Real estate investment get-rich-quick methods upset me for a couple of reasons. They generally assume that you are going to self-manage the property yet ignore your cost of time to manage. Moreover, they promote “no money down” methods yet fail to warn you about the risks of high leverage. Besides, I find it difficult to trust anyone claiming to have found a goldmine when they anxiously peddle a map so it can be found. If they really discovered the way to real estate investment riches, why would they share it?
Actually, there is no secret way to attain real estate investing success.
In real life, you must work hard with good research and a commitment to a sound and systematic analysis. Pathways leading from get-rich-quick seminars are littered with disappointment; the key to successful investing, however, is to take as much time as necessary for proper preparation. Time is on the side of the prudent real estate investor.
In this article, we are seeking to help you better understand several nuances associated with real estate investing. We would like to discuss the importance of building a sound investment plan with meaningful goals and then cover the formulas of four popular financial analysis models used regularly in real estate investing.
Build a Sound Investment Plan
Having a plan with stated goals is one of the most important foundations of successful investing. However, it’s not about having lofty intentions and then declaring, “I want to be worth twenty million dollars one day.” There’s nothing wrong with desiring better things in life, the problem is that simply declaring something doesn’t bring you any closer to achieving it. The idea is to develop a general plan with stated goals and a method on how to get there.
Goals Must be Meaningful
Goals are the shortcuts to your desired destinations. Goals are not essential to life, many people do just fine without any kind of goal at all, but goals are essential to successful real estate investing. For a goal to work for you, however, it must be attainable, measurable, tied to a timetable, and clearly defined.
Moreover, divide long-range goals (say further out than one year) into intermediate goals, and your investment plan into subsections such as “cash flow requirements,” “net worth projections,” “tax shelter benefits required,” “cash withdrawal from plan,” and so on.
Start here: How much cash do you have available to invest comfortably? What length of time do you plan to stay invested? How much of your own effort do you plan to contribute?
Define a general plan: You plan to develop or own only the highest quality properties in prestige locations. You plan to own the largest market share of office buildings under 12,000 square feet in your local market. You plan to maximize your tax benefits on purchases and use tax-deferred exchanges and installment sales when available.
Define a detailed plan: How much cash do you want to collect each year beginning in the 10th year? What net worth do you want to attain by investing in rental properties after the 15th year? You plan on withdrawing $8,000 in three years to take your family on a cruise, or perhaps to generate $20,000 by the 4th year to buy a second car. And so on.
The idea is to create a target and then monitor your progress continually against that target to insure that you’re on the right course. A written plan with stated goals that projects where you’re headed and then reviewed regularly is critical to successful investing.
Financial Analysis Models
Okay, let’s switch gears and summarize four very popular investment value measures used regularly by investors and real estate analysts.
1) Cash on Cash Return – Cash on cash measures the initial profitability of a rental property. The higher the better, and typically a first-year cash on cash return ranges from about 4% to 10%.
Formula: Cash on Cash = Before Tax Cash Flow / Cash Equity (Initial Investment)
2) Gross Rent Multiplier – Gross rent multiplier measures the ratio between annual gross rental income and sale price. Think of it as an indication of the number of years it takes the annual rental income to equal the price, so the lower the better. It is good for simple comparisons to other rental property opportunities but insufficient as a stand-alone number.
Formula: Gross Rent Multiplier = Purchase Price / Gross Rent
3) Capitalization Rate – Capitalization Rate (cap rate) is essentially a return on asset indicator of how much debt an income property can carry. The higher the return rate, the more debt a property can support, and hence the better the investment opportunity for the real estate investor. Sellers of income property, of course, prefer to sell at lower cap rates. Local markets dictate capitalization rate (there is no one-size-fits-all) but they typically run from about 5% to 12%
Formula: Capitalization Rate = Net Operating Income / Purchase Price or Value
4) Internal Rate of Return – The IRR model essentially calculates the average discount rate that equates all future returns over the projected holding period back to the present value of the initial equity investment. It’s the most frequently used measurement of projected holding period overall returns because IRR delivers in one number an investment return that integrates rental growth rates and property value appreciation. IRR should be used as a comparison to the real estate investor’s required rate of return for making capital allocation and initial investment decisions. IRR can be computed for before or after tax cash flows.
Formula: To compute IRR you must use Excel or a qualified real estate investment software program.