How the cost of money affects investment - real example

Question

I am a long time reader of biggerpockets but a new contributing member. This past August I bought my first property - an owner occupied duplex with an FHA loan. What I am struggling to understand is how the cost of money affects your investment. Obviously, if you pay more up front you will cash flow better versus mortgaging a larger portion. After the 50% rule your cash flow varies so greatly depending on how you finance the property. How do you account for this in determining how successful an investment is? Here is my real life example of my purchase.

155,000 using an FHA loan with approximately 5,500 down (I was able to negotiate the seller to cover closing costs.)

The property is a duplex with 3br 2ba each side with current rent at $850 but will be raised to market values closer to $900.

At $850 per unit or $1700 gross total, the 50% rule says that I will cash flow at about $124 per month after my PI of $726. I will admit that I purchased this pretty close to retail value because it was important to find a great place for my family to live in as well as an investment for me. But with a cash investment of about $5,500 I am very happy with a positive cash flow. However, using the 50% rule I know many investors here would require better cash flow.

Please share insights and opinions on how the cost of money affects investments and on the property itself. Thank you!

Aaron Helmholdt · Answer

@Harry M. Excellent breakdown! I love the spread between cap rate and cost of money. Thank you!

Aaron Helmholdt · Answer

@Brant Richardson I completely agree. In my circumstance I knew I was paying more than I should for a strict investment but because my family also needed a good home in a good school district, we were pretty selective which made the investment side of things a little less attractive.

Harry M. · Answer

@Aaron Helmholdt - congrats on the purchase! I agree with Jeff's thoughts about trading some cash flow for a more solid property. When you factor in less turnover and less repairs, it is often a wash with a shakier property that appears to cash flow more.

Regarding factoring in cost of money, there are a few ways you could look at it.

1) Calculate Cash on Cash (COC) return. That's just your yearly cash flow divided by your total cash outlay (including closing costs, etc) to acquire the property. That will give you a percentage return for your money.

2) Calculate your total return on investment (ROI). That's your yearly cash flow, plus amount of mortgage principle paid, divided by your total cash outlay. This is better for calculating your actual return (though locked up, the mortgage principle paid is still yours), but not as good in practical terms (mortgage principle paid can't pay for your groceries!)

3) You could calculate the spread between the cap rate of the property and the cost of the money. Cap rate is your net operating income (NOI): gross rent minus all non debt related expenses, divided by the cost of the property. For example, lets say you buy a 100K property with 25% down. Gross rent is 1200/month and expenses (not debt service) are 50%. You pay 5% interest. Your cap rate is 14400*0.5/100000 = 7.2%. So you make a 7.2% return on the 25K you put down. On the remaining 75K, you make 7.2%-5% = 2.2%. Not bad, since you are making that 2.2% on money you don't actually own. But as Jeff says, if interest rate were to increase to say 7%, you'd have trouble selling the property unless rents also went up.

Hope this helps!

-Harry

Edit: Most of this is covered in the posts above. We were all typing at the same time, but I was the slowest ;)

Brant Richardson · Answer

Adam beat me to it.

Aaron Helmholdt · Answer

@Jeff S. Great point with trying to move the apartment buildings when the cost of money is high - something that must be taken into consideration when thinking about an exit strategy with buildings that don't cash flow strongly.

@Adam Johns Thank you very much for that Cash on Cash explanation. Using my real life example in those equations really cleared up some of the lingering questions I had. While my cap rate isn't especially strong, it is made up for in CCR. Thank you!

Brant Richardson · Answer

I'm a newb too but here's my 2 cents. The 50% rule is a quick screening tool, you would like to see $100 cash flow per unit. If the property passes then you move on to taking the time to get the exact figures. Your property does not look great by the 50% rule but if you look at your cash on cash $124 x 12 months / $5500 money down = 27% ...that is good money. Some would say the headache of running 2 units for $124 isn't worth it. You need to sit down and plug in the real expenses to see where you stand. If you are handy then maybe your repair costs will be lower than the 50% rule would predict. If you pick the right tenant then lower vacancy.

Jeff S. · Answer

@Aaron Helmholdt to find a place for your family that will cash flow is great. In all things there is a give and take. In your case you are trading some cf for quality. This is a great trade-off for your family. Chances are the lower cf property will be just as profitable as one with high cf in the long-run. Like they say different strokes for different folks.

Rates have everything to do with the value of investment properties. In this low rate environment the financing is allowing commercial properties to be sold at unheard of cap rates. You can be sure if/when the cost of money becomes 10% it will be hard to move the 5 cap apartments.

How the cost of money affects investment - real example

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