RANT: Stop Using Bad Math to Analyze Real Estate - Plus A Hot Tip
I'm writing this post to shed some light on a problem I keep encountering with aspiring investors who are new to real estate.
They read a book or two, hop on BiggerPockets and learn about a few ways to analyze a potential deal, and somewhere along the way they form a "Golden Number" that all future deals must have to be worth considering.
The 1% Rule is the biggest violator on here, but it could be any other metric that the investor has created an unrealistic standard for that they try to apply to every deal. No matter the property type, geographic location, or local averages for the metric.
The classic example of this is a new investor who calls me up and wants to find a great rental in a B class area with above market rents, low crime, great schools, etc. and expects to pay $100k less than those properties are going for on the market. Not going to happen.
In this article I'll take a look at a few other common examples and show how when they're dogmatically used to analyze real estate to the exclusion of all other factors, you're doing yourself a major disservice and are passing up on tons of potential deals.
CASH ON CASH RETURN
BiggerPockets already has an excellent article written on Cash on Cash Return that I will borrow from below:
"Calculating cash-on-cash return is simple. We simply divide the received net cash flow for the year by the amount of cash invested. It will produce a percentage rate that measures the received pre-tax cash flow relative to the amount of money invested to acquire the asset.
The cash-on-cash return is a great metric and is widely used throughout the real estate industry both investors and real estate agents. The primary reason for this is due to the metric’s simplicity in calculating the percentage return.
The cash-on-cash return specifically drills down in the return on the capital invested. It does so by only considering returns that are driven by the property’s net cash flow.
Because the cash-on-cash return is only looking at the net cash flow and comparing it to the actual amount of cash invested, it’s a great indicator for the effect of leverage. Using leverage will decrease your cash-on-cash return, which makes the metric a good way to measure different levels of financing."
But the big problem with cash-on-cash return is that it doesn't account for taxes, loan paydown, or appreciation, which are all a huge part of your actual returns on investment.
When you take those things into consideration, you can get a way different evaluation of the same property or market using different metrics.
For a real world example of this, consider this article here about the Best Cities to be a Mom-and-Pop Landlord:
"Oklahoma City is the best city to be a small-time landlord in the short term, which is when comparing rental income versus assumed monthly mortgage payment, according to a new research released Friday by real estate website Zillow. In that city, short-term profit amounts to $536 a month.
However, the greatest returns are actually in markets like San Jose and San Francisco where there are short-term monthly losses, but the long-term earned equity makes them the best markets to invest in.
Including home equity gains, tax benefits, property and income taxes, and maintenance, in addition to the difference between monthly rental income and mortgage payments after holding the property for six years, San Jose, Calif., with $8,927 in long-term profit, is the best city to be a small-time landlord."
So while the Bay Area might of had negative cash on cash return, it made FAR greater profits over time than the high CoC markets did. And buy-and-hold real estate is a long term game, which is why CoC isn't the best metric to use as a single filter.
I see this happening a lot on the west coast in markets like California and Arizona, and investors expecting to get 12% cash-on-cash returns like we're in some high cash flow market like Cincinnati or Oklahoma (it might even be rare there, not my market).
If you know of a way to get this kind of first year return in the current market where you're at, please do share.
More on this "geographic metric swapping" below...
IMPOSSIBLE METRICS LIKE THE 1% RULE
The big problem with a 12% cash-on-cash return or the 1% Rule where the gross monthly rents should be 1% of the purchase price is that in some markets they are next to impossible to find and therefore completely useless.
Let's use both of them to analyze the purchase of a $250,000 property in Anytown, USA. We won't even account for other expenses to keep it simple, and will just use the PITI as the base expense.
Purchase Price: $250,000
25% Down: $62,500
PITI @ 5% INT: $1,340/mo
Rent for 12% CoC: $2,000/mo
Rent for 1% Rule: $2,500/mo
Now, take a look at what your tenant could buy that property for themselves:
Purchase Price: $250,000
5% Down: $12,500
PITI @ 4.5% INT: $1,710/mo
Difference from 12% CoC: -$290/mo
Difference from 1% Rule: -$790/mo
So why on earth would your tenant agree to pay you $300-800 more per month for rent when they could purchase the property with only 5% down and pay way less? Unless you've mastered the Mind Control Powers of Dracula this is simply never going to happen.
The simple fact is these metrics are completely broken beyond a specific price point, to the point of being almost useless.
The only way you're going to get close to the 1% Rule on residential properties in west coast markets like Sacramento or Phoenix is with a fourplex. And it'll be rare at that. And probably in a neighborhood you don't want to invest in, or in a condition that's going to require tons of additional capital in maintenance and repairs.
What good is a 1% Rule property if it's full of bullet holes and you can't collect the rents?
Obviously there's more to the picture than just a single ROI metric. Here's how you can use them to analyze a property.
COMPARE AGAINST THE AVERAGES FOR YOUR MARKET
If you're going to use ANY metric, you should compare each potential property's scores for the metric against the average for that geographic market. And I would even consider narrowing it down further to neighborhood, price point, and property type.
For example, I recently did an analysis of all 2-4 unit properties in Sacramento priced between $400k and $600k. The average 1% Rule score was 0.58%. Not too glamorous when you compare it to that "gold standard" of 1%.
But there were three properties that scored above 0.75%, WAY above the average. So these properties could be considered "great deals" even though they are still below the 1% mark because they perform so much better than average for the area.
The problem occurs when new investors bring cashflow figures from Oklahoma and expect to find them in San Jose, or take appreciation figures from California and try to apply them to any flyover state. You're going to be looking for a deal for a LOOOONG time if you do.
All in all, real estate is complex investment that should be analyzed using many different metrics in tandem to analyze the potential long term returns on a given property.
If you abandon all other metrics for some "golden number" or something, no matter what that golden number is to you, you're doing yourself quite the disservice and will pass up on many great deals because of it.
OTHER THINGS TO CONSIDER WHEN ANALYZING DEALS
Think of all the other things that must be considered when analyzing a potential deal:
- Crime Rates
- School Ratings
- Population Growth
- Job Growth
- Rent Growth
- Historical Home Value Appreciation
- Nearby Commercial Development
- Gentrification / "Up-and-Coming" Neighborhoods
- Long-Term Projections
- And so much more
For example, more than 2 years ago I made a massive post about the coming "Millennial Migration" from the Bay Area to Sacramento, and have seen how much that migration pattern has changed the local real estate market there.
I bought a owner-occupied short sale in October 2016 for $260k with only 5% down. Nearly three years later it's worth $350k and generating over $500/mo in positive cash flow.
If I had been stuck on getting a certain metric like the 1% Rule or 12% cash-on-cash return, I would've totally missed this opportunity. Don't let that happen to you. Look at the bigger picture and think long-term.
Want another migration pattern years ahead of time? Here you go. Thank me later.
MIGRATION PATTERNS AND TRENDS
According to a new survey by Edelman Intelligence, 53% of Californians are considering moving out of state due to the high cost of living. Millennials are even more likely to flee the Golden State — 63% of them said they want to.
And it's not just people who are leaving -- businesses are too.
In fact, some other states are actively targeting California companies. Arizona launched one such effort in 2013, after Californians approved a tax hike. Texas, too, has tried to seduce companies away from California.
The difference in cost of living and taxes and close proximity make Arizona a nice alternative for these migrating Californians, particularly if they're from Southern California. SoCal has more than 5x as many people as the Phoenix Metro Area, so it's simply an issue of supply and demand... and traffic hahahah.
How many SoCal millennials do you think are willing to finally give up the beach for affordable housing? The median home price in Phoenix is HALF what it is in Los Angeles and hundreds of thousands cheaper.
P.S. If you're a millennial in SoCal reading this, realize that Puerto Peñasco AKA Rocky Point in Mexico is less than four hours away from Phoenix if you really must see the ocean on a regular basis.
How many of the 10,000+ Baby Boomers turning 65 every day and retiring are sick and tired of snow and cold weather in northern states and are deciding to come to Arizona and wear shorts on Christmas in warmer weather?
Enough to make AZ the #2 retirement destination in the US, second only to Florida.
Perhaps these two migration factors are why the Phoenix Metro Area is set to DOUBLE in population by the year 2050. Tucson will play a huge part of it two as the cities grow closer and closer together, filled up with millennials moving from expensive California and Baby Boomers moving from colder northern states.
Don't believe me? Then why is Phoenix already the #1 market in the country for population growth?
Those businesses are coming to... Phoenix was #2 for job growth in 2018 and Arizona expects to add 165,000 jobs by 2020.
To some, this may sound like a sales pitch for a market that I just so happen to be a licensed real estate agent in.
To them, I would say "Why do you think I moved here in the first place? The heat?" LOL :-P
But those aren't the only migration patterns affecting real estate values. Consider the following:
2018 Top Inbound States for Population Growth
- Idaho
- Arizona
- South Carolina
- Tennessee
- North Carolina
2018 Top Outbound States for Population Decline
- Illinois
- California
- New Jersey
- Pennsylvania
- Maryland
Are there migration patterns and other trends affecting your local real estate market? Is tech bringing new jobs to your city? Are high taxes and cost of living pushing people out? Are there "Secondary Markets" nearby that could receive a massive surge in demand?
Because that's exactly what's happening with Sacramento and the Bay Area, and Los Angeles and Phoenix. And it could be happening in your market too.
TOO LONG, DIDN'T READ
In summary, my advice to you is to consider ALL aspects of a potential investment, regardless of how complicated that puzzle might be to put together. You can't just rely on one single piece (like a single metric or standard you adhere to).
I know, I know... you don't have time to do all that research or even read all of this post. Which is why there are licensed professionals like me to do a lot of that work for you. I still advise you do your own due diligence, but networking and the sharing of knowledge is what Bigger Pockets is all about.
If you're dead set on achieving some certain ROI figure, ask in the forums where you can find markets that offer it. If you're looking for it in a certain area, ask in the forums if your expectations are realistic and what kinds of returns others are finding instead.
