RANT: Stop Using Bad Math to Analyze Real Estate - Plus A Hot Tip

RANT: Stop Using Bad Math to Analyze Real Estate - Plus A Hot Tip

Real Estate Agent · Phoenix, AZ · Member since 2016 · 738 posts · 1k+ votes

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

  1. Idaho
  2. Arizona
  3. South Carolina
  4. Tennessee
  5. North Carolina

2018 Top Outbound States for Population Decline

  1. Illinois
  2. California
  3. New Jersey
  4. Pennsylvania
  5. 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.

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Rental Property Investor · Yuma, AZ · Member since 2019 · 637 posts · 46 votes
7y

@Wes Blackwell too long

See this reply in the discussion

56 Replies

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  • Real Estate Agent · Philadelphia, PA · Member since 2018 · 416 posts · 396 votes
    7y

    I agree that new investors have unrealistic expectations. I hear people complaining all the time that they offered 20% less on a property on the MLS that's been on market for 10 days and the realtor gave them flack or the people shut them down. Then you see posts that say "Do I need a new realtor" or "Every offer is getting denied. REI is a lie". Purchasing turnkey investments are fine. Just know that you'll be paying MARKET VALUE, unless, the owner is going through some hardship and needs to sell quickly. Buying properties at a discount require some thinking and knowledge to move some pieces into place. @Brandon Turner always says that deals are created.  Not found.  REI is about helping people solve problems that a property might be causing or that a sudden large amount of cash can fix.  That’s where the deals are.

  • Lender · Mesa, AZ · Member since 2019 · 62 posts · 49 votes
    7y
    Originally posted by @Steve K.:

    @Aaron David Lietz the thing is if you have property management deal with all those things, you have to pay them, and then you have zero or more likely negative cash flow. The 6-12% base a PM gets just covers basic rent collection, maybe an annual inspection and fielding emergency calls. It doesn't usually come close to covering all the extra BS that comes along with owning high cap rate/ high cash-flow properties. For example an eviction will cost extra, maintenance will cost extra, a turnover will cost (a lot) extra, lease renewals cost extra, filling a unit will cost extra, having them coordinate capex/repair projects costs extra, having them go clean up the property will cost extra, lawncare/snow removal... the list of things that will cost you extra is long. In my experience anyone touting "passive" income from REI is probably making more money selling books and seminars, earning commissions as an agent, or running an REI website than they do off owning property. It's never passive in my experience (syndications and REITS excepted once you've done your DD on them). At the very least you have to manage your manager and make decisions on issues when they come up, then open your checkbook to have others deal with them for you. If you expect to have a PM do every little thing, you have to pay them for their time, the base 6-12% will only pay them for a few hours a month and beyond that you've got to pay them more or else find a new PM because they will go out of business if they are running around doing every little thing for you and aren't charging enough for their time. If you want to be totally passive, you'll spend all day writing checks to your PM lol. Going in thinking it will be passive is a recipe for losing money, and like Jay says, is probably the main reason why so many investors flame out after a year or two or three and sell at a loss or if they're lucky and have some appreciation, maybe make a little money or break even. I cringe whenever I hear the word passive now.

    Hey, thanks for the sharing your thoughts! Perhaps it's just a ruse but the BP books (and some podcasts) have made it appear that once all of your "systems" are in place (such as your RE "team" - Prop Mgt, handyman, contractor, etc) it becomes more passive. In your experience is this not the case? I was under the impression that once you have scaled up (acquired many units) and built 'systems' in place to assist in the management and upkeep of those units (i.e. -see the book Landlording on AutoPilot), things become a lot easier such that you will have significantly more free time to do the tings you love to do (all while having monthly income coming in that does not derive from having to 'clock in'). No?

    Is it your thought that someone like Brandon Turner is actually snowing everyone, giving them the impression that most of his income comes from rental properties when it actually comes from BP, book sales, talks, etc? This would be a tragedy of course. Perhaps the bigger point here is that I have a certain goal in mind and I'm exploring the best ways to meet that goal (whether it's RE or not). 

    Thank you again for the insights. 

  • Jay HinrichsBusiness Member
    Real Estate Consultant · Summerlin, NV · Member since 2014 · 45k+ posts · 66k+ votes
    7y
    Originally posted by @Aaron Lietz:
    Originally posted by @Steve K.:

    @Aaron David Lietz the thing is if you have property management deal with all those things, you have to pay them, and then you have zero or more likely negative cash flow. The 6-12% base a PM gets just covers basic rent collection, maybe an annual inspection and fielding emergency calls. It doesn't usually come close to covering all the extra BS that comes along with owning high cap rate/ high cash-flow properties. For example an eviction will cost extra, maintenance will cost extra, a turnover will cost (a lot) extra, lease renewals cost extra, filling a unit will cost extra, having them coordinate capex/repair projects costs extra, having them go clean up the property will cost extra, lawncare/snow removal... the list of things that will cost you extra is long. In my experience anyone touting "passive" income from REI is probably making more money selling books and seminars, earning commissions as an agent, or running an REI website than they do off owning property. It's never passive in my experience (syndications and REITS excepted once you've done your DD on them). At the very least you have to manage your manager and make decisions on issues when they come up, then open your checkbook to have others deal with them for you. If you expect to have a PM do every little thing, you have to pay them for their time, the base 6-12% will only pay them for a few hours a month and beyond that you've got to pay them more or else find a new PM because they will go out of business if they are running around doing every little thing for you and aren't charging enough for their time. If you want to be totally passive, you'll spend all day writing checks to your PM lol. Going in thinking it will be passive is a recipe for losing money, and like Jay says, is probably the main reason why so many investors flame out after a year or two or three and sell at a loss or if they're lucky and have some appreciation, maybe make a little money or break even. I cringe whenever I hear the word passive now.

    Hey, thanks for the sharing your thoughts! Perhaps it's just a ruse but the BP books (and some podcasts) have made it appear that once all of your "systems" are in place (such as your RE "team" - Prop Mgt, handyman, contractor, etc) it becomes more passive. In your experience is this not the case? I was under the impression that once you have scaled up (acquired many units) and built 'systems' in place to assist in the management and upkeep of those units (i.e. -see the book Landlording on AutoPilot), things become a lot easier such that you will have significantly more free time to do the tings you love to do (all while having monthly income coming in that does not derive from having to 'clock in'). No?

    Is it your thought that someone like Brandon Turner is actually snowing everyone, giving them the impression that most of his income comes from rental properties when it actually comes from BP, book sales, talks, etc? This would be a tragedy of course. Perhaps the bigger point here is that I have a certain goal in mind and I'm exploring the best ways to meet that goal (whether it's RE or not). 

    Thank you again for the insights. 

    Keep in mind the  statement   or thought process that you want real estate to create more time for family and work for yourself.

    those are trigger words that were created in MLM years ago.. 

    We have two things at play here   Theory   and      Reality  

    Theory makes all these things seem very simple and achievable.. You see it in all industries.. just look into a franchise of any kind.

    all of them can work.. all of them can fail.

    Reality of creating a income stream that takes little to no time or effort in real estate.. it can happen.. but its market specific and timing is a huge part of the equation.. keep in mind all the BP books or most are written to sell the sizzle. And methods that worked in 2010 to 2013 ish no longer apply to today.. prices have risen faster and higher than rental rates so net income has gone down.. ergo back in 2010 were 2% rule deals in AZ were common and easy you could buy them right off of MLS today no way.. you have to spend thousands to create those opportunities and have the time to follow up on them etc..

    Rental real estate appeals to the masses since its the easiest to understand and the easiest for most investor to get started in as financing for rentals has come back to the market..  When things get tough in a market lenders get very picky to even stop providing that product this is what happened in 07 to 2011 2012  investor loans were near impossible to get..  All your seeing is a market were its now plentiful for investor capital so therefore values have risen but rents have not so there for returns are lower.. 

    Rental real estate in my mind starting today not 10 years ago and the bottom of the trough.. is a different game .

    Its like the BRRRR books that is old news.. My HML company that's all we did for investors for 6 to 7 years was BRRRR its how 90% of rental real estate in the Mid west was sold the original turn key model was all BRRRR we financed over 2,000 of them for investors.. this was 2001 to 2008 when the refi market froze.

    So in my mind starting TODAY at TODAYS valuations..  short of buying in the Hoods of America which is NOT passive .. you have to look at what cash flow is there for the average investor to start and once you run the numbers you will come to realize this is a LONG game.. 

    the way to scale is you have to create equity then turn that equity over and do it again.. if its simply buy rentals that cash flow 200 a month with max debt .. then its simple math how many of those do you need.. and how hard are you going to have to work for that.. and how much debt are you taking on to achieve it.. 

  • Realtor · Boulder, CO · Member since 2016 · 3k+ posts · 5k+ votes
    7y

    @Aaron David Lietz I think Jay summed it up very nicely with his reply. PM's, handymen, contractor's etc... they only do so much. In my experience, landlording is like any business in that the more active one is within the business making sure everything is running smoothly, the better the business will perform. There are definitely ways to make it run somewhat on autopilot for the most part, until things go majorly wrong of course, which they inevitably do because REI is a business dealing with both the human element and physical structures that need maintaining. After a dozen years or so experience in several areas of the business I definitely don't trust anyone who throws the term "passive income" around when talking about owning rentals. Passive is index funds, REITs and to a lesser degree syndications, not operating rentals.

  • Member since 2018 · 1 post · 0 votes
    4y

    This post if GOLDEN! I was so baffled why people on forums continuously dismiss appreciation and yet investors in my area are snapping properties at 0.5% rule in one day. Two years later it aged very well: https://www.benzinga.com/real-...

  • Member since 2022 · 4 posts · 0 votes
    4y

    In my experience, tenants choose not to buy for several reasons. David Ramsey (Dave) has a big influence on many people in my market, and now people don't want to get into debt. They save and save their cash, but then realize they can't afford what they thought they could, or don't want to spend their money for their current area, so they choose to continue to rent. Only focusing on the short-term, instead of the long term. Additionally, there are certain YouTubers who propose buying a home is the worst thing you can do, it's only a ploy for banks to lend money... yada yada yada... which all may be true, but that is enough information to stop the people from buying and keep them renting. IMHO 

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