As an investor looking at multiple properties, how do you decide which one is right for you?
Do you pick the one with the most bedrooms?
Do you pick the one with the biggest discount to past value?
Do you pick the one with the cute kitchen and the new paint?
First things first, a new investor must decide on what type of investor they are. This means, does the investor want to buy-and-hold the property, or do they want to flip the property?
For this article, I will assume the investor follows the buy-and-hold model, as I am not the most qualified guy on BiggerPockets to speak on the subject of flipping properties.
So back to the question at hand, how does an investor decide on which property to buy for their investment portfolio?
First, let’s review the average new investor for a minute:
The new investor likely has limited capital, meaning that there is significant opportunity cost if he or she makes a poor choice. In addition the investor likely has friends or family screaming, “don’t do it,” “you will regret it,” and “real estate investing sucks.”
Our investor is resolute and has done the homework, but still doesn’t know which investment property to buy.
Establishing Metrics: What is the Yield?
While every investor has his or her favorite metric, my personal favorite is something I call “Yield”. I want to understand the return I am earning on all out of pocket cash, and if you have been following my post for some time, you realize I utilize a two-step process in my investment business.
When investors use “yield,” they can review every property against a consistent metric instead of letting gut feeling drive a decision. To see how I calculate and use “yield” in my business, I will review the numbers behind a recent transaction.
Calculating Yield: An Example
Purchase Price $38,000 + Closing Cost $2,000 + Make Ready Cost $8,000 = Total Invested $48,000
Rent $1,150 – $150 (Tax and Insurance) – $100 (Property Management) – $150 (Misc Repair) – $50 (Other) = $700 Cash Flow or $8,400 a Year
To calculate my “Yield” I simply take expected cash flow and divide by total invested cash: $48,000 or $8,400/$48,000 = .175 (Multiply by 100% turns this into a Percentage) or 17.5%
Congratulations, we just completed step one in my process. I run every deal and property through this equation, as it clearly points out the best deals. When I do my homework, I can look at 20 deals and quickly stack rank them best to worst.
As we close out this post, let’s finish up with our second step in our model. We take this free and clear property that has been rehabbed and leased to our private investors. In this case, we were looking to establish a First Trust Deed and a 5-10 year note paying 10% interest only in the amount of $40,000.
Private investors like the double digit return and security of a rehabbed and leased property.
When this second step was complete, the numbers we calculated in step one above changed significantly.
Our out of pocket cash dropped from $48,000 to $8,000
Our Cash Flow Dropped from $700 to approximately $350 a month or $4,200 a year in expected cash flow.
Given these changes our Yield calculation looks like this as we complete Step Two: $4,200/$8,000 = .525 *100% = 52.5% Yield.
At the end of the day, we took a distressed asset, rehabbed it, leased it, secured private money, and ensured we are earning 50% on our invested capital. Not bad for a 60 day process start to finish.
I don’t like to talk about value or equity position so let me just say the house is worth a lot more after we took it from distressed to rentable condition.
As we close, I recommend buy-and-hold investors get a good handle on the math behind calculating yield, as it will help them prioritize property selection and reduce chances of buying a dud.