Now that we're ready to start looking at houses, we need an objective method of eliminating the possibilities. I like to use Excel spreadsheets to evaluate properties before I even look at them. This eliminates a lot of properties and saves you time driving around. For the purposes of this blog, I will be writing about residential rental properties, but the same basic criteria apply for commercial and industrial properties as well. I have used these same methods in evaluating mini-storage, office and retail space.
As we discussed in Part 6, investments generally create cash flow or appreciation. By using my Excel spreadsheet, I can evaluate both. I have been slowly building this spreadsheet over the past 10 years. Basically, I added formulas and pages to it as I made investment mistakes. The mistakes that went into making this spreadsheet have cost me about $500,000, but I am giving you the spreadsheet for free!! That is quite a bargain for you. I hope it helps you learn "How to Safely Invest in Real Estate."
For cash flow I buy rental houses in the Section 8 market. For appreciation, I buy new or nearly new homes in nicer neighborhoods that will appreciate over time. I try to rent these houses as close to break even as I can, knowing my return will come at the end of the investment, usually about 5 years.
I use Internal Rate of Return (IRR) and Cash-on-Cash (C-on-C) to evaluate properties. My favorite, however, is IRR, because it takes the whole investment cycle into account, where C-on-C only looks at Year 1 returns.
Basically IRR takes into account the Time Value of Money by looking at the income stream from a number of years. Cash-on-Cash looks at the Net Cash Flow/Total Cash Invested.
Below are some examples of a cash flow investment and an appreciation investment. I will use the basic information below to calculate IRR and C-on-C.
Cash Flow Model
Sales Price $30,000
Monthly Rent $550
Down Payment $3,000
Interest Rate 6.875%
Term 30 years
Mortgage Payment $177.37
Annual Insurance $350
Annual Taxes $350
All Other Annual Expenses $2000
Assumed Appreciation Rate 0%
Year 1 Net Cash Flow - Down Payment $ (528.44)
Year 2 Net Cash Flow $2,471.56
Year 3 Net Cash Flow $2,471.56
Year 4 Net Cash Flow $2,471.56
Year 5 Net Cash Flow $2,471.56
IRR 467%
C-on-C Net Cash Flow Y1/Amt Invested. $2,471.56/$3,000 82%
Appreciation Model
Sales Price $292,000
Monthly Rent $1,700
Down Payment $29,200
Interest Rate 6.875%
Term 30 years
Mortgage Payment $1,726.41
Annual Insurance $550
Annual Taxes $2,000
All Other Annual Expenses $3000
Assumed Appreciation Rate 6%
IRR 21%
C-on-C Cash Flow Y1/Amt Invested $(5,866.92)/$29,200 -20%
You'll note that I assume 0% appreciation for my Section 8 houses. That's because they are in run-down neighborhoods and I can still buy properties for that price after 5 years. In addition the rents for Section 8 are fixed and have been for a number of years.
Based on the information above, which investment is the right one to make? Really, there is no right or wrong answer. Both are good investments, and they both come with inherent risks. The important thing is to know what you want to get out of a property before you get into it. The Cardinal Rule for Appreciation Investing is, "You make your money when you buy the property." In other words, don't pay too much on the front end with the expectation that the property will appreciate and cover your false assumptions. A lot of people made that mistakes in recent years and are now facing foreclosure.
The first rule of investing is, "Don't lie to yourself." I know how easy it is to do this. I have done to myself many times. With just a few keystrokes, I could make my examples say some amazing things. You have to take the time to get some hard facts. Tom Lundstedt, a real estate investment speaker, once said, "If your spreadsheet doesn't have pennies in it, you're lying about the numbers."
Dan.
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