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As we discussed in our previous post, everyone today seems to think it’s cool to invest in real estate. And, most people who ask me about real estate, ask me about flipping houses. I suppose that’s the sexy method of making money in real estate since that’s what’s all over TV. And while we do have a division which focuses on development/redevelopment with the intent to sell for a profit, I think it’s important to know what your goal is before you decide to go that route. You see, buying, adding value, and selling is the way to make money NOW. And, if you do it right, you can make a lot of money doing this. The problem is that you’re always searching for the next deal, and it’s harder to accumulate EQUITY, which is what will lead you to your end goal which is inevitably WEALTH. Wealth is what will give you financial freedom. Wealth is when you know that whether you find a house to flip this month or not, you have enough passive income to live a comfortable life.
So, how do you accumulate WEALTH in real estate? The answer is simple: You accumulate Income Properties. Income Properties are properties that you own and lease to others. You maintain ownership of the property, and your Tenant(s) lease the property from you, which should ultimately pay down your debt (ie. Loan) over time and should also give you additional profit (ie. Cash Flow) each month. As you acquire multiple properties, your monthly cash flow builds, and your equity grows through debt pay down and appreciation.
Unlike flipping a house which is a one-time lump sum of profit if you do it successfully, Income Properties will continue to give you a “drip” of money month-after-month, year-after-year. It can take longer to see the gains, but the result at the end of many years of dedication and determination can be massive because the gains of each property continue to build upon each other.
So, you ask, what do we need to know in order to be successful at investing in Income Properties? While there are many aspects which will separate a good investment from a bad investment (ie. financing structure, management, leasing, improvement strategies, etc.), the most important thing that you must know is your NUMBERS!
If you do not know your numbers...if you do not buy the property at the right price...if you don’t know how to properly evaluate the deal on a financial level, you will fail before you even get started.
Unlike residential properties which sell based on “comps” (ie. Their value is directly related to what other properties of a comparable nature, in the same location, have previously sold for.), Income Properties should be evaluated by their existing or potential Income Statement (also known as the P&L, or Profit & Loss). In other words, an Income Property is worth the profit you can generate from owning and leasing the property. For example, if you have a gorgeous building, but there doesn’t appear to be a logical way of generating a profit from the building, the building essentially has no value to an investor. However, you may have a very inexpensive property to construct but due to certain factors, the property generates a large return. That property would have significant value to an investor.
Once you know the income you can generate, you use metrics such as the Cap Rate (year-1 snapshot) and IRR, or Internal Rate of Return (longer-term analysis), in order to determine the value of the property. We’ll discuss these metrics in more detail in a subsequent post, but the gist is that you use the income you can generate and the rate of return you want to make on your money to determine the price you are willing to pay for the property.
Cap Rate, for example, is calculated as Value / NOI = Cap Rate, where Value is the price you pay for the property, NOI is the net operating income, and Cap Rate is the capitalization rate or rate of return on your money. So, for example, using the Cap Rate method of evaluation, if you pay all cash for a property and you want to make an 8% annual return on the property which produces $100,000 / year in net income, you can pay $1,250,000 for that property. ($100k / .08 = $1,250,000).
As discussed earlier, if you can’t evaluate the numbers of a deal, you will likely not be successful in your investment. To help you with this, let’s discuss how to accurately put together an Income Statement.
Here are the basics of an Income Statement:
Income (-) Operating Expenses = NOI (Net Operating Income)
Your NOI is essentially your profit without using debt. This is the number most commercial real estate agents and investors will use when determining the value of a property.
Now, let’s dive a little deeper. The number one reason we see or hear about individuals losing money in real estate is that they miscalculated their numbers. They either forgot an expense they needed to include, they misjudged an expense, or they were overly optimistic with their revenue projections. Remember, be conservative in your estimations. For revenues, include vacancy projections, money lost due to tenants who skipped town, etc. For expenses, make sure you’re not leaving items out.
Here is a more in-depth Income Statement example:
_____________________________________________________________________________________
Total Net Income (–) Total Operating Expenses (=) NOI or Net Operating Income
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Obviously, income and expenses will vary greatly based on each deal. A multi-family property will have expenses that an industrial property will not have, and vice versa. The above is simply an example with some basic line items seen on different types of properties. Some properties will even have expenses that are reimbursed by the tenants. We’ll save those details for another post, but the point here is simply that whatever deal you are evaluating, make sure you know the terms of the leases, the revenues the property generates and the expenses the property incurs.
In general, the operating expenses seen above are known as “above-the-line” expenses. These are expenses related to the daily operations of the property and are generally recurring in nature. They will be fairly consistent from one investor to another. In order for commercial real estate agents to market properties and investors to evaluate properties on a level playing field, the Cap Rate or NOI numbers are generally used. In the example above, the property has an 8.5% Cap Rate based off of a $2,000,000 purchase price and an NOI of $170,000. (ie. $170,000 / $2,000,000 = 8.5% return on your money).
Now, to take this one step further, we’ll move on to “below-the-line” expenses. These expenses are not included in NOI, and they consist of expenses such as tenant improvements, capital expenditures, rental commissions, and debt service (ie. loan payments). Because these items either fluctuate between different investors and/or are not as predictable and not part of daily operating expenses, we do not include them in NOI. For example, your debt service can vary greatly based on whether you borrow 80% or 60% of the purchase price and whether your interest rate is 4.75% or 6.5%. To include this expense in the NOI numbers would completely skew the numbers, and it would be inaccurate for many of the investors evaluating the property. As such, we do not include these numbers in the NOI, but we do include these numbers separately.
What you should do when evaluating properties is use the Cap Rate as a comparison of one property to another. Once you determine there is a property you are interested in, you should then add in the below-the-line numbers with accurate estimations for the particular deal you are evaluating.
Once we include these items, we end up with the following formula:
NOI (Net Operating Income) (-) Below the line or “Other” Expenses (=) TNI or Total Net Income
Here is a more detailed breakdown with the following assumptions:
1.) Annual debt service = $123,705.84
a. 20% down payment
b. 6% interest rate
c. 25 year amortization
2.) $25,000 will be set aside each year for capital improvements to the property such as a new roof.
While we do not use the TNI in our basic Cap Rate formula shown above to give a surface level value to the property, these numbers should be considered and should factor into your decision-making process. As you can see from the above two charts, the advertised 8.5% return will only yield you a 5.3% return on your cash invested after debt service and reserves (ie. $21,294.16 / $400,000 down payment = 5.3%). (Side note: This is only annual cash flow. It does not include equity gained via debt pay-down, which we’ll discuss in another post).
The key here is to be smart about your estimations. Include every possible expense, and be realistic with your revenue projections. Miscalculating your Income Statement can be the difference between making a ton of money in real estate and going “belly-up.” Use the above info to help you hone your skills in properly evaluating Income Properties, and you'll be well on your way to making smart, informed real estate investment decisions!
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