With the Real Estate market as hot as it is right now, this might get controversial!
If you read my previous post about the power of forced appreciation in multifamily real estate, you might assume that I’m going to tell you that appreciation is the way to go. You would be wrong.
Don’t misunderstand, forced appreciation is a powerful tool and one I would encourage you to really understand. The problem with appreciation is that it’s not actually cash in your pocket. Its hypothetical value until you either sell the asset or cash out refinance. Depending on market factors and interest rates neither of those options may be feasible when you need the cash. You may have to wait for the right buyer to show up or for interest rates to move in your favor before you can actually access the equity you have in the property.
The number one rule (in my very humble opinion) is that when you’re investing in real estate you should always invest for cash flow. Any attempt to time the market and cash in on appreciation is a gamble – one that might work out in your favor if you’re very smart or very lucky but I hate gambling so that is just not appealing to me. If you invest in the right market, your property can still provide strong cash flow even if the market corrects and property values take a hit.
Calculating Cash on Cash Return
So what does it mean to invest for cash flow? Very simply it means that every month the property is generating positive cash flow after all expenses, mortgage payments and capital expenditures.
Let’s look at a very simple example: We purchase a property for $1M and put 20% or $200K as a down payment. This property makes $125K in annual rental income. We have various expenses such as utilities, lawn maintenance, unit turms, property tax, insurance etc that toal $63,750. This gives us a Net Operating Income (NOI) of $61,250.
To calculate cash in your pocket, you can’t stop there. NOI does not take mortgage payments or other reserves into account. In this case We have annual mortgage payments of $40K and we are reserving $10k for capital expenditures. After all of this, what remains is our cash flow: $11,250. Note that the amount you reserve for capital expenditure represents a future expense and should be set aside for that purpose. What you reserve here is up to you and depends on the age and health of your property.
In this case your cash flow represents a 5.63% return on your initial capital investment. Maybe that’s a great deal for you, maybe it’s not, but it’s important to know how to calculate this metric and determine if it meets your investment criteria.
One more thing to note about cash flow – it might be tempting to compare this number directly to the return you get on other investments. Remember that with real estate investments there are many more tax advantages when compared to other types of investments. This means that even though a stock may have a greater annualized return, if you sell the stock your net return may be less overall after tax.
Now before you go off and base your entire investment criteria on cash flow, it is important to remember that appreciation has its place in your overall strategy as well. If you’re looking to exit or refi your property at any point in time, you need the asset to appreciate either through forced appreciation or market appreciation! Your exit strategy and timeline are going to be unique to the property and the market; so it is important to understand the trends and how that might impact the future value of your asset. As author Bill Ham says “Cash flow pays the bills, equity (aka appreciation) is what makes you wealthy.”
Forced Appreciation
What we love about multifamily real estate is the ability to force the appreciation of the property. The concept of forced appreciation revolves around how multifamily assets are valued. Unlike single family homes, multifamily assets are businesses that are valued based on the net operating income (NOI). This means that you have control over the asset’s value because you can control the NOI through increasing revenue or decreasing expenses.
Here are the factors that go into calculating the value of a multifamily asset:
Net Operating Income: Very simply this is your net income before any debt service fees and capital expenditures.
(Rental Income – Vacancy and Bad Debt) – Operating expenses = Net Operating Income
Capitalization Rate (aka Cap Rate): Is a calculation of the asset’s return, calculated as the NOI divided by the value of the asset. This value tends to be driven by the market and is a reflection of the risk and quality of the investment. A riskier, less stabilized market will tend to have a higher on average cap rate than a predictable, growing and stabilized market. The Cap Rate does not take into account any mortgage payments. This number is most valuable in a market where there are comparable sales to determine if the price being offered is reasonable relative to other sales.
Let’s look at an example.
Let’s say you purchase a 20 unit apartment building in Cash Flow, USA for $1M. The Net Operating Income of the property is $80K. You purchased the property at an 8% cap. We can also assume that the relative cap rate of the market at the time of purchase is 8%, based on the valuation of similarly priced assets based on recent sales.
Over the course of 2 years you increase the income of the property by renovating all of the units and bringing the rents up to market value. You also introduce coin-based laundry machines and begin charging for covered parking spaces. You reduce expenses by fixing maintenance issues like water leaks and negotiating better contracts for things like garbage and snow removal.
At the end of 2 years your NOI is now $120,000. At a market cap rate of 8%, your asset is now worth $1.5M! You forced the appreciation of the asset by $500k over the course of two years!
Calculated by: NOI / Cap Rate = 120,000/8% = $1,500,000
To sum it all up, we don’t believe that you have to choose between cash flow and appreciation. If you buy right you can have the best of both worlds. And let’s say the market stalls and values drop, at least you’ll have cash flow to cover the bills!