Is this real and what does this mean?

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Is this real and what does this mean?

Abdul Azeez
Real Estate Investor · Monroe Township, NJ · Member since 2016 · 468 posts · 85 votes

Folks - I am a beginner real estate investor in NJ and one of my subject properties is a foreclosure. I used Frank Gallinelli's book What Every Real Estate Investor Needs to know about Cash flow on one of my subject properties. I constructed an APOD (Annual Property Operating Data) and then derived cash flow before taxes as well as what would be my before tax sales proceeds if I sold the property at the end of 1 year, 2 year, 3 year etc. until 10 years. From here I plugged the numbers into an IRR calulator to see what my overall return would be based on the different holding periods above.

The subject property is a foreclosure which I believe could be obtained around $145k. At end of first year based on comparables, I believe it can be sold for $180k. One key item I engineered here for the calculation is that the initial $5k or so that I would need to put in to get the property to a rentable situation is not accounted for as either 1st year repair or 1st year cap cost. Instead, I used this as an addition to my initial investment so that my denominator on the cash on cash return becomes Downpayment + Closing cost + Cost to get property to rental condition. 

The following is my analysis. If you skip over until you reach the IRR, what this tells me is that my overall return will go down the longer I hold the property and the best recommended time frame to sell it is after 1 year. Discounting the fact that you have higher capital gains tax for property sold in a year, then the next best time to sell it is after 2 years. Is this telling me a true story that the longer I hold the property, the lesser my overall return is going to be? Is this typical of foreclosure properties? I am a bit confused by what this analysis is telling me. I would appreciat some help or guidance.

Year 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026
INCOME
Gross Scheduled Rent Income 21,600 22,248 22,915 23,602 24,310 25,039 25,790 26,564 27,361 28,182
Other Income 0 0 0 0 0 0 0 0 0 0
TOTAL GROSS INCOME 21,600 22,248 22,915 23,602 24,310 25,039 25,790 26,564 27,361 28,182
VACANCY & CREDIT ALLOWANCE 3,600 3,708 3,819 3,934 4,052 4,173 4,298 4,427 4,560 4,697
GROSS OPERATING INCOME 18,000 18,540 19,096 19,668 20,258 20,866 21,492 22,137 22,801 23,485
EXPENSES
Accounting 200 206 212 218 225 232 239 246 253 261
Insurance (fire and liability) 600 618 637 656 676 696 717 739 761 784
Legal 300 309 318 328 338 348 358 369 380 391
Repairs and Maintenance 1,296 1,335 1,375 1,416 1,459 1,502 1,547 1,594 1,642 1,691
Taxes
Real Estate 5,266 5,424 5,587 5,755 5,928 6,106 6,289 6,478 6,672 6,872
TOTAL EXPENSES 7,662 7,892 8,129 8,373 8,626 8,884 9,150 9,426 9,708 9,999
NET OPERATING INCOME 10,338 10,648 10,967 11,295 11,632 11,982 12,342 12,711 13,093 13,486
ANNUAL DEBT SERVICE 6,420 6,420 6,420 6,420 6,420 6,420 6,420 6,420 6,420 6,420
CAPITAL COSTS 0 1,335 1,375 1,416 1,459 1,502 1,547 1,594 1,642 1,691
CASH FLOW BEFORE TAXES 3,918 2,893 3,172 3,459 3,753 4,060 4,375 4,697 5,031 5,375
CASH ON CASH RETURN 8.59% 6.34% 6.96% 7.59% 8.23% 8.90% 9.59% 10.30% 11.03% 11.79%
CAPITALIZATION RATE 7.13% 7.34% 7.56% 7.79% 8.02% 8.26% 8.51% 8.77% 9.03% 9.30%
DEBT COVERAGE RATIO 1.61 1.66 1.71 1.76 1.81 1.87 1.92 1.98 2.04 2.10
Projected selling price 170,000 173,400 176,868 180,405 184,013 187,693 191,447 195,276 199,182 203,166
Cost of sale 11,900 12,138 12,381 12,628 12,881 13,139 13,401 13,669 13,943 14,222
1st mortgage payoff 106,603 104,677 102,677 100,570 98,382 96,099 93,718 91,233 88,641 85,936
Before tax sales proceeds 51,497 56,585 61,810 67,207 72,750 78,455 84,328 90,374 96,598 103,008
Internal Rate of Return 21.52% 18.58% 17.40% 16.68% 16.17% 15.77% 15.43% 15.15% 14.91% 14.25%
Purchase price 145000                  
Mortgage 108750                  
Downpayment 36250                  
Closing cost 4350                  
Getting ready to rent 5000                  
Actual cash invested 45600                  
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Stephen Greenway
Vendor · Santa Rosa Beach, FL · Member since 2015 · 1 post · 2 votes
10y

The first year is figuring the "flip". Your projected sales price of $170,000 at a purchase of $145,000 skews to a larger return immediately. If you are able to find such deals on a regular basis then great keep at it. But the decreasing irr comes from holding the property and averaging more modest and sustainable cash flow returns over the long haul bringing down the initial "flip" return. 

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  • Abdul Azeez
    OP
    Real Estate Investor · Monroe Township, NJ · Member since 2016 · 468 posts · 85 votes
    10y

    Apo

    Apologies. I just realized copy and paste does not render as well as images. Image of my analysis below.

    0Reply
  • Abdul Azeez
    OP
    Real Estate Investor · Monroe Township, NJ · Member since 2016 · 468 posts · 85 votes
    10y

    tax is included. Look under expenses.

    0Reply
  • Abdul Azeez
    OP
    Real Estate Investor · Monroe Township, NJ · Member since 2016 · 468 posts · 85 votes
    10y

    also expenses - rent is simplistic. Where do you factor in cash needed to get the property to a rent ready state? If you take it in expenses you will likely result in negative cash flow. That's why I have factored it in initial investment and a denominator number in cash on cash return.

    0Reply
  • John Thedford
    Real Estate Broker · Naples, FL · Member since 2013 · 9k+ posts · 6k+ votes
    10y

    You got the best book in the business. As to your analysis, you went all the way. If I spend money prepare a property right after purchase, it is added to the acquisition cost and then depreciated. That is exclusive of any appliances which have a different depreciation rate. The longer you hold it the lower your return will be. That doesn't stop someone like me, who is only concerned with monthly income, from holding till death (this is truly my exit strategy--leaving everything for wife and kids). 

    1Reply
  • Abdul Azeez
    OP
    Real Estate Investor · Monroe Township, NJ · Member since 2016 · 468 posts · 85 votes
    10y

    john - thanks. That's what I have done isn't it or are you saying I have missed something? If it's the former then is my conclusion right in that the average return on this property is going down the longer I hold it and is a primary candidate for buying, renting for two years and then selling it off?

    0Reply
  • James Blalock
    Investor · Fredericksburg, VA · Member since 2016 · 33 posts · 8 votes
    10y
    Decreasing IRR over time, assuming you're not taking anything out over time, seems counter intuitive. I don't see how that could happen unless the initial amount invested is somehow decreasing over time (as in the mortgage being paid down and that being factored in to the calculation). Why not just use cash on cash return over time to determine if this is a good investment?
    0Reply
  • Abdul Azeez
    OP
    Real Estate Investor · Monroe Township, NJ · Member since 2016 · 468 posts · 85 votes
    10y

    James - thanks for your response. That's exactly my confusion as to why IRR is going down. As you see the mortgage payoff reduces over the years so this has been factored in. I do have a line on the above analysis which does show cash on cash going up. Where do you factor the initial cost to get property to a rentable ability. I have factored it as part of my initial investment and not as part of the first year operating expense or capital cost. The reason for this is that this is a one time activity and inclusion of this in net operating income would result in negative cash flow. I have made it a part of cash on cash by using it as a denominator number as part of initial investment. I still do not know why IRR is decreasing over time. Seems like I have done everything correctly. Would appreciate if someone could shed some light on this.

    0Reply
  • Account Closed
    Investor · Buffalo, NY · Member since 2016 · 668 posts · 209 votes
    10y

    Possibly your selling price is rising faster than your rent increase? In other words, your income is not keeping up with property appreciation?

    0Reply
  • Abdul Azeez
    OP
    Real Estate Investor · Monroe Township, NJ · Member since 2016 · 468 posts · 85 votes
    10y

    Michael - In terms of percentages, I have used 2% for property appreciation and 3% for rental appreciation. So, property appreciation is lower than rent appreciation in percentage terms but property appreciation may be higher on a dollar basis.

    0Reply
  • Stephen Greenway
    Vendor · Santa Rosa Beach, FL · Member since 2015 · 1 post · 2 votes
    10y

    The first year is figuring the "flip". Your projected sales price of $170,000 at a purchase of $145,000 skews to a larger return immediately. If you are able to find such deals on a regular basis then great keep at it. But the decreasing irr comes from holding the property and averaging more modest and sustainable cash flow returns over the long haul bringing down the initial "flip" return. 

    2Reply
  • Simcha Davidman
    Rental Property Investor · Baltimore, MD · Member since 2014 · 408 posts · 209 votes
    10y

    @Stephen Greenway is absolutely right.  That'll happen just about every time because of the large flip increase.  The value of that decreases over time because of "time value of money."

    1Reply
  • Abdul Azeez
    OP
    Real Estate Investor · Monroe Township, NJ · Member since 2016 · 468 posts · 85 votes
    10y

    stephen - you hit the nail over the head!!! From the morning I was worried if my calculations were incorrect. But what you say makes perfect sense. So in this case I would think buy, rent and sell in two years makes sense. 

    0Reply
  • Alexander Ball
    Ann Arbor, MI · Member since 2008 · 90 posts · 20 votes
    10y
    Hi Abdul That seems right. Subtle nuance here may be if you can't find deals like this regularly and you have periods of inactivity, you may get more out of holding for longer. Good luck.
    0Reply
  • Abdul Azeez
    OP
    Real Estate Investor · Monroe Township, NJ · Member since 2016 · 468 posts · 85 votes
    10y

    Alexander - that makes sense. Thank you.

    While on the topic, is it OK the way I have done to factor expenses related to getting property ready for rent as initial investment instead of repairs as part of first year operating expense or as capital cost? My rationale is this is not operating expense because it did not arise from operating the unit as a new rental and it does not fit cap cost because getting it ready may require some level of clean up and tuning none of which can be depreciated. Of course if the getting to ready involves installing new appliances or roof etc. I could move them to cap cost but at this time without doing an inspection I would not know it until a bit later if I do get it.

    0Reply
  • Cheryl Packham
    Rental Property Investor · Surprise, AZ · Member since 2014 · 196 posts · 86 votes
    10y

    Hi Abdul,

    I hear you saying your overall return is going down each year, yet you are referencing the IRR. I feel like there might be some confusion as to what that number represents. There are many factors to consider when looking at an investment and while the IRR is a good tool to know if an investment is going to meet the required rate of return, there are other figures that should be considered as well.

    0Reply
  • Abdul Azeez
    OP
    Real Estate Investor · Monroe Township, NJ · Member since 2016 · 468 posts · 85 votes
    10y

    cheryl - IRR is the overall return of a stream of cash flows. So I am correct in using it as an evaluation metric here.

    0Reply
  • David Dachtera
    Rental Property Investor · Rockford, IL · Member since 2014 · 4k+ posts · 2k+ votes
    10y

    @Abdul Azeez,

    I think you may be trying to "build a starship before learning to build a model rocket".

    Learn to build a business which produces cash flow first, then make an assessment of what can be tweaked to achieve specific rates of return.

    My $0.02 ...

    0Reply
  • Cheryl Packham
    Rental Property Investor · Surprise, AZ · Member since 2014 · 196 posts · 86 votes
    10y

    The following is a completely hypothetical analysis and is not financial or legal advice in any way.  

    From what I could determine from the figures you provided is that your initial out of pocket investment would be around $45,600 with down payment, repairs, and closing costs. This is YOUR investment into this property. This investment gives you two possible returns, your monthly rents and and the proceeds at sale. So, if you collect rents and your costs are as expected lets say you put what is left over in the bank each year, you do not spend it or reinvest it. At the end of year one you sell the property for the $170,000 like you stated, after you payoff your mortgage and pay selling costs, and set money aside for income taxes, you walk away about $47824. So you received your 12 months of rent for year one and had $3774 left over after taxes. Then you sold the property and had $47824 left over after taxes. This totals proceeds of $51,598. Take out your original investment of $45,600 and you have a Return on Investment for year one of $5998 or 13% ROI.

    That is if you sold at the end of year one but say you kept the property until the end of year two.  Well you still had last years proceeds from rents and now year two proceeds.  Your sales price increased and equity increased.  Now you get a check from your sale of $50,754 and your rents have accumulated to $6421 for a total of $57176.  Minus your original investment and you have $11,576.  This is a 25% Return on Investment.  

    Lets jump to year 10.  You have still only invested the original $45,600 but now you have accumulated $34,498 in rents over the 10 years.  Again your estimated sales price has increased and your equity has also increased.  So you get a check for $113339 from the sale of this property.  Leaving you with a $67,739 return or 149%.  

    This was meant to be an example of different ways of looking at an investment and whether it makes sense for your investing plan. Another things you should consider is opportunity cost, could that $45,600 investment generate higher returns in another investment? This is where the IRR may come in to better use. Comparing two potential investments.

    I hope this helps.  

    1Reply
  • Cheryl Packham
    Rental Property Investor · Surprise, AZ · Member since 2014 · 196 posts · 86 votes
    10y

    Issues with 'Internal Rate of Return (IRR)'

    While IRR is a very popular metric in estimating a project's profitability, it can be misleading if used alone. Depending on the initial investment costs, a project may have a low IRR but a high NPV, meaning that while the pace at which the company sees returns on that project may be slow, the project may also be adding a great deal of overall value to the company.

    A similar issue arises when using IRR to compare projects of different lengths. For example, a project of a short duration may have a high IRR, making it appear to be an excellent investment, but may also have a low NPV. Conversely, a longer project may have a low IRR, earning returns slowly and steadily, but may add a large amount of value to the company over time.

    Another issue with IRR is not one strictly inherent to the metric itself, but rather to a common misuse of IRR. People may assume that, when positive cash flows are generated during the course of a project (not at the end), the money will be reinvested at the project’s rate of return. This can rarely be the case. Rather, when positive cash flows are reinvested, it will be at a rate that more resembles the cost of capital. Miscalculating using IRR in this way may lead to the belief that a project is more profitable than it actually is in reality. This, along with the fact that long projects with fluctuating cash flows may have multiple distinct IRR values, has prompted the use of another metric called modified internal rate of return (MIRR). MIRR adjusts the IRR to correct these issues, incorporating cost of capital as the rate at which cash flows are reinvested, and existing as a single value. Because of MIRR’s correction of the former issue of IRR, a project’s MIRR will often be significantly lower than the same project’s IRR. (For more, see: Internal Rate Of Return: An Inside Look.)



    Read more: Internal Rate Of Return - IRR Definition | Investopedia http://www.investopedia.com/terms/i/irr.asp#ixzz4Kcl8KCaE
    Follow us: Investopedia on Facebook

    1Reply
  • Abdul Azeez
    OP
    Real Estate Investor · Monroe Township, NJ · Member since 2016 · 468 posts · 85 votes
    10y

    i know what you are saying about some deficiencies of IRR. But it is still a metric that factors in time value of money and provides an overall number for a set of cash flows. Your ROI metric may be a misleading in this example because I don't believe it fully accounts for the time value. In this case I am not comparing projects of two different durations or evaluation between two opportunities. I am just looking at overall return which seems to go down over time.

    0Reply
  • Wayne Brooks
    Real Estate Professional · West Palm Beach, FL · Member since 2012 · 23k+ posts · 13k+ votes
    10y

    @Abdul Azeez Yes, as @Stephen Greenway pointed out, the 1 year result is skewed because you're getting the "equity" back at the end of one year, which is the biggest chunk of return. However, that really only applies IF you could repeatedly, every year, do another one of these to get the same yield. If your money stays parked for a year, or only makes a few points, you'd be better keeping the property. A similar claim, but not related to your question, that I find amusing is the guy who buys a tax lien that may get redeemed in a month, or a similar low dollar quick pay out deal, and he gets 2.5% in a month........he then brags about his "30% annualized return". Well, if you can only do that once a year, it's still 2.5%. I also agree that ROI is an often misused term on this site......"ROI" for periods greater than a year are an irrelevant number to me.

    1Reply
  • Abdul Azeez
    OP
    Real Estate Investor · Monroe Township, NJ · Member since 2016 · 468 posts · 85 votes
    10y

    Folks - There seems to be several major misconceptions above especially the reinvestment myth for IRR. Check out the article at http://www.propertymetrics.com/blog/2014/06/09/wha...

    To quote:

    The internal rate of return measures the return on the outstanding “internal” investment amount remaining in an investment for each period it is invested. The outstanding internal investment, as demonstrated above, can increase or decrease over the holding period. It says nothing about what happens to capital taken out of the investment.

    The Myth of The Reinvestment Rate Assumption

    One of the most commonly cited limitations of the IRR is the so called "reinvestment rate assumption." In short, the reinvestment rate assumption says that the IRR assumes interim cash flows are reinvested at the IRR, which of course isn't always feasible. The idea that the IRR assumes interim cash flows are reinvested is a major misconception that's unfortunately still taught by many business school professors today. 

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  • Cheryl Packham
    Rental Property Investor · Surprise, AZ · Member since 2014 · 196 posts · 86 votes
    10y

    Yes, my ROI example is very simplistic in nature and also should not be the sole factor used to make decisions. Return on Investment is a very simple calculation. The resulting figure is only as good as the base assumptions. My point is that while IRR may be a good metric, it should not be the only metric. You state that your overall return on investment is going down the longer you hold the property, however, I do not believe that if all factors were taken into account that this would be the case. While the IRR percentage decreases over time, I do not believe that your overall investment return would decrease over time. IRR does not equal your "overall return". As you stated, "If you skip over until you reach the IRR, what this tells me is that my overall return will go down the longer I hold the property and the best recommended time frame to sell it is after 1 year."  I am trying to express that I believe this assumption to be incorrect and other factors should be considered when making the decision on the holding period of this property for your best overall return on investment.  

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  • Abdul Azeez
    OP
    Real Estate Investor · Monroe Township, NJ · Member since 2016 · 468 posts · 85 votes
    10y

    @ Cheryl Packham - Thanks for your response. I think this is where I disagree with you a little bit. There is a good fool.com article that explains and can be found at http://www.fool.com/knowledge-center/the-differenc...

    The key takeaways from the article are the following which leads to believe IRR is a good measure of annualized returns:

    1. As the example in the article provides, an IRR of 16.2% was calculated for an investment with ROI 57% (similar to how you compared against ROI in my example). ROI represents the simple percentage gain over the entire period, not annualized as in the IRR calculation.

    2. Internal rate of return will tell you the annualized percentage returns of an investment over any period of time which is what I believe I have done and shown in my example.

    3. For monitoring your performance over the long term or against benchmarks like the S&P 500, the internal rate of return is more informative because it describes the performance in consistent, annual terms. However, for determining short term gains or understanding your cash-on-cash returns, the return on investment number gives you everything you need with a much simpler calculation.

    So, I do retain my original idea that IRR is a better measure to evaluate holding period for the property in question whose example I have provided. This thread was initiated not to agree on the best return metric but as an academic exercise to enable me to understand why the annualized return (IRR) goes down over time for a subject property I was analyzing.

    @ Stephen Greenway correctly explained that the decreasing irr comes from holding the property and averaging more modest and sustainable cash flow returns over the long haul bringing down the initial "flip" return. 

    0Reply
  • Cheryl Packham
    Rental Property Investor · Surprise, AZ · Member since 2014 · 196 posts · 86 votes
    10y

    Based on the CAGR you would see on average an 11% growth per year. While the first year is a 13% growth and the second year is 12% growth and the last year is a 10% growth. You must take into account that this is still growth, your overall investment return is not decreasing just the rate at which the investment is growing. I believe that this is also reflected in the IRR. The ROI was just an example to prove that the overall return on investment was not decreasing as I interpreted your question from the original post.

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