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6 Rules of Thumb For Every Real Estate Investor
Those of you who follow my newsletters and articles know that I emphasize maximizing your potential for success by understanding the metrics of investment property. I’m not going to tell you that you’re going to get rich by thinking positive thoughts, building your self-confidence, and being fearless. Instead I urge you to learn about the financial dynamics of working in income-producing real estate. Whether you’re investigating a piece of property you already own, you want to sell, or you may choose to buy or develop, you need to master the metrics. Numbers are always important.
And so here are my six rules of thumb for every real estate investor.
1. vacancy – Let’s start with a simple one. What percentage of the property’s total potential gross income is being lost to the vacancy? Start by gathering some market data, so you’ll know what’s typical for that type of property in that particular location. Is the property you own or can buy very different from the norm? Obviously, very high vacancy is not good news and you want to find out why. But if a property’s vacancy rate is much lower than the market norm, it could mean the rent is too low. If you are the owner, this is a problem that you need to deal with. If you are a potential buyer, this may indicate an opportunity to acquire the property and then create value through higher rents.
2. Loan-to-value ratio (LTV) – When financial markets return to some semblance of normalcy, they will likely return to traditional standards for their underwriting. One of those criteria is the loan-to-value ratio. A typical lender is usually willing to finance between 60% – 80% of the property’s purchase price or its appraised value. Conventional wisdom has always held that leverage is a good thing—it’s smart to use “other people’s money.”
The caution here is to be careful of too much of a good thing. The higher the LTV on a particular deal, the riskier the loan. In the post-meltdown era, it doesn’t take much imagination to realize that the cost of loans in terms of interest rates, points, fees, etc. can rise exponentially as risk increases. Having more equity in the deal may be the best or possibly the only way to secure proper financing. If you don’t have enough cash to make a substantial down payment, consider getting a group of partners together so you can get a property with a low LTV and therefore optimal terms.
3. Debt Coverage Ratio (DCR) — DCR is the ratio of an asset’s net operating income (NOI) to its annual debt service. NOI is the total potential income of your property less vacancy and credit losses and less operating expenses. If your NOI is enough to pay off your mortgage, your NOI and debt service are equal and their ratio is 1.00. In real life, no responsible lender is likely to provide financing if it appears that the property will only have enough net income to cover its mortgage payments. The property you want to finance must show a DCR of at least 1.20, which means your net operating income must be at least 20% higher than your debt service. In certain property types or certain locations, the need may be higher, but it is unlikely to ever decrease.
4. Capitalization rate — The capitalization rate expresses the ratio between an asset’s net operating income and its value. Typically this is a market-driven percentage that represents what investors are achieving in a given market for their investment dollars for a particular type of asset. In other words it is the prevailing rate of return in the market. Appraisers use cap rates to estimate the value of an income property. If other investors are getting 10% return, which asset will give 10% return today?
First remember that the cap rate is a market-driven rate so you need to inquire with some appraisers and professional brokers about what rate is common in your market today for the type of property you are dealing with. But you also need to recognize that cap rates can change with market conditions. Over our long and checkered careers we’ve seen rates as low as 4-5% (corresponding to very high ratings) and as low as the mid-teens (very low ratings), with historical averages probably closer to 8-10%. . If you’re investing for the long term, and if the cap rate in your market is currently pushing the top or bottom of the range, you need to consider the possibility that the rate won’t stay there forever. Look at some historical data for your market and keep this in mind when you estimate the cap rate that a new buyer can expect ten years down the road.
5. Internal Rate of Return (IRR) — IRR is the metric of choice for many real estate investors because it takes into account both time and cash flows and proceeds from sales. It can be a bit difficult to calculate, you can use software or financial calculator to make it easier. Once you have your estimated IRR for a given holding period, what should you do with it? No matter how talented you are at selecting and managing assets, real estate investing has risks — and you should expect to earn returns commensurate with those risks. There’s no magic number for a “good” IRR, but from my years of talking to investors, I think some will be happy with anything less than a double-digit IRR, and many want something in the teens. At the same time, keep in mind the “too good to be true” principle. If you project a surprisingly strong IRR you need to revisit your underlying data and your assumptions. Are rent and operating expenses accurate? Is the proposed financing feasible?
6. Cash flow – Cash is king. If you can first project that your property will have strong positive cash flow, then you can take a breath and start looking at other metrics to see if they suggest satisfactory long-term results.
Negative cash flow means reaching into your pocket to make up for the shortfall. There is no joy in finding that your income assets fail to support you, instead you must support your assets. On the other hand, if you have a strong positive cash flow, you can usually ride out the ups and downs that can happen in any market. An unexpected vacancy or renovation is much less likely to push you to the brink of default, and you can sit on the sidelines during a market downturn, waiting until the time is right to sell.
Overly ambitious financing is a common cause of poor cash flow. A tipping point can mark anything from higher leverage, higher debt costs and better cash flow resulting in higher debt service. Revisit LTV and DCR, above. We’re all thumbs, so to speak, and so I hope you find these rules to help guide you to more successful real estate investments.
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