Rate of Return in investment property

32 Replies

Hello,

I am in the contract of a house in Rockwall, Texas (Dallas area). I run the rate of return online and this is what I get. Please advice me anything you know, I appreciate that. I am a new guy, this is my first investment property. 

Updated 9 months ago

Should I use 20yrs instead of 30yrs for loan payment?

@Francis Dinh this a Negatively Cashflowing property. You are losing a lot of money upfront. If the market crashes, which we are looking at trying to anticipate right now, you will end up underwater, as you will not be able to sustain that rate of annual growth. Also, this is no where near the 1% rule.

You are hoping appreciation WILL happen, but nothing is guaranteed. If you are playing the appreciation game, you are gambling. You're holding and praying the market moves up, in the meantime you are losing money every month and every year. Also this projects rents to go up, what happens if they stay the same or fall a little bit. There is no room for error on this deal, no wiggle room for the unseen.

Personally I will not buy a negatively Cashflowing property

Originally posted by @Robert Herrera :

Francis Dinh this a Negatively Cashflowing property. You are losing a lot of money upfront. If the market crashes, which we are looking at trying to anticipate right now, you will end up underwater, as you will not be able to sustain that rate of annual growth. Also, this is no where near the 1% rule.

You are hoping appreciation WILL happen, but nothing is guaranteed. If you are playing the appreciation game, you are gambling. You're holding and praying the market moves up, in the meantime you are losing money every month and every year. Also this projects rents to go up, what happens if they stay the same or fall a little bit. There is no room for error on this deal, no wiggle room for the unseen.

Personally I will not buy a negatively Cashflowing property

 Thank you for your respond. If I like this property and want to buy it. Is there anyway to eliminate the risk and increase cash flow. I cannot control the tax, bank payment and insurance.

@Francis Dinh Only way to buy right is to buy closer to the 1% rule. That means you need to buy closer to $175k. You must at least have positive Cashflow or you will be throwing money into a money pit, year after year, hoping for a good return.

Either get it cheaper or be able to raise the rent closer to $2,400/month. If the numbers don't work, move on until they do. Everything is over valued all over, that means we are near the top, if you ask me.

I only buy properties that Cashflow. Appreciation is an unexpected/unplanned bonus. If you start thinking about Cashflow first, you will get that appreciation. It's just a matter of finding the right one. Sometimes there are no Cashflow deals. If anything keep building purchase money, and wait till the market drops out, then buy up the market

Is your interest rate 3.8% correct, which is extremely low for investment property? Even a primary resident house needs 3.875%.

Do you pay any point?

The maintenance fee is low and need around 10% of rental amount.

What will happen if you change it to 30 years fixed rate to low monthly payment?

Good luck,

John

Originally posted by @Robert Herrera :

Francis Dinh Only way to buy right is to buy closer to the 1% rule. That means you need to buy closer to $175k. You must at least have positive Cashflow or you will be throwing money into a money pit, year after year, hoping for a good return.

Either get it cheaper or be able to raise the rent closer to $2,400/month. If the numbers don't work, move on until they do. Everything is over valued all over, that means we are near the top, if you ask me.

I only buy properties that Cashflow. Appreciation is an unexpected/unplanned bonus. If you start thinking about Cashflow first, you will get that appreciation. It's just a matter of finding the right one. Sometimes there are no Cashflow deals. If anything keep building purchase money, and wait till the market drops out, then buy up the market

 Thanks Robert, I will try to increase the renting, and get the correct tax and insurance before decide to sign the deal. 

If your expenses are accurate, you would have to buy this property for $80k for it to make sense.

@Francis Dinh

Hi Francis, I'm not sure you understand the calculations, especially in the Table called "Breakdown Over Time."

The problem I find in BP is that most people just don't understand these calculations.

It's an Internal Rate of Return Calculation broken down by what the selling price of the house would be at the time, based on the Value of the house which is dependent on the Capitalization Rate and the NOI.

In other words, those calculations projects your rents and expenses out for 20 years, as well as calculates the Value by using a 3% appreciation Rate, which is extremely low.

It then seems to add all of it together and spits out an IRR of 9.24%

The problem is that the majority of Investors anywhere, not just here on BP, just doesn't really understand that kind of calculation.

Funny, but this is the kind of calculations that I really think all Investors need to know.

What you would really need to know is not if this is a negative cash flow or not, but can you carry the $347 per month loss until the time it break even in cash flow, which those calculations don't tell you.

Then, if you can do that, by the 20th Year, taking everything into account, including the negative cash flow for that short period of time (I can calculate it but am pressed for time when you would break even on cash flow), it would be the equivalent of putting your money into a Savings Account at the rate of 9.24%

Now, that's not bad as an Investment.

Also, the 3% Appreciation Rate may be far below what is the historic rate in that area so it could be way off and that would mean you get a much greater return.

ANYWAY.... my views are very much out of the mainstream but that's because I fully understand all of the numbers you posted. Most people can't get beyond the negative cash flow so they don't see the entire picture that you are presenting.

Originally posted by @Llewelyn A. :

@Francis Dinh

Hi Francis, I'm not sure you understand the calculations, especially in the Table called "Breakdown Over Time."

The problem I find in BP is that most people just don't understand these calculations.

It's an Internal Rate of Return Calculation broken down by what the selling price of the house would be at the time, based on the Value of the house which is dependent on the Capitalization Rate and the NOI.

In other words, those calculations projects your rents and expenses out for 20 years, as well as calculates the Value by using a 3% appreciation Rate, which is extremely low.

It then seems to add all of it together and spits out an IRR of 9.24%

The problem is that the majority of Investors anywhere, not just here on BP, just doesn't really understand that kind of calculation.

Funny, but this is the kind of calculations that I really think all Investors need to know.

What you would really need to know is not if this is a negative cash flow or not, but can you carry the $347 per month loss until the time it break even in cash flow, which those calculations don't tell you.

Then, if you can do that, by the 20th Year, taking everything into account, including the negative cash flow for that short period of time (I can calculate it but am pressed for time when you would break even on cash flow), it would be the equivalent of putting your money into a Savings Account at the rate of 9.24%

Now, that's not bad as an Investment.

Also, the 3% Appreciation Rate may be far below what is the historic rate in that area so it could be way off and that would mean you get a much greater return.

ANYWAY.... my views are very much out of the mainstream but that's because I fully understand all of the numbers you posted. Most people can't get beyond the negative cash flow so they don't see the entire picture that you are presenting.

 Thank you so much for your detailed explanation. I will update soon when I get the more accurate number from my mortgage officer and definitely need help here. 

@Llewelyn A. what @Francis Dinh needs to weigh, and what you are assuming most people dont understand, is... are you willing to lose money for 13 years, in order to make $150k in 20 years? I can take any property, in any market, and assume 3% appreciation, and make the final number look good. I'm not willing to lose money for better than a decade on any property when I can easily find properties in nearly any market that make me at least a little money from the beginning, and provide a much less risky way to make 9% total annual return on my investment. Any way you look at this deal, it's a losing investment.

@Jason DiClemente

I totally get what you are saying. But the Geek in me wants to bring the analysis out a bit further. Here is a spreadsheet I whipped up for reference:

Given the assumptions of 3% Rental increase and 3% Expense Increases, you are absolutely correct, it breaks even by year 13 as you can see in column T.

However, I wanted to see how the monthly Cash Flow will be affected. You can see that every year, the monthly cash flow decreases and gets much more affordable. I know a lot of people may say that a $200 loss per year is unacceptable, but now lets take it a bit further.

Let's look at the fact that he has a 20 year mortgage.

In Row 22, I computed the Balances after each year.

In Row 23, I computed the Equity based on ZERO Appreciation... meaning no increase in Value over the years. However, that does not mean he is not building equity. This row gives you the CUMULATIVE Increase in Equity.

In Row 24, I computed the Equity that was gained from the Original Mortgage of $196k (based on the $245k at an LTV of 80%). So Year 1 Gain of $6,673 is Equal to $196k original balance minus $189,327 new Balance after 12 payments.

In Row 25, I took each 12 month period and I computed the gain on average per month. You can see it's increasing nicely.

So... there are two things that are happening here.

1) His Monthly Cash Flow is getting More positive (or less Negative)

2) He is building Equity Faster via Mortgage Reduction

The Bottom Line is Row 26.

I take the Monthly Cash Flow and add it to the Monthly Equity Gain via the Mortgage Reduction.

You can see that it starts out at $209 per month and by year 13 it's at $877 per month.

This all assumes NO APPRECIATION.

I'm not trying to say I'm right or your wrong. I'm just putting out the Analysis so the readers of this post can see that while one can say it's a negative cash flow property for 12 years, he breaks even on the 13th year, all with no assumption of appreciation.

If there were appreciation, an annualized appreciation rate of 3% per year, which really is low even nationally, is really conservative.

I thought since he gave the numbers, that this was a good exercise for anyone interested to see in more details.

I perform this kind of analysis normally so I can get a 10 or 20 year vision on the Investment.

This kind of analysis also serves as a pro-forma business plan which helps others decide if they want to invest with you.

If it can be explained in detail, this can help your business if you are recruiting partners.

They get the bottom line, which is a negative cash flow for 13 years but the cash flow losses decrease each year. They get equity build up every year. And, if there is an assumed 3% Appreciation Rate, the over all return is 9.24% per year as if it was a Savings Account.

It's better to do this deal than to keep your money in a Savings or Checking Account earning virtually zero interest.

Just food for thought!

Agreed with this being a losing investment the way it’s currently set up.  You’re paying out of pocket to hold this for 20 years with no way to know what it would sell for.

It sounds like you’re serious about the property @Francis Dinh , so I’d suggest to come up with some different exit strategies, Since you’re currently under contract at $245,000, it’s tough to say, “Bring that price down to $170,000!” I would think it’s also tough to say, “Bring that rent up to $2,450.” Again the goal here is to be to that 1% rule sweet spot.

I’m not familiar with the Rockwall area, but I know Texas is a pretty hot market. Knowing the description of the property like rooms and square footage would probably help get more detailed suggestions as well.

My thought is simple, I think that I will sell this property within 5 years when they market are still hot. in Dallas area, I've seen that some houses were sold after 3-5yrs and the seller got 20-25% profit. Am I thinking this way right? The reason I chose 20years for mortgage is because I want to build my equity. For the rent this this area $0.9-$1.2$/sqft. My house is 2350sqft. however, I see some houses around mine have different rate for renting, so that I assume the lowest one. My mortgage officer updated me that my mortgage +tax+ insurance= $1950 for 20yrs. The tax I will need to pay is $630/month.

@Francis Dinh I don't know much about Dallas market, but people in the Bay Area are predicting a market correction of 10-25% in a few years (2020-2022).  I know you can't predict the future but some investors are already unloading a part of their portfolio to cash in when prices drop.  Personally, I think you should buy and hold longer than 5 yrs and make sure you'd be able to ride out the down turn.  

Happy investing!

@Francis Dinh - Personally, I would not purchase the place you have under contract. I think there are much better deals out there but they take time to find. I’m under contract for an 11 unit building for $320k and will get $6250 for rental income. You should make your mo st on the buy. Good Luck !!

@Robert Schumacher That's almost a 2% deal you got there!  Where/how did you find that?  Is it an off market deal?  

The complex was 36% occupied and the 4 tenants are moving to a new complex the seller built. This resulted in an empty complex and banks don’t like to finance empty units. Our agent was able to sell them on our ability to complete the transaction in cash if necessary and they accepted the offer. It will take us 30 days to get 10 of the 11 units rented (1 needs rehab) and then we will get permanent financing and have no cash in the deal by the end of the year.

My point with the OP is that being patient for the right transaction makes you an investor. Buying a home at retail pricing with the hope for appreciation is ordinary and is risky.

@Robert Schumacher

@Francis Dinh

Hi Robert.

That sounds like a great deal!

But keep in mind not everyone, which may include the OP, can qualify for that kind of deal.

I've been in the business for 2 decades and have $20 Million of Investment Properties in Brooklyn with Partners. I don't expect a single individual to buy like I do and I try to break it all down, which inevitably means that you need to find Partners for those deals since Brooklyn properties are generally over $1 Million each.

While I am not advising anyone to buy in a Particular Strategy, at least half of my properties were initially Negative Cash Flowing. I tend to have to add value to them like House Hacking it with an extra unit that I stayed in to make it at least break even.

In NYC, if you can NOT pay rent and live, you are doing GREAT! Today, there is huge protests about the "Rent is too Damn High." So when you can buy a place and not have to worry about Rent, consider yourself luck in NYC and I suspect, SF.

All my properties, including the ones that I started out with Negative Cash Flows, are doing FANTASTIC. For instance, I bought a property for $140k in the year 2000. That has a Negative Cash Flow for about 3 or 4 years. It's now worth $1 Million 17 years later. I originally put down $28k and renovated it for $40k. That's $68k invested. If I sold it today, I would put in my pockets $895k, that's a profit of $827k from an Investment of $68k. The ROI on that increase is 1,216% ($827k / $68k) over 17 years = 71% PER YEAR, not including about $2.5k in cash flow PER MONTH today! Not bad for a $68k Investment.

Francis, I forgot to answer the other question you had. You asked if it was better to use a 30 year fixed. It's easy to do the same calculations since I have a spreadsheet developed. I'm going to assume that for the 30 year fixed, it's at a higher interest. Let's just say 4% instead of 3.8%. So here is the spreadsheet with that small change:

See how quick it is for me to make a change on a spreadsheet and let it recalc all the numbers? Now, you will have a Negative Cash Flow for 5 Years, and most of it is barely a Negative Cash Flow.

NOW, to appease anyone who is totally disgusted at Negative Cash Flow, all we need to do is add a higher Down Payment and then you no longer have a Negative Cash Flow. So.... let's do 30% down.

Here is the new spreadsheet:

Good Buy Negative Cash Flow.

These spreadsheets are POWERFUL. I would advise everyone who doesn't know how to do them to PLEASE run your own spreadsheets and answer the what if questions.

The above spreadsheet answers the question, What do I need to do in order to make this Investment Cash Flow on Day 1.

I also want the reader of this post to realize that Cash Flow is NOT about the Investment, It's actually more about the INVESTOR. Basically any property can Cash Flow if you don't have a Mortgage. Having a Mortgage is dependent on the Investor, not the Investment.

Hopefully all these spreadsheets didn't put anyone to sleep! :)

Llewelyn, I do the same analysis for properties I look at. But I don’t use it just to justify a negative cash flow deal. I also have a property that was negative for a few years. Bought with $10k down and now have $300k in equity. Today it cash flows great.

But I also use it to compare to other deals. Deals can’t be looked at in a vacuum. In the case of the OP’s deal, what are the alternatives? Is there another property, cash flow or not, that looks better on paper?

Personally, I wouldn’t do this deal. Sure, 9% IRR is better than putting it under your mattress or bank. But I don’t think it’s good enough considering the market risks, illiquidity, tenants, etc... I’m selling a place with a 13% estimated IRR because it’s too low and there are better options. And yes, that’s using the same type of analysis you use. I have similar spreadsheets and our line of thinking is aligned.

Originally posted by @Llewelyn A. :

@Robert Schumacher

@Francis Dinh

Hi Robert.

That sounds like a great deal!

But keep in mind not everyone, which may include the OP, can qualify for that kind of deal.

I've been in the business for 2 decades and have $20 Million of Investment Properties in Brooklyn with Partners. I don't expect a single individual to buy like I do and I try to break it all down, which inevitably means that you need to find Partners for those deals since Brooklyn properties are generally over $1 Million each.

While I am not advising anyone to buy in a Particular Strategy, at least half of my properties were initially Negative Cash Flowing. I tend to have to add value to them like House Hacking it with an extra unit that I stayed in to make it at least break even.

In NYC, if you can NOT pay rent and live, you are doing GREAT! Today, there is huge protests about the "Rent is too Damn High." So when you can buy a place and not have to worry about Rent, consider yourself luck in NYC and I suspect, SF.

All my properties, including the ones that I started out with Negative Cash Flows, are doing FANTASTIC. For instance, I bought a property for $140k in the year 2000. That has a Negative Cash Flow for about 3 or 4 years. It's now worth $1 Million 17 years later. I originally put down $28k and renovated it for $40k. That's $68k invested. If I sold it today, I would put in my pockets $895k, that's a profit of $827k from an Investment of $68k. The ROI on that increase is 1,216% ($827k / $68k) over 17 years = 71% PER YEAR, not including about $2.5k in cash flow PER MONTH today! Not bad for a $68k Investment.

Francis, I forgot to answer the other question you had. You asked if it was better to use a 30 year fixed. It's easy to do the same calculations since I have a spreadsheet developed. I'm going to assume that for the 30 year fixed, it's at a higher interest. Let's just say 4% instead of 3.8%. So here is the spreadsheet with that small change:

See how quick it is for me to make a change on a spreadsheet and let it recalc all the numbers? Now, you will have a Negative Cash Flow for 5 Years, and most of it is barely a Negative Cash Flow.

NOW, to appease anyone who is totally disgusted at Negative Cash Flow, all we need to do is add a higher Down Payment and then you no longer have a Negative Cash Flow. So.... let's do 30% down.

Here is the new spreadsheet:

Good Buy Negative Cash Flow.

These spreadsheets are POWERFUL. I would advise everyone who doesn't know how to do them to PLEASE run your own spreadsheets and answer the what if questions.

The above spreadsheet answers the question, What do I need to do in order to make this Investment Cash Flow on Day 1.

I also want the reader of this post to realize that Cash Flow is NOT about the Investment, It's actually more about the INVESTOR. Basically any property can Cash Flow if you don't have a Mortgage. Having a Mortgage is dependent on the Investor, not the Investment.

Hopefully all these spreadsheets didn't put anyone to sleep! :)

 Thank you. So what do you think I should do if I still want to get this deal. I want the house in Dallas, but this area has this $200k- $260k, with renting $1500- $2000. Which factor should I adjust in order to get advantage in this area. I cannot change the fix rate like tax, renting market, house price and mortgage rate. Sorry for asking too much, I am so new.

@Francis Dinh

From a purely mathematical point of view as demo'd in my spreadsheets, this is not a disaster. Using the original numbers and the 1st Spreadsheet I posted, It's still an overall 9.24% IRR, but you have to put in $347 per month for the first year, and the negative cash flow diminishes every year until the 13th when it becomes positive.

What I do for investing is analyze the economics of the local, city, State, National AND GLOBAL markets. Normally, you don't need to know the Global Markets, but I do because this is NYC, an International City.

If the Dallas Area has decent FUTURE Economics, then it will cause your IRR to be a lot better and your Negative Cash Flow will be breaking even in years earlier than is projected in my Spreadsheet.

There are a lot of Investors here and elsewhere that eliminates Negative Cash Flow Situations (notice, I said situations because it's the Investor that Cash Flows an Investment), but I personally don't.

HOWEVER, there must be a compensation for me to put in money into the Investment.

Normally, in that situation, for me, I would need to be compensated with a Higher than normal return than what I can get with buying a straight Cash Flowing Situation.

I make intelligent analysis on the Future using Economics and other factors, such as City Developments in the local area and the migration of people to that area.

I can't really advise you for the specific Dallas Area because I am an expert in my Area, Brooklyn, NYC. I never advise or Invest in areas I don't have a thorough knowledge of the future economics of the area.

I think you have a lot of information from everyone's postings including mine. I'm just providing a fresh point of view that doesn't shoot you down just because there is a Negative Cash Flow situation.

@Francis Dinh , I might have missed it, but what is your goal with investing? Are you looking for cash flow or something else? 

You are right, you can't change some of the hard numbers and I would keep expenses for vacancy and maintenance conservative.  If the numbers don't make sense based off of your cash flow objective, you can either make a low offer where the numbers would make sense or you can move on and keep looking for a property where the numbers make sense.

Originally posted by @Jennifer S.:

@Francis Dinh, I might have missed it, but what is your goal with investing? Are you looking for cash flow or something else? 

You are right, you can't change some of the hard numbers and I would keep expenses for vacancy and maintenance conservative.  If the numbers don't make sense based off of your cash flow objective, you can either make a low offer where the numbers would make sense or you can move on and keep looking for a property where the numbers make sense.

 My goal of investing is create a cash flow after 5 years, so after that I can do the things I enjoy which makes less money. As a result, i won't have to worry about my financial issue with low pay job which I like to do.

@John J.

Hi John,

I'm not trying to justify what the OP is trying to do. I'm giving the calculations and then the OP makes a decision.

Once the pro-forma 10 or 20 year projection spreadsheets are fully created and the assumptions are verified to be conservative, then it's just a matter of using that spreadsheet to compare it to other potential Investments.

These are all subjective to the goals and means of the person who is looking at the calculations.

It is not Right or Wrong, it's just Math.

I cannot say that positive Cash Flow MUST happen in Year 1 or the deal is a dead deal. That's up to the person who uses the Analysis.

What I do know is that for me, it's all about the IRR, and I try to achieve higher than 15% as a goal, whether or not it starts out as Negative Cash Flow.

All Negative Cash Flow means is do I want to make it positive by putting more down or do I want to carry the property during that time?

It's about your strategy. The 3 versions of the spreadsheets tell us Cash Flow is about what you are doing in terms of finance, not about what the Investment is doing.

The NOI is the NOI. The Cash Flow changes depending on the Debt Service.

I just want to readers of this post to realize it's just math. It tells us that Cash Flow is a characteristics of the Investor and his means to finance the property, not about the Property itself. That's why the Cap Rate excludes Debt Service.

Personally, I would walk away from this deal. It seems you may have an emotional attachment to this property. Just buy based on the numbers and keep the emotions out of it. There are many more opportunities that will come your way once you start looking for them.

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