@Dan Heuschele two quick thoughts one I am only saying what has worked for us. Having a healthy % based differential between loan and cash flow allows us to sleep well at night. Second, I dont think the A class = 1.3 necessarily is accurate. The debt coverage ratio is an equation. Where I = income, E = all non financing operating expenses, P= debt financing costs (a function of loan constant) and NOI= net operating income it looks like this.
NOI = I-E (in other words net operating income is all operating income--probably just rent minus all operating costs --everything except for principle, interest and taxes on profits--property tax is an operating expense)
NOI/ P= Debt Coverage Ratio
Here's an example that might help
Purchase price $100,000
Monthly rent $1200
Annual rent $14,400
vacancy allowance at 5% $720
management at 8% $1152
Cap ex at 7% $1008
Tax and Insurance $2500
Total expenses $5380 (720+1152+1008+2500)
NOI= $9020 (14400-5380)
If there is no debt then there is also no debt coverage ratio
No debt it cash flows $9020 per for a yield of 9.02%
Now let add debt if you assume we can amortize over 30 years and get a rate of 5% it looks like this
0% down loan payment = $537/ month or $6444 per year
20% down loan payment= $429 per month or $5148 per year
Now I know that 0% down is unlikely but lets just assume we can do that for this example. Then look at the DCR. Recall DCR=NOI/P
So at 0% down DCR looks like this
$9020 (NOI)/$6444 (Annual Payments or P)= 1.4
which is to say I wouldn't do this deal unless I was confident that I could swing the payment for awhile personal and had a plan to increase rents or decrease costs to get it in line with my target of 1.5 but in truth Id probably pass, However if I liked the property and had 20K to put down the deal is different
At 20% down the DCR looks like this
$9020 (NOI)/$5148 (P)= 1.75 DCR
That easily passes my goal of 1.5 and I could justify this deal as safe enough that I dont have to worry about it. It doesnt really matter that much if its a b or c class the numbers are the same now obviously if I have a choice between a A class at 1.75 and a C class at 1.75 I take the A class but in my experience the NOI on an A class with lower expenses might be better by the purchase price is higher so I need a larger down payment to meet my DCR goal
I dont know if I am doing a good job at explaining it but it works for my model. In truth we havent always been as particular about it and sometime we have wavered but I think its at least worth considering this before making a purchase. Banks always have a minimum DCR that require on larger loans so this process will prepare you for the big time.
@Jeffrey Holst I think you explained it fine. I am going to assume your cap ex estimate is in reality a maintenance/cap Ex estimate as I saw no maintenance (I combine these myself but use a much larger number).
My point was that your criteria leaves out the key variables related to quality of property and location. I could achieve your numbers easier in a class D area than a class B area. However, I am unsure that I would expect the actual returns on the class D area to be better than the actual returns on the class B area. Projected returns and actual returns do not always match and my belief is that the lower class of the area the less likely projections match reality. In addition, I expect the class D property to be a lot more work than the class B property.
>obviously if I have a choice between a A class at 1.75 and a C class at 1.75 I take the A class
This is my point. If I used only your initial criteria to purchase I will mostly be purchasing in lower class areas.
What I suspect, but was not stated in your post, is that you use your criteria in only a certain class of areas/properties (maybe C+/B-) so that it works for you to be a quick initial screening process. The point of my reply was that there area a lot of newbies. They see rules like the 2% rule and think hooray I just found a 2% property. What they fail to realize is that the properties that come the closest or exceed the 2% property are typically in the worst areas that most experienced RE investors avoid (exception for those that specialize in rough areas) . I see your criteria could lead newbies to the same issue. Newbies are typically the least prepared for lower class properties; the RE in lower class areas are work.
@Dan Heuschele No rule by itself will ever take in all variables. And you are right about a couple things one this is not a stand alone consideration, two the rule is only as good as its assumptions. We only buy in areas where we are fairly confident on the numbers and yeah I just made those percentages up for example the 7% cap ex is low if you are also including regular maintenance unless perhaps its a new build or a condo or something.
And yeah newbies should avoid D class (well most everyone should really) and I'd say unless you are very high C class newbies should avoid those also. It doesn't pay to get in but under estimate the costs of operating in a particular area.
@Jamie Nacht Situation #2. Couple reasons, for me:
1. As markets appreciate, rents tend to appreciate as well (not in lockstep, of course, but certainly correlated). Rent increases are long term B&H's sugar daddy.
2. Appreciating markets tend to be more expensive. Same return with fewer properties is preferable.
3. Capital gains are half the tax cost of current income.
4. Cash-out refis are financially efficient to access profits.
Love my friends who favor owning properties and optimizing for free cash flow. God speed. And no qualms with anyone who equates projected appreciation with "gambling" or "speculating." That's cool. The trick is to only gamble when you're the house ... and not the poor sucker on the slot machine. It's just math.
All this probably isn't helpful for the investor who needs current income to feed the kids or doesn't have a strong asset base. So, no attempt to alter anyone's strategy ... just, maybe, hopefully helping articulate how some of these crazy appreciation-favoring folks are behaving rationally and objectively with the same risk-aversion of others.
This stuff is more fun to discuss with a glass of wine in hand...
I think most of this depends on your location. Longer term holders will likely come out ahead in appreciation models and the cash flow also appreciates in those markets. Consider Kansas vs NYC over a 20 year period and this math becomes more clear. I have seen more than a few times folks who solely invest for cash flow actually still make more in appreciation when the full story is unpacked even though that was never the intention. Hedge fund RE returns average 60/40 favoring appreciation if that matters. Good luck!
A quick question. Shouldn't appreciation (the valuation of the property) be driven by increases in positive cash flow (Discounted Cash Flow Analysis)? If so, investing for appreciation driven by other factors would be in the same category as going to the Casino.
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