, and remember to include the mortgage payment since this one is totally focused on financing:

Net Annual Income / Total Cash Invested = Cash-on-Cash Return

Understand the difference? One is a measure of how good of a deal you are getting on the purchase price and the other tells you the exact return on your money you are getting. They are the same for an all-cash buy but can be very different for a leveraged purchase.

If you compare the Cash-on-Cash Returns of an all-cash buy versus a financed buy. You may quickly see the benefit of leveraging! Way more bang for your buck! Try it out on a napkin sometime.

 

Practice Problem, on an Actual Napkin

Apply these steps to an actual property? On a real napkin? You got it. Even more fun, I’m going to use a property that I bought for myself just a few months ago in Atlanta.

napkin2

What do you think? Good deal? Absolutely! I’m pocketing $358/month in cash flow (the actual number when there are no vacancies and repairs is $558!), the Cap Rate is 9.7% and the Cash-on-Cash Return is 17.97%. Not only are the returns great, but the tenants are under a 3-year lease and the property is in a great area. Score!

Running the numbers on a potential rental property purchase is easy. If you can remember what numbers you need to know it will take you no time at all to do this for every property you look at. Jot down the list of expenses on a scrap sheet of paper, fill in the numbers, and calculate your cash flow. Done. I’ve done this on multiple napkins in the past. Write everything out and look for positive cash flow. If it’s not there, ditch the property and move onto the next.

The only trick to this version of running numbers is that it doesn’t include any expenses for rehabs or any work that may have to be put into a property once you purchase it. I usually only deal with turnkeys which are fully rehabbed when I buy them, so this formula works great because there is no work required on the houses.

At the end of the day, numbers are just that- numbers. The reality of a property after you buy it may turn out to give you far different numbers than what you initially calculated. For instance, Detroit. Oh Detroit. On the surface, the numbers are out of this world. In reality, because of several key market factors, those initial numbers often turn out to be so far from reality (in a bad way) you wouldn’t believe it. If you are a Detroit investor, rock on and I wish you well. It’s just not my thing. Or, another example, I have another Atlanta property that had two back-to-back evictions in only six months, so my initially calculated 32.1% cash-on-cash return most definitely didn’t pan out that year. Point is, don’t ever just go off the numbers on a property, but the numbers are the most important. If you don’t have solid reason to believe you will be getting positive cash flow consistently out of a property, don’t bother with it.

Any horror stories? If you initially calculated that a property would have great returns and then the reality was something totally different, what caused it?

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{ 114 comments… read them below or add one }

Glenn Espinosa January 19, 2013 at 2:03 pm

Great post Ali!

I can totally see this as a great beginner resource for new investors.

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Mark January 21, 2013 at 10:39 am

Absolutely a fantastic resource for new beginners.

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Ali January 21, 2013 at 2:21 pm

Thanks, Glenn! It’s definitely geared towards simple. Numbers can obviously get more complicated, but they don’t need to start out that way. Thanks for the comment!

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Ankit Duggal January 19, 2013 at 2:25 pm

Awesome job. Clear and concise way to analyze income properties on a back of the “napkin”.

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Ali January 21, 2013 at 2:22 pm

Thanks, Ankit! The trick is to remember not to throw away the napkin or use it to clean up a mess or you have to start all over again :)

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Brandon Turner Brandon Turner January 20, 2013 at 12:25 am

I like the approach to this, Ali. I think too many people complicate the math – but it’s really fairly simple. Then again – I was the co-president of my High School Math League… so I’m kinda a math nerd.

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Ali January 21, 2013 at 2:23 pm

Hey Brandon, does it help you feel better about being a math nerd if I tell you I minored in math in college? Not quite as stellar of a nerd ranking, but at least I was trying :)

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A.King January 20, 2013 at 6:54 am

Great article! In your Cap Rate calculation on the napkin, where are you getting the Annual Net (minus mortgage) value of $9168? I’m just not seeing it. Thanks!

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Josh g January 20, 2013 at 7:53 am

The $9168 is the monthly net (cash flow-$358) plus the mortgage payment added (406) then multiplied by 12 months

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Ali January 21, 2013 at 2:23 pm

Thanks, Josh! You nailed it. Sorry, A.King, I should have clarified that better. I kind of snuck that one in there.

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Brain Helfrich May 23, 2013 at 5:16 pm

So, even though you say “NOTE: I don’t include the mortgage payment in this calculation.”

You do need to include the mortgage payment in the Cap Rate calculation. Right?

Thanks,
-Brian

Ali Boone September 25, 2013 at 3:14 pm

(this response is months late… I wrote this a while ago and just now realized it never went through!)

Hi Brian (I assume Brian, not Brain?). No, the cost of financing (in this case the mortgage payment) is never included in a cap rate. It is, however, included in a cash-on-cash return. That is standard. Basically, whether or not a buyer is financing is, as I like to say, their own problem and should not reflect on the purchase price of the property, which is what a cap rate is used for. Cash-on-cash returns are what you care about as a financer, and there you would include the mortgage payment.

Dennis January 20, 2013 at 12:52 pm

Just figuring there are some on this site who are not completely familiar with financial calculations. That being said I would also include dividing the number arrived at after dividing net yearly income by purchase price should be multiplied by 100 to acquire a percentage figure.
I just received a panicked email from a person who ran a deal past me a year age, I told him to grab the place. He was heart broken with his result $13,260/$50,000 = .2652. Thinking the cap rate as less then 1 percent. He is now beaming with a 26.52% cap rate.

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Dennis January 20, 2013 at 12:55 pm

I should have proof read a bit better, I hope you get the idea, multiply fraction by 100 to gain percentage figure.

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Remrie January 20, 2013 at 4:37 pm

Aka move the decimal two places.

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Mark January 21, 2013 at 10:42 am

exactly.. just move the decimal point two places to the right to get a percentage from a decimal.

Ali January 21, 2013 at 2:24 pm

Ooh, Dennis, great note. Yes, 0.2652 is definitely a bummer of a deal! ;)

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Bryan Scott January 21, 2013 at 8:49 am

Hi Ali, Good article. Just some added food for thought… If you intend to buy-and-hold for 5 years, one’s “back of napkin” estimates are quite different than holding for 30. In that 5 years, it is very unlikely that any rehab will be required before selling the property (while ROI can be maintained at a high percentage). However, hold that property for 10, 20, or even 30 years (part of the 401-K plan) and returns can very quickly turn back to “ho-hum” (not including effects of appreciation, which we hope there will be) after having to upgrade the kitchen and the 2 bathrooms, along with replacing carpet and lino, repainting inside and out, replacing the roof and siding and also the outdated appliances, etc., before the property will sell at that point. As a matter of fact, in 30 years, it is possible to do at least 2 fairly major rehabs just to keep pace with renter expectations and to maintain the highest rental income. So, I guess my concern is not just exit strategy as a buy-and-hold vs. fix-and-flip, but that they also know how long they intend to hold. This would give rise to the need to “budget” the big items at certain intervals in order to make sure enough cash-flow is held back to pay for these items when it comes time. Additionally, having been a landlord for many years, I can personally attest that the HUD-recommended amount of hold-back for expenses and vacancy is very nearly 16% across a portfolio of many different properties with varying Year of Construction. This is pretty much in lock-step with your estimate of 10% for vacancy + another 5% or so for repair. The above might imply that we need to “schedule” the big-ticket replacement items over time and derive a monthly percentage to hold back in addition to repair.

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Ali January 21, 2013 at 2:29 pm

Hi Bryan, great add! Yes, the reality of repairs is a serious consideration. Obviously there is no golden formula to predict everything that may go wrong with a property, but all things should be considered. Definitely when I buy the turnkeys at least, since they are freshly rehabbed, I don’t usually have anything in terms of maintenance for quite a while. but I still throw in that estimate even in the beginning because it will average out later when repairs do start popping up. Anytime an investment opportunity arises, an investor should always think about exit strategy. Your point definitely goes towards the debate of buying really cheap older properties… even if you get it fixed up to start, what hasn’t been fixed and how much could that cost you later?

Excellent note! Thanks for sharing.

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Mark January 21, 2013 at 10:38 am

Wonderful information. Never thought of adding in non-vacancy and maintenance and repair into the numbers. I’m a new investor, and will definitely put those percentages into the equation on my first rental purchase.

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Ali January 21, 2013 at 2:32 pm

Hi Mark, glad that helps! You aren’t alone by any stretch. Most investors, oftentimes even the experienced ones, don’t account for vacancy and repairs. I didn’t know to do that when I first started either. Funny it’s not more widely known since those two things are usually, if not always, what end up costing an investor money! Just be sure to always gauge your estimates wisely… like higher repairs % if the property is an old foreclosure.

Happy investing! I hope you’re enjoying it so far! Warning, it can be a bit addictive ;)

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Lucas Hall January 21, 2013 at 1:25 pm

Ali,
Well Done. I’ve often tried to think of the best, most simplistic way to explain the preliminary calculations for a rental purchase. I never thought about framing it in a napkin. Even the most novice of investors would be open to hearing about that! Brilliant!

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Ali January 21, 2013 at 2:36 pm

Thanks for the comment, Lucas! But don’t let me mislead you… writing on your hand, chalk on the driveway, dry erase marker on your mirror, crayon on your kid’s homework… they all work just as good as a napkin. Never limit yourself.

:)

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Giovanni Isaksen January 21, 2013 at 8:18 pm

Great article Ali.

One simple next step is to compare the Cap Rate to the Cash On Cash Return (CCR). If the CCR is higher than the Cap Rate you have positive leverage, i.e. you can expect a better return using the financing you have in mind. If the Cap Rate is higher than the CCR then your leverage is negative and your return would be higher buying all cash. If that is the case the deal needs to be reviewed more closely. Not saying it’s a deal killer, just that revisiting the financing options would be worthwhile.

To take a step up from the napkin/kid’s homework we developed the Dealizer, which crunches all those numbers and more. It’s an Excel template so it’s easy to store your numbers for each deal you look at and come back to them when you need to. We use it every day in our business and are in final testing on version 5 which includes more what-ifs, more detailed financing options and a couple new reports.

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Ali January 21, 2013 at 9:49 pm

Thanks for sharing, Giovanni. Any tools available for investors helps. I’ve seen various Excel spreadsheets and have made some myself and they can definitely come in handy.

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Christopher January 22, 2013 at 9:33 am

Hey everyone! I got lucky awhile back with finding a excel spreadsheet that did all the calculations for me that basically were used in the great “napkin presentation”. It helps to understand the numbers more I agree.

Here is my biggest issue right now REPAIRS! If I look at a property and know it will need 30k in repairs upfront because it is a foreclosure or something how do I add this to my financing equation? For straight cash I figured you just add it to the purchase price and great the cap rate will be easy, but for financing I am stuck since that is what I want to use. I wonder why anyone ever uses cash since leverage is so powerful in rentals (and is the only way I think makes holding rentals worth it). Should I simply figure out how long I plan to hold the property, and then from there I can bump my repair % to match that? heeeeeelllllllppppppppp.

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Ali January 22, 2013 at 12:56 pm

Hey Christopher, thanks for writing! I agree with you about the paying all cash versus leveraging thing, but truthfully I think people tend to be scared of being “in debt”. I’ve heard arguments for and against there being a difference between ‘good’ debt and ‘bad’ debt, but I’m definitely on the bandwagon of good debt rocks! The returns on your money are much higher and less risk to your own pockets.

I haven’t worked with rehab jobs yet since I only buy turnkeys, but I would imagine you could just add in the cash required to fix her up to the amount of ‘total cash invested’ in that cash-on-cash return and get an accurate % of your return. For the cap rate, add that $30k to the purchase price, since that total is really what you’d be buying the property for (technically), to see if that cap rate is still good. Know what I mean?

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Giovanni Isaksen January 22, 2013 at 7:49 pm

Christopher, that is a great question. When we run numbers on the Dealizer it shows the Cap Rate based on the purchase price and it also shows the ‘All in’ Cap Rate based on the total investment, including the repairs and costs to close. The ‘All in’ Cap Rate is the one you should use for analyzing a potential purchase, Since it represents your real investment in the property. When you’re trying to sell a property most brokers will show the regular Cap Rate to a potential buyer, hoping they don’t know the difference. You can check out the Dealizer by clicking on my name, above.

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Giovanni Isaksen January 22, 2013 at 8:03 pm

Example of ‘All in’ Cap Rate:
Purchase Price + 150,000
Closing Costs + 5,000
Repairs 30,000
= Total Investment 185,000
Net Operating Income 12,000
All in Cap Rate* 6.49%
*All in Cap Rate = NOI / Total Investment

Example of regular Cap Rate:
Purchase Price + 150,000
Closing Costs + 5,000
Repairs 30,000
= Total Investment 185,000
Net Operating Income 12,000
Cap Rate* 8.0%
*Cap Rate (regular) = NOI / Purchase Price

Note how the regular Cap Rate makes the deal look better…. unless you are the buyer who still has to come up with the 5k of closing costs and 30k of repairs, which will have a real impact on returns; it’s also how sellers make a 6.5% Cap Rate deal look like an 8% Cap Rate.

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Ali January 22, 2013 at 10:43 pm

Sorry Giovanni, have to admit I’m a bit lost on your numbers. I’ve never heard of an “All in” cap rate versus a regular. Without sitting down and trying some different math, I don’t know where your numbers are coming from.

Giovanni Isaksen January 23, 2013 at 11:19 am

Ali, sorry I couldn’t demonstrate the numbers better due to the nature of the comment form here. Let me try a different way of explaining it. A cap rate is essentially the cash on cash return you would earn on a property you bought with no loan. So imagine that the property your considering will be an all cash purchase, even if you do intend to mortgage the property.
The purchase price is $150,000.00
The closing costs are $5,000.00
The repairs are $30,000.00
In our imaginary scenario we’re buying with all cash so the question is; what number are we going to base our cash on cash return on? Will you use just the $150,000 purchase price? No because you’re actually putting $185,000 into the deal so your cash on cash return, and therefore your cap rate, should be based on your entire investment, not just the purchase price. To differentiate that from the seller’s version (based solely on the purchase price) we call it the All In Cap Rate at Ashworth Partners, my apartment investment company.

No need to apologize Ali, but if you ever wonder why your property that the seller told you was an 8 cap performs more like a 6-1/2 cap hopefully you’ll remember this thread.

Frank Gallinelli January 22, 2013 at 2:42 pm

Ali – I’ve made a career (or maybe a nuisance) out of telling people it’s all about the numbers, so I couldn’t be happier than to hear you saying the same. Also, I love simple — and you’ve done a spectacularly good job of keeping the basics just so.

Please permit me to offer a minor tweak to your approach; there’s a more-or-less standard drill where the sequence is slightly different, but which ends up in the same place as yours — and it should fit on the same napkin:

Potential Gross Income (same as your monthly rent, but usually expressed annually)
minus Vacancy and Credit Loss Allowance
equal Gross Operating Income
minus Operating Expenses (mortgage is not an OpEx, so don’t include that here)
equals Net Operating Income

apply the cap rate to NOI to get your estimate of value

take that NOI and now subtract your annual debt service
that equals your annual cash flow

Of course, in real estate investing as in real life, things can get complicated. If you’re planning to hold for several years, you need projections of how the future might look, and it might not be a linear path. Tax calculations can get messy (don’t even ask about the new Net Investment Income tax or the changed capital gains rules); and partnership allocations, if you need them, are no picnic.

What you have here is an excellent way for an investor to start looking at an income-property investment. Then, if the deal looks promising, he or she can take the numbers to the next level. Maybe a roll of paper towels, landscape mode? ;)

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Ali January 22, 2013 at 10:40 pm

Hi Frank, I love it! I’m a fan of paper towels myself. I do believe I’ve jotted down some numbers on them before. I wouldn’t put it past me.

Thanks for the different order of calculating things. You are very right that some people prefer to look at everything annually from the start, so good note there on being able to do that. And you nailed it with noting where in the process the financing amount comes out and where it is included.

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Christopher January 23, 2013 at 7:31 am

1) Ali- Thanks for the response! It got me to the right place on where I need to put my numbers in. I have been wondering where to put closing costs and repairs in for awhile. Xcel spreadsheets are great only if you know what they mean haha! I basically need to figure out my end number for the strategy I intend to use. I plan on using Hard Money to buy residential detached housing and instead of flipping it I will turn it into a rental. There are lenders out there that will re-finance at 70% ARV, so if the deal is good enough I can practically have 100% financing for my rental. Now that is a fun cash on cash return isn’t it? The banks blow and I am not about to put 25% down for a non-owner occupied and sink another 30k into the property, so Hard or Private Money can be a great avenue for investors to keep their OWN CASH working for them.

2) By the way Ali, There are many people who have no clue how to utilize leverage but what we do is a BUSINESS. Still boggles my mind to see duplexes out there that were selling 5 years ago 3-4x what their true value was, but that is why investors are different. Leverage is the reason why real estate produces more millionaires than any industry, because it allows you to purchase assets you otherwise could not. It also allows you to get an ROI of 50+% on your money from borrowing which is stupid crazy. You just need to know how the numbers work, which is why I am glad I found this website!

Unless you are already rich (which I sure as hell am not) the only way to truly acquire wealth in real estate is through leverage. Borrow capital an make a spread with your investment. Everyone has different ways of explaining it, but the important thing is that you KNOW if you have positive leverage and what the spread is. The larger the spread the less risky the property is to you.

3) Hey good point there too Giovanni! In my example where I am doing a rehab project with the intent to refinance (the only way to make the numbers work well in my view) I just have to come up with my “end cash invested”, but for anyone else it makes sense.

4) Basically Ali the cap rate is somewhat flawed in that a true “purchase price” of a home is really my ACQUISITION COSTS. I tend to think this a better term because that is essentially what I am doing.

Because most of us always are utilizing a mortgage we put closing costs and repairs (as in your response to my question) in the CASH INVESTED OUT-OF POCKET side, but as Giovanni states they should really be added to the purchase price as well to give you a more accurate view of the CAP RATE. After all, if I am an all-cash investor my ROI is based off of the TOTAL amount of cash it took me to acquire the property not just the purchase price.

5) Lastly, I think

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Christopher January 23, 2013 at 7:41 am

Lastly, I think UNDERSTANDING YOUR LOAN CONSTANT is extremely key to understanding leverage and the spread you are making. To me, it gets real messy just looking at cash flow or cash-on cash return and being OK with just saying “yep I got positive leverage!”. Or really any other method.

Your interest rate is NOT your loan constant! Also, the down payment does not come into play for loan constant. This is helpful because we all know the less cash you put into the property the higher the cash-on-cash return is. However, if you have a very small spread and the house is very risky would you consider it still a great deal?

Ultimately it is like I said: The spread between the Cap Rate and your Loan Constant is one of the most important things to understand when utilizing leverage. The larger the spread mean the asset you are purchasing is less risky. THIS IS THE REASON WHY CAP RATE IS STILL IMPORTANT to those of us who always plan to use financing because It used to determine risk.

Don’t know if that can fit on a napkin LOL but for the basics and newbies like me I know personally this was valuable information I learned.

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Ali January 23, 2013 at 10:24 am

Hey Christopher, thanks for the detailed response! And you know, I think you busted me. You are totally right about adding the closing costs into the total purchase price of a property. I totally flunked on that one! See, perfect example of even the experienced investors can leave stuff out sometimes. Similar to the comment above about making sure to multiply by 100 :) I always run the same numbers multiple times because sometimes I start writing something quick and leave something out or write a wrong number.

Can you elaborate on what you mean by “loan constant”? I’m not even sure I know what you mean by loan constant, so I know the newer investors probably don’t either.

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Frank Gallinelli January 23, 2013 at 9:44 am

@Giovsanni_Isaksen Sorry to pile on here, but I have to express a bit of skepticism about the usefulness of “all-in cap rate.”

Essentially, there are typically two flavors of cap rate in common use:

Market cap rate (NOI / selling price), which is the rate at which similar properties in a given market have actually been selling, and

Derived cap rate, which is weighted average of the equity investor’s required rate of return and the debt investor’s (i.e., lender’s) required rate of return (i.e., interest rate).

In practice, the two typically end up being quite close because, I believe, the investor market generally factors in the realities of the local financing market. In my experience, I find that most appraisers and investors use the market cap rate.

Isn’t this “all-in” approach really just assigning a different meaning to “value” (price + acquisition costs + “repairs”)? And if the primary purpose of capitalizing income is to estimate the current value of an income property, aren’t you really using a non-standard metric to come up with a non-standard measure of value? I’m not sure I see how that’s helpful.

A wildcard here is the use of the word “repairs.” A repair is an operating expense, and is not the same as an improvement — although I often see them discusssed as if they were the same. Identifying a cost as one or the other is not always clear, but the difference in how they’re treated is important. An improvement is not a deductible expense and has no effect on the NOI. It is a capital cost. It adds to the basis of an income property (hence reducing the gain at sale) but it doesn’t really affect the market value of the property directly. It should, however, affect it indirectly by increasing potential revenue and/or decreasing operating costs.

On the other hand, a repair is a currently-deductible operating expense and reduces the NOI.

From my experience, an income-property investor who is buying a property that needs improvements might estimate its current value based on capitalizing the property’s as-is income stream before fix-up. But then he or she would look at the expected stabilized income stream after the improvements and repairs are made; next, use the standard income capitalization approach to estimate its resale value; and finally do a discounted cash flow analysis to decide if overall return would be satisfactory, considering the time and capital required.

I find this more straightforward, and I think it has the advantage that all parties involved are using common terminology.

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Ali January 23, 2013 at 10:26 am

I completely agree, Frank. Excellent add-in there about the repairs vs. improvements. Any information about initial rehabs helps because I don’t work with those myself. Thanks for elaborating on that one and good information to always think about.

I’m with on the All-In Cap Rate thing. Never heard of it. Sorry Giovanni.

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Christopher January 23, 2013 at 10:43 am

I tend to disagree Frank because if I am an all cash buyer I want to know what my ROI is for the total cash invested is to the property. The closing costs are what $1300 bucks for a cash buyer? Regardless they are minimal. The repairs are really the question here. I would think that when determining whether repairs should become an added cost for Cap rate or simply used in your operating expenses is whether the house is rent-able or not. I sold a rental last summer where you could probably have put 7k into the property if you wanted to but the condition was fine as-is for a rental. To me then you just bump up your maintenance and repairs to include the deferred maintenance that eventually will need to be replaced.

For what my question was specifically is foreclosed single family homes that are not rentable in their current condition. I know this will be an upfront cost to me, because I will have to put money into the home so it is up to code for the city and rentable. It should only make sense then that I add these costs to the purchase price to reflect a more accurate ROI that I can expect as a cash buyer. That is because I am also putting in a rent number that I know I can get premium dollar for since it will be turn-key.

IN THAT REGARD THEN I AGREE WITH YOU THAT THE EXAMPLE ABOVE IS INACCURATE. If you are putting 30k into the property the NOI should look and be quite different, because by golly the rental income should be dramatically changed! As well as the maintenance % as Ali described effecting the expenses of course.

I think from a practical standpoint most people that use financing are buying turn-key properties where they will always have repairs as part of the operating expenses. It then just comes down to figuring out if the property is 100% move-in ready or has deferred maintenance. Ali made a good point of this.

If there is one thing I have learned from this discussion is that there are many ways to analyze a rental property beyond the simplest methods. Ali’s napkin example is excellent when dealing with turn-key properties or ones that have very little deferred maintenance, and thus you can always factor in maintenance and repairs to your operating costs.

Where it becomes a little more challenging is in my scenario is buying foreclosed properties in very bad condition that are un-rentable in their current state. Of course the added layer is then when I refinance as well.

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Christopher January 23, 2013 at 11:47 am

Haha hey Ali I am probably the most knowledgeable guy that has never bought a rental…which kinda sucks but hey I am working on it. As a realtor though I work with both flippers and landlords, and so I have just kinda had to learn this stuff when analyzing deals to make sure I know what I am talking about.

http://www.investopedia.com/terms/l/loanconstant.asp#axzz2Ip5XOp9f

You can pretty much google loan constant but I used this off of Investopedia. As you will see understanding the “true cost of borrowing” is essential when looking at different financing options. From a practical standpoint it is not like there are a ton of options for financing, but what if I buy a contract for deed property? If I set up the terms correctly to get the lowest loan constant possible it may drastically change what I am willing to pay. It will offset the higher interest rate and probably more.

In general these variables effect the loan constant:

1) Interest rate- pretty self explanatory the lower the better
2) The length of the loan- this is where I think people may get a little confused, because the longer the better. If I have a great interest rate but it is only 10-15 years I will most likely pay something higher to have it at 30 years. I have the equation on my excel so can’t think of it off the top of my head, but this is where knowing the loan constant can help.
3) Whether it is interest only or amortized- Like I said there are not a ton of financing options available and who can get interest only? This would probably only come into play for contract for deed homes.

So to me the loan constant is best used when trying to figure out a loan that may be 10, 15, of 30 years in relation to the interest rate. You as the investor always want the lowest cost of borrowing. I think where people make the mistake is they always assume the lowest interest rate is the best option and that would be incorrect!

Secondly as I stated loan constant is the “true cost of borrowing” so you can’t use the interest rate when figuring out leverage. You must determine this number and see what the spread is in relationship to cap rate. I don’t know what the rule of thumb should be, but my best guess is you need 4% or more for the asset to be considered less risky.

For example, let’s say you are paying something like 6% for a 30-year conventional loan, and you are an average joe using his w’2 because he does not buy in a LLC. You put 20% down. Your loan constant is going to be around 7.2%, which means 11% or more cap rate.

Now sure you will still have positive leverage if your cap rate is at 8% but boy you ain’t making much of a return on that. And on top of that we all know crap don’t work out the way we think it should most of the time haha! If you get that tenant from hell or some major repairs you did not see coming things can get bad real quick.

It just goes to show you that even when using financing for rentals you must not use the cash-on-cash return when determining if the property is a good buy or not. I think it is the #1 reason why people get into trouble buying rentals.

Now technically it is true that if the cap rate is higher than cash-on-cash return you will have negative leverage, but the point I am trying to make is for the people who get excited on 12-15% returns. I am telling ya it is not worth it! You have one bad year and those numbers can go negative really fast.

It is also possible to have negative leverage but still positive cash flow.

Like I said you all that own rentals probably know more than I do, but as a realtor I see deals every day that do not make sense. I work with the part-time wannabe investors, and it never ceases to amaze me the difference between them and the full-time investors who run this like a business.

For myself I appreciate the dialogue on this thread because I certainly don’t want to be classified in the wanna-be group!

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Ali January 23, 2013 at 12:24 pm

Hmmm. Thanks for the explanation, but I still can’t say that I have a clue what a loan constant really is or how it gets calculated. Even the Investopedia article didn’t explain much.

I’m going to have to stick to my napkin on this one. I understand where you are coming from but for me this is teetering paralysis by analysis. Yes, you are correct that there are always things we can’t anticipate for fact with any investment, but my theory on that is leaving a big enough margin. Most of my properties are netting $500/month or so, so I consider that to be plenty of margin to make up for any complicated (if not impossible) unknowns.

Thanks again for sharing. I’ll keep an eye out for that term in my readings, but for now, it just won’t fit on my napkin and I don’t believe it can make my investment 100% fool-proof anyway, so at that point it is going a little too far. For me, at least. Not saying it should be for anyone else.

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Giovanni Isaksen January 24, 2013 at 8:58 am

The loan constant is the amount of the loan you have to write a check for every payment period. With an interest only loan the constant will equal the interest rate. If you have an amortizing loan like a standard thirty year mortgage your monthly payment will be include the interest owned on the balance plus an amount of principal, which means that your payment will be higher than an interest only loan for the same amount.

To figure out what your loan constant is divide the total of your annual payments (monthly X 12, quarterly X 4, etc.) into the loan balance. If you are borrowing $100,000 at a fixed annual rate of 6% for 30 years with monthly payments your payment will be $599.55*. Multiply 596.6 X 12 to get the total annual payment which is $7,194.60. Divide 7,194.6 into 100,000 and you get the loan constant of .071946 or nearly 7.2%. *Calculated with payment due at the end of the period.

Conversely, if you know the loan constant for a particular interest rate and term you can calculate the payment. So for any 30 year 6% loan with monthly payments you can multiply the loan amount by the constant .071946 to get the total annual payment and then divide that by 12 to get the monthly payment.

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Christopher January 23, 2013 at 12:47 pm

haha indeed the KISS rule (keeping it simple stupid) is usually the best in most cases.

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Ali January 23, 2013 at 1:28 pm

Muah! ha.

I agree. Not to be confused with Stupid Simple. Just Simple, Stupid. Stupid Simple is dangerous, as opposed to his brother Smart Simple. Have to be smart about it, but being smart doesn’t mean it can’t still remain (fairly) simple.

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Frank Gallinelli January 23, 2013 at 1:20 pm

@Ali Loan constant is the payment amount for a loan of $1 at a given interest rate and term. Yes, it’s usually a long decimal and there are eyesight-destroying tables of these things you could download. If you know the constant for a $1 loan, you can multiply it by the actual amount of a loan to get its payment. Very 20th-century method, but in short it is a single numeric representation of the rate/term.

In one of my books, I have a crafty formula that includes the use of the mortgage constant, and which allows you to calculate the maximum possible amount that a lender might approve under a set of underwriting guidelines.

@Christopher Sorry to be an old curmudgeon, but the whole discussion of cap rates and NOI is pretty much irrelevant to single-family houses, and to most 2-4’s as well. Those properties are typically not valued for their ability to produce income, but for their amenities as a personal residence. Hence, the price you pay to buy and the price you receive when you sell will not be governed by the property’s actual or potential income stream, but rather by comparable sales of similar properties, adjusted for the subject’s condition and amenities. The value tends to rise and fall in step with movement in the neighborhood’s housing market, while the value of a true income property is a function of its income stream.

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Ali January 23, 2013 at 1:33 pm

Sorry, Frank, I can’t totally agree with you on that one. What you say is correct that you can’t determine the value of the property ahead of the time you plan to sell it because it will be based on comps rather than income, but you can definitely (and should) calculate NOI and cap rates when you go to buy the properties because you are buying for the purpose of getting a return. You have to know what that return is going to be, and you have to know what kind of deal you are getting when you buy it (cap rate).

You’re right, cap rate and NOI don’t matter for a sale later, but it needs to be clear that these numbers DO matter at some point, specifically the purchasing.

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Frank Gallinelli January 23, 2013 at 1:31 pm

@Christopher — btw, the use of a cap rate applied to NOI as a method of valuation of a true income property does in fact assume you are an all-cash buyer. Remember, NOI is before debt service. This is how a professional appraiser would approach the matter, and when you think about it, it makes perfect sense. The value of the property should not be affected by the kind of financing a particular buyer could obtain. If you had perfect credit, and I were a deadbeat, you might get better terms, but should that mean the property’s value should change depending on who is buying it.

Going beyond the appraisal issue is the question, “At what price the property meet my investment criiteria?” That’s when you want to take into account your financing costs, if any, and do a discounted cash flow analysis over time. It’s not just the number of dollars returned, but also the timing; the latter can have a significant impact on your overall rate of return.

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Christopher January 23, 2013 at 1:49 pm

Man my head is starting to hurt. Now I know why people just tell me to get them $500-$600 positive cash flow and be done with it hehehehe!

Since I am starting to write a novel I am going full circle back to Ali’s napkin approach:)

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Frank Gallinelli January 23, 2013 at 2:55 pm

@Ali Actually we don’t disagree very much at all — I just didn’t express myself as clearly or completely as I should have, and you’re raising an important point. In fact it’s a discussion I often have with my students on the subject of current appraised value vs. the price the investor should pay to achieve a certain objective.

So, to try to clarify what I bumbled over before: With a single-family house, its appraised market value is based on comparable sales, not on its ability to produce income. By analogy, with a true investment property (i.e.,commercial or residential larger than four units), its current market value by standard appraisal technique is its capitalized NOI. The question that comes up in my grad class usually is, “So is that the price is I should be willing to pay as an investor?”

The answer is, “Not necessarily.”

The typical income-property investment scenario is to buy and hold for some period of time. Hence, you’re not looking at a once-shot stream of income (current NOI) but rather an ongoing series of cash flows, including what you hope will be a big one when you sell. The best way to start the decision process is first to decide on a target IRR. Mid-teens is what I usually see from our investment analysis customers, but it can be higher or lower depending on the perceived level of risk. Then build a pro forma for some number of years to hold the property and work backwards to determine what purchase price will allow you to achieve that rate of return over the holding period.

You’ll use cash flow and net sale proceeds for this, rather than just NOI because the financing does have an impact on the return on your cash investment, as does the timing of cash flows and the overall holding period. It’s not uncommon to see the IRR peak for a certain holding period, but then decline if you keep the property longer.

The short version here (sorry for too many words) is that I absolutely agree that you must try to make a sensible estimate of your expected return, regardless of the type of property. Where the single-family is different from conventional income properties, however, is in the fact the your ultimate resale (which is really the last of your cash flows) will not be based on the property’s capitalized income, but rather on its comparable-sales value as a home. Add your original purchase price should also not be based on NOI or comparable sales, but rather on the type of DCF analysis I described here. Hence, discounted cash flow analysis can just about always contribute to your decision-making, but capitalizing NOI doesn’t have much of a role with single-family.

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John September 8, 2013 at 1:58 pm

Frank,

Can you explain why IRR’s sometimes peak for a holding period, but then decline if you keep the property longer?

Thanks!

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David January 25, 2013 at 10:28 pm

Wow, I couldn’t get through all the comments, so a very interesting topic, nice job!

That said, I think 5% for maintenance/reserves is inadequate. Even if every mechanical system, and the roof, is brand new (which I doubt, even in a renovated turnkey), then you need to start putting aside 5% per year just to cover reserves. On top of that, you will have your turn expenses (cleaning, paint, possibly floor replacement and other repairs) that will amount to a few percentages points, and this correlates directly to the average length of tenancy, and whether you have a peaceable turn or an eviction. And then there are some inevitable work orders that come up in the course of a year. In short, 10% is the minimum that I think makes sense unless you are absolutely certain that you plan to sell the property before anything needs to be replaced (in which case you theoretically get less since buyers will discount the “old stuff”; I know I pay more for a house with new mechanicals). So in the end, I’d content that 10% is the better (and conservative) number.

Length of tenancy is the key driver. It determines lease-up fees, vacancy rate, and turn expenses. This is one of the factors favoring single family homes that gets overlooked sometimes. And I’d contend that often the “stickiest” tenants are in the working class areas, where they tend to be long term renters.

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Ali January 27, 2013 at 9:30 pm

David, you make extremely valid points here. Every investor needs to figure out for himself what he (she) believes makes sense for how much % to allocate for both vacancy and repairs. You bring up excellent points for additional expenses in the repairs category to consider.

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Michael January 27, 2013 at 12:37 pm

Love the napkin post Ali. I use the quick # approach to determine quickly if I want to dig in more. There is so much to look at & this helps to weed out a lot in a short time.
Good debate going on here & my head is spinning. LOL. Still love real estate & buying and holding now as well.
Great Job!!!

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Ali January 27, 2013 at 9:31 pm

Thanks, Michael! You totally nailed it. I always scratch out the basics on a napkin or my hand or wherever else is handy just so I can know if I want to continue to dig in more. If the napkin numbers don’t show me anything good, I can toss the property, with the napkin, into the trashcan.

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JKC January 30, 2013 at 7:22 am

Great article Ali! And great discussion in the comments. What I wanted to focus on is the last paragraph of your article and how location impacts cashflow – as you point out with your example of Detroit. In my experience, the worse the location, the “better” the numbers. Just keep in mind that those numbers aren’t free (you have to earn them). If you are in a rough location, your napkin calculation may look good, but make sure you put your boots on the ground before you buy.

Alternately, in some of the nicer neighborhoods in a given area, the “napkin numbers” may not look as good, but the unit attracts nicer tenants and the area is often perceived as “less risky” in terms of appreciation and resale value.

My rule of thumb is: “The nicer the neighborhood, the worse the cashflow.”

I believe each investor needs to find a balance of return and risk that is comfortable to him/her.

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Ali January 30, 2013 at 6:11 pm

I can’t agree with you more! And I think investors need to understand this. There are always exceptions of course… not every expensive property with lesser cash flow will end up with perfect tenants, and not every cheap property with huge returns will end up with bad tenants, but it’s a chances game. Your chances are better with better properties and worse with the cheaper ones. No doubt. Some investors are fine going the cheap route and actually make a lot of money doing so. Others don’t. Some don’t like expensive.

You’re right. It’s about everyone’s individual comfort levels.

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John January 31, 2013 at 2:39 pm

I was doing a few calculations and came up as follows…
Assumes the following – Purchase price 40k / 15 yr mortgage @ 4.25 with 6k down

Gross mo income – 650
Expenses
Tax – 175/mo
Insurance – 50/mo
Mortgage – 260/mo
Vacancy – 65/mo
Repairs (15) – 100/mo
Net Income – 0
Cap rate – 3120 / 40k – 7.8 percent
COC Return – 3120 / 6000 – 52 percent

Is this right? If so, how can net income be zero but cap rate and COC return be high?

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Ali January 31, 2013 at 2:57 pm

Hi John, thanks for sending a sample problem!

So a couple things I see here:

– $3,120 is the net income not including the mortgage. Correct. But you should only use this one for the cap rate. So you’re cap rate is correct, because it does not include financing costs.

– For the cash-on-cash, you do need to include the financing cost, meaning the zero net income. So essentially you would be doing 0/6,000 = 0. You are making no money on the money you invested.

Is this a real property you found? What market?

Ali

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John January 31, 2013 at 3:07 pm

So in other words, run from this one…
Yes, I live in Sioux City IA. There are several properties available in that range. The monthly rental income may be slightly low in my example (although I did figure it at 19.5 percent of purchase price). Is that appropriate? I may have some wiggle room with my banker as well which could affect the numbers.

What term are you figuring your mortgage payment on?

I am searching for my first rental and want to get this right.

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Ali January 31, 2013 at 3:16 pm

John,

I definitely want to suggest in this case that you work with a local real estate agent or property manager to determine what the realistic monthly rent should/will be. How did you come up with the 19.5% number? Either way, there is no magic formula for knowing what you can predict for rents. You can only go off the comparables in the area, and that’s where you need a professional. Especially in this case since you are so close to the fence of having zero net income. That’s a huge problem if you want this property as an investment.

Remember- First rule of investing: Don’t lose money. This house is really close to wanting to break that rule.

As far as mortgage, you can probably lessen the payment by switching to a 30-year but it depends on what is more important to you. Cash flow or paying it off quicker. Also, where are you getting $6,000 down from? Have your lender provide you with the definite numbers because I’ve never seen a lender do an investment property loan for under 20%, and you are estimating a 15% down payment. Plus, you are going to have closing costs that need to be factored into your returns equations.

Hope that gives you some ideas to work on. But in general, I’d run far away from this property if those are the actual numbers.

Ali

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David January 31, 2013 at 3:18 pm

John — try to get a 25 or 30-year amortization. Also, your insurance and taxes look ridiculously high. Insurance shouldn’t be more than 1% of your purchase price (annually), and I can’t imagine your tax rate there is more than 2.5% of assessed value (annually). You may need to appeal the assessment upon purchase. In most jurisdictions, it is fairly routine to get the assessed value knocked down to your purchase price (Detroit may be an exception, for example). The 15% maint is on the high end of what most would use. I’d recommend 10-11% for SFRs in working class neighborhoods, as long as they have been reasonably rehabbed on the front end, and the house isn’t extremely old.

DON’T determine rents based on a swap % of the purchase price. You need to do a rent survey, using Craigs List, For Rent signs, Zillow, rentometer, calling prop mgr’s, etc.

A gross yield of 20% or so is pretty decent, it’s just shy of the exalted 24% target (ie. 2% rule) that everyone chases. Depends entirely on the quality of the neighborhood and quality of the property whether it is the right target, however. People routinely buy at 15-18% gross in “nice” neighborhoods, but lower neighborhoods you won’t make a penny if your gross rent is less than 24%, due to the higher maintenance and greater tenant issues.

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Ali January 31, 2013 at 3:22 pm

Great adds, John! And I agree. The numbers look really off.

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John January 31, 2013 at 3:28 pm

Thanks for the info. My tax numbers come directly from the county assessor page. Property is a foreclosure assessed at more than 2x listing price. I just guessed on insurance at this point. The 15 percent down figure comes from meetings I have had at the bank. They are a small, local bank.

What percentage do you figure for closing?

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Ali January 31, 2013 at 4:21 pm

And you definitely made sure to clarify that this will be a mortgage on an “investment property” rather than an owner-occupied property? That makes a big difference for down payments and interest rates. But if you did clarify that with them and you can definitely do a 15% down loan, that is awesome and I’m quite jealous.

I don’t want to give you a % to use in calculating closing costs. You need to get an actual number from the bank for those. There are some basic %s you could use, but I feel like they will mislead you. You are safer to get the numbers from the lender. They can give you those.

I caution you in general to be very wary of assigning uniform estimates to any property you look at. Like assuming the rent will be a % of the purchase price or property value. Or assuming an exact % of the loan for closing costs. Because success in real estate investing is so dependent on numbers, always always always try to get exact numbers whenever possible. Because even with almost all “exact” numbers, there will always be something to throw those numbers off. So you want to estimate as accurately as possible to start.

John January 31, 2013 at 4:25 pm

Thanks for your help. Yes my banker knows this is an investment property. Having a good relationship with him and the bank probably helps. I will get some definite insurance numbers. This is just one I found a very prelimary figuring at this point. Wanted to make sure I was on the right track. Thank you again.

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Sabrina Laplante February 5, 2013 at 5:40 pm

Ali, awesome article!!!! Love how simple you make it. I appreciate the time you take to explain these things to some of us beginners! What some could say about numbers and them being scary, you show us a very appealing version!! Thank you so very much, and good luck with everything! Looking forward to reading many more of your blogs on here!!!

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Ali February 6, 2013 at 12:15 am

Thanks, Sabrina!

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Jacquelyn February 6, 2013 at 6:47 pm

Hello Ali:
Maybe I missed it but on the cash-on-cash example, I am not seeing where you got the 4296. I thought that the annual net was 9168. Thanks

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Ali February 6, 2013 at 11:33 pm

Hi Jacquelyn! No, you didn’t miss it, I just didn’t expand on that as well as I should have. I’ve had a lot of questions on it. So for the cash-on-cash return, you want to use your annual net income, but unlike the cap rate you do want to include financing costs here. So the $4296 is the monthly income, after all expenses including mortgage, times 12. The cap rate number didn’t have that mortgage payment taken out of it.

Hope that helps!

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Junior May 9, 2013 at 8:25 am

Hey Ali, Great post by the way! Especially amazing for someone like me who is looking to get into the basics of renting turnkey properties. One question, why when you calculate your cap rate do you exclude the mortgage payment from your net per year?

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Ali Boone May 9, 2013 at 12:03 pm

Hey Junior, love your name :) Good question. The cost of money is never calculated into a cap rate. If you are financing, you always want to go the extra step and calculate that cash-on-cash return because that will account for the mortgage or financing cost. Cap rates are a measure of a property price versus the income it brings in. That doesn’t include financing. As I like to put it, financing costs are your own problem, not the sellers’. And by problem of course I mean gift from heaven :)

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Chris K. May 27, 2013 at 11:37 am

Ali,

How would i calculate cash on cash return for a property i’m now renting that was my primary residence for approximately 8 of the last 11 years?

Assumptions:

Total purchase price: $269K in 2002
Total improvements: $31K

Current monthly costs:
*$1,187 Mortage (30yr @ 4.625%)
*$342 Taxes
*$85 Insurance
*$100 Vacancy (this is conservative since we’ve had, and still, have a great tenant since Day 1)
*$100 Repairs and maintenances (again, very conservative, knock on wood)

Current monthy rent:
*$2,100 (this is low – comparative rents are $2,350-2,500)

It seems my cap rate is especially low. Part of my short-term strategy to hold the house while we moved to Woodland Hills, CA was to let the property re-appreciate, and that seems to have occurred. Worth about $375-425K when we moved almost 3 years ago, the property is worth about $600K right now. My long term plan, however, was to hold the house as income property, pay it off, and have it in our retirement as an income-producing asset. That is still feasible, but i suspect i need to reduce current expenses, increase revenue, or both, to make it a good play for my money (return wise). But we’re also very seriously considering selling right now to take advantage of the IRS code that allows me and my spouse, filing jointly, a cap gain exemption of up to $500K for living in the house 2 of the last 5 years. I would clear about $300K tax free in this scenario….money that could perhaps be reinvested in income property with better returns?

Your or anyone else’s thoughts here would be greatly appreciated.

PS – i have really benefited from this napkin posting and all the comments and replies, so thank you…

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Ali May 27, 2013 at 9:50 pm

Thanks Chris K.! Glad the article has helped.

Your cash-on-cash return would just be calculated using your net income and how much cash you have actually put into the house (not how much the total purchase price was, how much you owe, or how much it’s worth). You can’t really calculate a cap rate on this, I mean you can, but there is no point. Cap rate is only related to buying or selling a property.

If you have that nice of equity and profit potential, I’m in favor of the idea of selling that house and using that profit to buy properties with higher returns. Multiple properties, higher returns, more tax benefits, etc. Just my 0.02 tho!

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Chris K. May 28, 2013 at 8:58 am

Thanks Ali. I only owe $215K on the note now. So, if it was you, you would take the one-time tax savings huh, and not try to pay down the note aggressively? (goes against your strategy of using leverage to create positive cash-flow, i know)

Is there a point, in your opinion, in calculating cash on cash return then? i mean, how much money i put in the house would be difficult to calculate (beyond the improvements i know about, it would be 8 years of mortgage payments (P&I) and taxes and insurance….and that can’t be good for any cash on cash return calculations).

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Ali May 28, 2013 at 5:16 pm

It would only be relevant if you want to keep it as an investment. But it would still only give you a heads up about the return you are getting on your money, it wouldn’t change any of the numbers.

But yes, you’re correct, I’m a HUGE fan of leveraging and never paying anything off. :)

Michael Spindler July 7, 2013 at 11:07 am

Hi Ali,

Thank you so much for this. Normally formulas boggle my brain and I just shut down. But your intro made it so easy, I actually started looking at and understanding the more advanced stuff, ROI, NOI, etc… This goes along way to answering my own questions rather than asking for group consensus on a deal.

I am a firm believer in paying myself first and then use the net profits to reinvest. Does anyone else include themselves in the equation. Ex: Instead of paying a PM, reassign the 10% to self pay? Or even in addition too?

Thanks again!

Sincerely,

Michael

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Ali July 7, 2013 at 11:26 pm

Hey Michael! You can definitely tweak the numbers any way you want. The net cash after everything on the napkin is the money that would go in your pocket, but if you want to split that up further somehow, you totally can.

Glad you like it! Thanks for the response.

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Sarah L August 13, 2013 at 1:20 pm

Hi Ali,

Thanks so much for posting! This article is so helpful! I’m just starting out and this article made all the real estate finance not so intimidating. I assume this would just be a good starting point to decide if it’s worth looking into a property more – are there additional formulas I should be looking at?

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Ali August 14, 2013 at 1:02 am

Hey Sarah. Not that I can think of to start!

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Lisbeth Madrigal August 15, 2013 at 4:35 am

Ali,

Great article! I have not yet bought my first investment property but am one day closer. Using this time to continue educating myself to be a well informed RE investor and minimize my error and maximize my potential cashflow via reading some of these post. I have found some property evaluators on different sites etc., but I would like to see numbers on extra principle payments, so if I apply cashflow towards principle payments. Also calculating percentage of tax on that earned income deducted monthly. I am working on setting these formulas on an excel spreadsheet, etc. Not a math nerd, but like to know how things work.

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Ali August 15, 2013 at 12:18 pm

Hi Lisbeth, good for you for getting all set up so you can evaluate properties quickly. One thought for you is to maybe not worry too much about the tax because if normally your expenses, once written out as write-offs, should balance out the taxes you would owe on the income. So any house expenses, depreciation, travel expenses, etc. are usually enough to make it a situation where you won’t owe any taxes. It’s one of the mega benefits of rental properties. Look into it though.

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Joe Butcher August 22, 2013 at 5:36 pm

Hi Ali,
I know this is an old post, but I have a question, and I’m sure it is something I am overlooking, as I am not much for math, but under the Cap Rate equation, you have your Annual Net as $9168, and under the Cash On Cash equation you have the Annual Net as $4296, but since the cap rate doesn’t include the mortgage shouldn’t the Annual Net be LESS??
How did you arrive at $9168?
I know this is something I am overlooking I am sure, so apologies in advance.
Thanks
Joe

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Lisbeth Madrigal August 23, 2013 at 3:13 am

Morning Joe:

Here you go:

Josh g January 20, 2013 at 7:53 am
The $9168 is the monthly net (cash flow-$358) plus the mortgage payment added (406) then multiplied by 12 months

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Ali January 21, 2013 at 2:23 pm
Thanks, Josh! You nailed it. Sorry, A.King, I should have clarified that better. I kind of snuck that one in there.

REPLY

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Joe Butcher August 23, 2013 at 5:31 am

Thank you Lisbeth…..so just to clarify we are INCLUDING the mortgage in our Cap Rate equation, but NOT our COC, correct?
Thanks
Joe Butcher

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Giovanni Isaksen August 23, 2013 at 11:50 am

Joe the standard cap rate is calculated before any debt service, as though you bought the property for all cash. To get the cap rate you divide the NOI (Net Operating Income which is rents less vacancy plus other income minus expenses) by the purchase price.

To calculate the cash on cash return you subtract the debt service from the NOI to get your pre-tax cash flow and divide that by your total cash invested. The cap rate is a better measure of the property’s performance while the cash on cash return is a measure of your investment results.

For illustrations of NOI, Cap Rate and Cash-on-Cash Return click on my name above and go to the Investment Property Analysis page on our website.

I highly recommend reading Frank Gallinelli’s “What Every Real Estate Investor Needs to Know About Cash Flow… And 36 Other Key Financial Measures “. This is the investor’s bible on analyzing real estate deals and if you know how and when to use the formulas Frank lays out you will know as much as or more than most RE brokers. That’s key because the difference between a sales ‘proforma’ and reality is the difference between success and failure in real estate.

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Genna September 25, 2013 at 1:31 pm

Ali,
Can you use COC formula for more than the first year of a property? Does it work to use all the money invested up front in down payment, then use the net income of the property to figure out what your COC returns are at any point during the investment?

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Ali Boone September 25, 2013 at 3:17 pm

You definitely can Genna. And it’s good to. Like if you buy a property and originally calculate 7% for vacancies and and it is actually 15% once you get into it, you can recalculate and see your actual returns. Now, whether you can do anything about it then or not is another story. Until you go to sell, what the returns are really don’t impact anything, other than potentially triggering you to want to sell. But yes, you can always adjust. Especially for repairs…they will only become more and more as you go on.

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Giovanni Isaksen September 25, 2013 at 4:35 pm

Gemma I would add to Ali’s reply that while you can look at COC returns every year over time or over a span of years there are better ways to measure your returns. $100 of cash flow today is worth $100 but $100 of cash flow seven or ten years from now will not be worth as much because of the time value of money. When looking at property returns over multi-year spans or the life of the investment measures such as IRR (Internal Rate of Return) or MIRR (Modified Internal Rate of Return) work better and are favored by those who work with property investments for a living… or whose living depends on those investments.

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Mike Glass October 21, 2013 at 7:29 pm

Ali help here,
Hoping to pull the trigger on a deal in the coming days, but I want some feedback if possible. At first when I was doing my numbers I was certain it was a good deal but lately seems like my numbers are getting clouded by too many opinions. Based on your plan can you tell me what you think.
Turnkey property (section 8 housing) that I will get once a 1 year lease is signed
Sale price 35,000
Cash at closing $11845
Monthly income $725
Tax $100
Insurance guessing $50
Prop management $80
Mortgage $100
Vacancy $50. ( I know a little lower than %10)
Repairs %30

Napkin test please?

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Ali Boone October 22, 2013 at 3:52 pm

Hey Mike! Sure, I can try to help. I didn’t go through actual calculations on these just because I can tell the numbers work out fine just by looking at it. You’re basically at the 2% rule already (only using that as a guideline, never a rule) which pretty much means the numbers will work out.

When you say “opinions”, are those from other people or your own? I think in this case, you should definitely weigh any “opinions” you hear. Remember, while numbers are the most important thing, they aren’t the only important thing. With this property being turnkey and that cheap… I have hesitations about it without even seeing it. Also, do you know for sure you can get a mortgage on it? I don’t know any lenders who will lend that low.

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Mike Glass October 22, 2013 at 4:29 pm

Opinions meaning lots of crazy optimistic opinions and lots of negative ones, they all seem to take their own experiences and print them as the gospel of real estate investing.
Yes, I was able to qualify through Huntington bank for this loan. I do have cash if needed but I really would like to use the banks money. Yes the houses are section 8 and location is not great but with it being section 8 I’m banking on the success of a close family friend who manages @200 of these as well as owns many as well. I know the appreciation probably won’t be great but I’m really in it for the passive income and tax breaks. Am I thinking about this the wrong way? It’s a 3br, 1.5 bath, no basement. This was appealing as I hope repairs are kept to a minimum. Again I’m very to new to this and want my deal to be good. I have several others just like this lined up to look at so this is the target market I seem to be headed toward.
Thanks for the quick reply

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Ali Boone October 22, 2013 at 9:15 pm

Hey Mike, sounds like you are on a smart path with it! I’m usually pretty big at knocking cheap property investing but it sounds like you have the right team in place and it could work for you. I’d go for it!

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Donald M November 10, 2013 at 4:21 pm

Not sure if anyone brought this up, but how do you account for personal federal and state income taxes? Why doesn’t the cash on cash return factor this in, if you’re going to have to pay 20%-35% on your income? Do people not factor this in with respect to real estate investments? Thanks.

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Ali Boone November 11, 2013 at 6:45 pm

Hey Donald, no it’s not factored into rental properties because if done right, for the most part rental income ends-up being ‘tax-free’ income, essentially. All of the write-offs, and the big one being depreciation, ends up usually equaling pretty close to what taxes would run, so it balances out to be tax-free income.

That is not however true for active income investments, such as flipping.

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Eric December 5, 2013 at 10:05 am

Forget about all the numbers and ROI. If you have had two back-to-back evictions, you need to get some education in tenant screening. You obviously do not know how to screen tenants.

As an experienced landlord, with 25 current renters, you need to look at credit score and know what it means. It means more than a criminal record ever could. Income tells me the renter’s ability to pay, credit score tells me the renters desire to pay.

With the national average renter credit score at ~658, anything below that and you are taking in a BELOW average renter. Stay above 620 and you will have fewer issues. If you take in a renter paying more than 30% of their gross income in rent, and a sub-600 credit score, you are a fool.

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Ali December 5, 2013 at 12:34 pm

Thanks, Eric. I don’t landlord properties myself though and I wasn’t the one who put those tenants in. The property managers I had working the property were absolutely horrible, unbeknownst to me in the beginning, and they’ve since been fired and I have a great manager (who knows what he is doing) taking care of the property.

Tenants will make or break an investment property all day long. Bad tenants = cost a fortune. It’s up to the landlord/manager to find the good people.

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Matt Henderson March 2, 2014 at 5:03 am

Hello,

I have a rental property that I’ve owned since 2007, and recently sat down and attempted to analyze the investment, to determine whether I should continue with it, or sell it and deploy the proceeds into other investment vehicles.

The property equity, right now, is what I consider is the capital that could otherwise be invested in an alternative investment, and that brings me to the first point: Shouldn’t current value be used in the above calculations, as opposed to purchase price? (Or at least, should it be used in my context?)

Second, the mortgage payment is comprised of two components: Interest and principle. The interest is an expense, but the principle payment increases my equity in the property. So my second question is whether that increase in equity over the year (due to the principle portion of the mortgage payments) should be taken into account in an analysis?

Thanks so much.

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Ali Boone March 2, 2014 at 7:51 pm

Hi Matt, thanks for reaching out. For your first question, no the value on a house doesn’t even matter if you aren’t going to sell it (or buy it), and it doesn’t matter unless it’s what you sell or buy for. The only price that matters is the one you will actually buy it or sell it for, regardless of the true value. For the second one, regardless of what is what in the mortgage payment and the equity you are building, that set amount is still an ‘expense’ for the month. It doesn’t matter what it’s doing to the value of your investment, it affects your monthly cash flow the same way regardless. Hope that helps.

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Paul May 17, 2014 at 12:44 am

Matt,

If your question is whether it would make sense to sell the property and deploy the proceeds elsewhere, then absolutely the relevant number is the current market value of the property, not the capital cost. So I disagree with Ali on this point. It doesn’t matter if the cap rate looks great because your initial investment was low; if you are sitting on a meaningful capital gain, it might make sense to sell.

In fact, since the average yearly return for the S&P has been about 8% historically, you can’t easily justify keeping a property that generates any less. (The fact that it’s so easy to make money in the stock market is precisely why I haven’t gotten involved with all the hassles of real estate–at least not yet.)

Now on to the second question: that’s exactly why the cap rate doesn’t take financing into consideration. You’re making a return, and the cap rate simply tells you that return; whether you decide to plow part of it into a mortgage payment is your business and isn’t related to the performance of the investment itself. But by the same token the cap rate doesn’t reflect your degree of leverage, so for that they’ve devised cash-on-cash. If your strategy is to focus on paying down your debt rather than logging a large monthly cash flow, then you could have a zero cash-on-cash and still be increasing your net worth by building equity in the property. Just not a strategy that most real estate investors favor.

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kris March 7, 2014 at 12:44 pm

What if you assume the existing mortgage on a property? What number do you use for the Cash-On-Cash to divide by?

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Ali Boone March 7, 2014 at 8:03 pm

Hey Kris. Whatever money you put into the deal should be in the denominator.

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MAY LE April 11, 2014 at 2:22 pm

Hi Ali,
Thank you so much for great information. So, base on your calculation, I set the cap rate as 7% as my goal, and calculate backward to find the ideal purchase price range.
However, I have been looking for houses for 6 months, and as far as I know, there’s no house that under $200,000 can rent out for $1300. Only condo or townhome can have that price, however their HOA is usually high ($250/month). So, I’m not saying that the numbers you give are not realistic, but I just wonder how you find such a good deal house that is low price, no HOA, and high rent. Maybe I have been searching for houses in the wrong way.
Please advise.

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Ali Boone May 1, 2014 at 12:32 pm

Hi May, thanks for writing. Chances are the issue is the market you are looking in. There are a lot of markets that have plenty of houses for say $150k and rent for $1300. Let me know what market you are looking for those in currently.

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Griff April 30, 2014 at 9:15 pm

Ali,

One quick question. In your napkin figuring when looking at potential investments, do you typically use a percentage of the purchase price to estimate closing costs? It appears in your example for “Cash to Close” you had 20% down and then tacked on an additional $5K for closing costs (roughly 5% of $94,500).

Much appreciated post and thank you.

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Ali Boone May 1, 2014 at 12:34 pm

No Griff I don’t usually go off of a set % of the purchase price. I used that $5k ballpark just based on what I had seen at the time, but I would definitely recommend clarifying with your lender how much exactly in closing costs you will be looking at. You could even get a ballpark to start and then confirm exact numbers later with him if that’s easier. It’s hard to say an exact % because lenders will vary in their fees. Not drastically, but I would always just ask them for what number to use.

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Jessica G May 7, 2014 at 6:57 am

Let me start this with a caveat, I’m not a huge fan of math…but I know I have to understand it, especially in the world of investing.

With that being said, I’m still stuck on the napkin calculations. From reading the article, I was thinking the equation for the cap rate would be $4296 ($358×12) / $94,500 = 4.5%
and the cash on cash equation would be $9168 ($358+406×12) / $23,900 = 38.35%
but the numbers on the napkin were different.

Clearly, I missed something. Could you point me in the right direction and tell me where I messed up?

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Ali Boone May 7, 2014 at 1:38 pm

Hey Jessica, great question! I realize I didn’t clarify well on those equations. You have it almost exactly right, but switch which equation you involve the mortgage payment in. The cap rate is not calculated with a mortgage payment, so it’s that one where you would do the ((358+406)*12)/94,500. You are just subtracting out the mortgage from the expenses, as you did for the cash-on-cash. The cash-on-cash needs to include that mortgage payment as an expense so that one stays $358, so (358*12)/23,900.

Does that make sense?

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Carrie July 2, 2014 at 12:52 pm

Thanks for the unique strategy of using a napkin! I really enjoyed the way you broke down each step for an easier understanding. If you’re looking more into RV’s and Cash Flow equations, check out one of our podcasts at hartmanmedia.com!

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Ali July 3, 2014 at 11:21 am

Thanks Carrie!

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Matt Svajda July 7, 2014 at 2:00 pm

Ali,

Are you still seeing this figures in today’s market? I’m in SoCal and have been looking at rentals in the desert area, but the numbers have been shifting. Where else are you seeing this napkin return?

M

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Ali Boone July 9, 2014 at 3:35 pm

I’ve definitely never seen those numbers anywhere in SoCal, Matt. At the time I did the article, that was an Atlanta property but it’s doubtful you’d see those there now. It depends a lot of what kind of property you are looking for. Distressed properties and lower-priced properties will yield those numbers a lot easier. So it really depends. You can see those numbers in Philly for sure, mayybe Houston but probably not quite there and the CoC wouldn’t be there. Chicago.

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Ken September 29, 2014 at 1:37 pm

Ali,

So I am currently still trying to get the hang of the evaluating process. So my question is why didn’t you include water, sewage, trash,etc… In the expenses? Wouldn’t that then give you your true cash flow? Or is this just a screening process and you use a much more in-depth analysis later on?

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Ali Boone September 29, 2014 at 1:58 pm

Good question Ken. No, the only time I would include the utilities as expenses is if I would be the one paying them (i.e. the owner). Typically tenants pay for all of those themselves, so it would not be an expense to me. More with multi-families or condos or apartments you might see owner-paid utilities. If I am looking at a property, I will ask if I would be responsible for those as the owner and if the answer is yes, I will include them in my calculations.Same with HOA. A lot of properties don’t have an HOA fee, but if one does, I will include that as an expense.

Ultimately, if you are analyzing a property, you should be fully aware of all the running expenses that you will be responsible for. And then, be sure you include all of those in your calculations to make them more accurate. Whatever the expenses may be, include them. But typically the owner is responsible for utilities.

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Ali Boone May 23, 2013 at 6:23 pm

Hi Brian (I assume Brian, not Brain? haha). No, the cost of financing (in this case the mortgage payment) is never included in a cap rate. It is, however, included in a cash-on-cash return. That is standard. Basically, whether or not a buyer is financing is, as I like to say, their own problem and should not reflect on the purchase price of the property, which is what a cap rate is used for. Cash-on-cash returns are what you care about as a financer, and there you would include the mortgage payment.

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