Working with many real estate investors, I get many clients talking to me about some new real estate investment opportunity that just can’t be passed up. It’s easy to let emotions take part in any investment decision, whether it’s real estate or the stock market. So when client’s ask me about a real estate invest opportunity and I advise that it’s not the sound opportunity they think it might be, it can come as a bit of a shock.
It’s been well documented in psychological studies how feelings can affect our decision-making and influence our behaviors. But, when it comes to important financial decisions, it’s important to keep a stoic mindset. If there is one thing I’ve learned, it’s to not get too excited about any investment opportunity, and instead, rely on the numbers.
Of course, feelings, like gut feelings, are great indicators and provide the conviction needed to execute on great investments. To aide that gut feeling, there are some important calculations that you must run before pulling the trigger on any rental real estate investment.
Numbers don’t lie and I’m here to help you by providing you with the three most important calculations to run before you purchase any real estate investment.
1) Internal Rate of Return
This calculation should really be used on a financial calculator of software program, but once you know the keystrokes, it should be easy to commit to memory.
This calculation can take into account uneven cash flows and inflation rates. It also allows to find an accurate future rate of return given those cash inflows and outflows or annual effective compounded rate of return.
The higher the IRR, the better the investment. You can use a IRR calculator HERE.
2) Cash Flow
This one seems pretty basic, but many real estate investors and professionals go wrong here.
The calculation is as follows:
Monthly Rent – Monthly Expenses = Monthly Net Cash Flow
Seems simple, right? It may not be as simple as you might think. It is very easy to neglect to add in all expenses necessary to come up with an accurate net cash flow number.
Here are some expenses that you need to think about to come up with you monthly net cash flow:
· An estimated vacancy rate
· Hazards insurance
· Property taxes
· Water, sewer, and trash that you may be responsible for parts of the year
· General maintenance and repair
· Electricity for part of the year that might apply
· Flood Insurance
· Fire Insurance
· Umbrella insurance
· Known future capital expenditures, such as a new water heater, A/C, septic, etc.
This is not an exhausted list, but enough to give you the idea that there are expenses that you may not have accounted for when coming up with the “simple” calculation for cash flow. If you are not coming up with the monthly net cash flow that you were hoping for, you may need to make some reconsiderations.
3) Equity Multiple
The equity multiple calculation helps you understand cash flow returns over time, similar to the internal rate of return. This is a good back-of-the-napkin calculation for understanding the overall cash flow return, but does not take into considerations cash flow fluctuations or the time value of money. However, this calculation gives you a good idea of the profitability of a property quickly.
The calculation is as follows:
Total Cash Disbursements/Total Equity Invested = Equity Multiple Ratio
In this equation, the higher the equity multiple, the better thee investment. Remember though that this does not consider fluctuations in cash flow disbursements or equity investment in.
Using Return Metrics
A single metric will never provide you with enough answers to confirm whether or not an investment property should be bought. However, when using this trio of metric return calculations, you have a much more powerful indicator of how that property will perform and what kind of cash return you will be receiving.
The next time you have a gut feeling about an investment property, use these three calculations to guide you to a conclusion. Remember that numbers don’t lie and feelings alone can persuade your decision-making abilities. Call my office if you need help through a specific scenario your life and I’m happy to guide you.
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual.
The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.
This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.
All investing involves risk including loss of principal. No strategy assures success or protects against loss. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
Asset allocation does not ensure a profit or protect against a loss.
Investments in real estate may be subject to a higher degree of market risk because of concentration in a specific industry, sector or geographical sector. Other risks can include, but are not limited to declines in the value of real estate, potential liquidity, risks related to general and economic conditions, stage of development, and defaults by borrower.