Real Estate 030: Cash on Cash Return vs. Overall Return

In my previous blog posts I discussed cash on cash return, debt service coverage ratio, net income and how these metrics are used by real estate investors to evaluate a potential acquisition and proforma over 5, 10, and maybe 30 years down the line. Other investors may look to buy all cash and consider comparing cap rates to make sure they are getting a healthy return when including other factors such as neighborhood class and type of property (e.g. single family rental vs duplex, etc.). While these metrics are valuable, they do not paint the entire picture, especially for savvy investors who are looking for value add opportunities.

By value add opportunities, I am talking about forcing appreciation on your deal by raising rents to market, rehabbing the property, and other things such as sub-metering individual units on a 2-4 unit and reducing your overall expenses. Value add opportunities allow investors to “force” appreciation in a short period of time.

To evaluate a value add deal, one must consider not only the cash flow, but appreciation, tax benefits, and loan paydown when financing your property. This is also known as the overall return. To calculate your overall return on a deal, you must add up the benefits realized in these profit centers and divide it by the number of years you held the property and total monies invested. 

Lets view an example below:

• Purchase price: $150,000

• Cash all-in (Downpayment, repairs, closing costs): $45,000

• Loan amount: $112,500 (75% LTV), 30 year fixed at 5% interest

• Annual Cash Flow: $3,000

Lets say that after 10 years, you decide to sell the property for $250,000, which reflect a gain of $85,000 after selling/closing costs of $15,000.

• Cash flow: 10 years * $3,000 = $30,000

• Appreciation: $85,000

• Tax Benefits: $1,000 * 10 years = $10,000 ($3,636 depreciation per year * 28% tax bracket = $1,000 per year savings)

• Loan Paydown: $21,500 ($112,500 - $91,000 Balance after 10 years)

Total return over 10 years = $30,000 + $85,000 + $10,000 + $21,500 = $146,500

Overall ROI: $146,500 / 10 years / $45,000 = 32.55% return

In this example, this means that your average return during the 10 year holding period was 32.55%. By using this simple formula, you will be able to better understand your overall return on the deal and compare it to others in your lead generation pipeline when having to choose one over the other.

As always, please make sure you do your due diligence and talk to your CPA/Attorney/Financial Adviser before making any investment decision.

Good luck!

Real Estate 029: Financing Rentals with 15 vs 30 year mortgages?

There are a lot of nuances when it comes to real estate investing, and one important decision is financing. Once you have decided that you are going to use good debt to leverage other people's money and scale your portfolio, you must also decide the terms. Investors typically finance their properties through conventional loans (secondary mortgages with Fannie Mae, Freddie Mac guidelines), as such, they decide between 20% or more in downpayment, or 15 or 30 year mortgage terms.

In simplistic terms, 15 year mortgages will generally have better interest rates as they are being amortized over a shorter period of time and seen as less risk to the bank. To the borrower, it may seem beneficial because you have a smaller interest rate, and less interest paid during the 15 years vs the 30 years. However, once you step back and look at the bigger picture, you may want to take into consideration other intangible factors such as flexibility, potential for interest rates to increase, and the ability to use good debt when your returns are expected to far exceed the debt service (Note: if your property is not covering the debt and leaving you with a healthy amount of cash flow each month, you are taking on a big risk as the property may not be self-sustaining from day 1).

Lets take a look at some of the savings on a rental property with a 15 year vs 30 year mortgage:

Purchase price: $100,000

Down payment: 20%

Scenario A: 15 year mortgage with 5.5% interest

This will leave you with a monthly payment of principal and interest of $653. Over the course of 15 years, the total amount disbursed will be as follows:

Total payment: $117,725.95

Principal: $80,000.00

Interest: $37,725.95

Scenario B:  30 year mortgage with 6% interest

This will leave you with a monthly payment of principal and interest of $479. Over the course of 30 years, the total amount disbursed will be as follows:

Total payment: $173,083.40

Principal: $80,000.00

Interest: $93,083.40

This results in additional interest of $55,357.45 ($93,083.40 - $37,725.95).

Looking at $55,000 of interest savings may make you think this decision between scenario A and B is a no brainer, however if we take a closer look there are various factors to consider:

• Additional interest can be converted into tax savings across rental portfolio

• Opportunity cost of fast loan paydown vs re-investing the difference

For example, the monthly PI of scenario A is $653 - scenario B of $479 results in a monthly PI delta of $179 that could be used to reinvest for a higher return or used as additional payments as conventional loans typically do not have pre-payment penalties. Lets take a look at how interest payments would change if we used the $179 to make additional payments toward the 30 year loan:

Total payment: $123,515.78

Principal: $80,000.00

Interest: $43,518.13

Now the difference in interest is only $5,792.18 ($43,518.13 - $37,725.95) all the while maintaining flexibility to change directions if you wanted to, instead of locking yourself into a decision for 15 years. In addition, the $179 in savings in scenario B may come in handy when other rentals in your portfolio are not performing or may be negative $200. The extra cash flow from a 30 year mortgage may be used to offset these fluctuations.

Lets take another example and say that you use your monthly $179 PI difference from a 15 year vs 30 year and combine it with savings to purchase a turnkey rental property with a cash on cash return of 12% (These are actual deals I am seeing in the midwest for a C class neighborhood).

With a $179 starting balance and contributing $179 monthly at 12% returns, you will end up with $632,034 after 30 years when you will have paid off your home in scenario B. Without even calculating, the difference is clear. Although this is just an example, investors must understand these variables and opportunity costs when they decide to forego one for another.  There is not real benefit to paying off your mortgage from a numbers perspective. 

I do believe that risk needs to be managed and am not looking to maximize the debt across all of my rental properties, however, depending on what season you are at life: 20-30s "grow", 40-50s "maintain", 60s+ "enjoy", you may find yourself wanting to lower risk and have peace of mind. 

As always, please make sure you do your due diligence and talk to your CPA/Attorney/Financial Adviser before making any investment decision.

Good luck!

Real Estate 028: Motivated Seller Questionnaire

A great way to build equity and rental portfolio in a competitive market is to find a motivated seller. A motivated seller is someone who doesn't want to sell, but needs to sell due to their personal circumstances (e.g. death, divorce, inheritance, debt, etc.). Chad Carson wrote on the BiggerPockets blog on the importance of hustle by sharing the following metaphor: “Every morning in Africa, a gazelle wakes up. It knows it must run faster than the fastest lion, or it will be killed. Every morning, a lion wakes up. It knows it must outrun the slowest gazelle, or it will starve to death. It doesn’t matter whether you’re a lion or gazelle. When the sun comes up, you’d better be running.“

Similarly to the lion or gazelle that is running, a savvy investor must be on the lookout for great deals through their marketing efforts in identifying motivated sellers. Once you have found a motivated seller through a lead generation software (e.g. bandit signs, flyers, postcards) or referrals from brokers or property managers, having a motivated seller questionnaire or intake script is useful for screening those leads. 

A big mistake made by newbie real estate investors is not being able to filter out the warm/hot leads from the cold leads and end up wasting valuable time with a person that will end up keeping their property.

Below is a list of information you want to document during the initial screening process:

Contact Information

1. Full Name

2. Phone number

3. Address

4. Spouse/Partner Name (if any)

5. Email Address(es)

6. Property Address for Sale

7. How did you find us? (Used to understand marketing efforts)

These are the basic information you need to ensure that you can get in contact with the seller in case they hang up accidentally and to follow up periodically. Next you want to screen them for motivation for selling their property:

Motivation:

1. Is property currently on the market?

2. If yes, how long has it been listed?

3. Why are you selling?

4. Have you listed your home with a real estate agent?

5. What is your plan if your house doesn't sell?

6. Do you have any written offers yet?

7. Who lives in the property right now?

8. Are your mortgage/tax payments current? 

9. Potential problem with co-owners? (Divorce, business, etc)

10. Any known severe property damage?

11. Other need for fast and immediate lump sums of money? How much?

These questions cut to the meat of why a motivated seller may decide to work directly with an investor rather than a conventional method of selling through the MLS with an agent. 

Property Details:

1. Property style: (Single Family, 4plex, ranch style)

2. Square footage

3. Age of property

4. Neighborhood Quality scale

5. CapEx useful life (Roof, Foundation, HVAC, electrical, plumbing)

6. Any other improvements needed?

These questions ask about the physical condition of the property and to a certain extent, the neighborhood. In most cases, the investor should already be knowledgeable about the surrounding areas and rough ARV to be able to quickly determine if the seller is in the ball park of an asking price. Motivated seller screening involves knowing how to ask open-ended and probing questions about the property, to get more accurate and time-saving answers. For example, instead of saying, "How is the roof? Good? Bad? Ugly?", you should ask instead, "When was the roof last replaced?"

Some landlords and property owners will call you assuming they can scam you into overpaying for their property. These people may become motivated sellers later on, but at the moment, they are not worth spending too much time with after the initial screening calls. 

Financial Data:

1. Asking Price

2. Mortgage loan balance and interest rate (Lender information)

3. Any 2nd mortgage on property? (HELOCs, Loans)

4. Mortgage loan terms and conditions

5. Are there any other liens or debts on your properties?

6. How much rent per month? Request rent rolls (if rental property)

7. Any non-rental income from property? (laundry, pets)

8. Any HOA (Homeowner's Association) fees? How much are HOA payments

9. How much is monthly PITI (Principal, Interest, Taxes, Insurance) payment?

10. Utilities costs (Gas, Electric, Water) for the past 6 months (Statements)

In conclusion, using a motivated seller questionnaire can help guide your interview process, and gives you a framework to make the screening as conversational as possible.  This information will help you determine the best way to structure this deal (wholesale, lease option, seller finance, or cash purchase) for a flip or rehab and long term hold. Using the information on this page, investors should be able to work out win-win solutions for your sellers and yourself.

As always, please make sure you do your due diligence and talk to your CPA/Attorney/Financial Adviser before making any investment decision.

Good luck!