6 general rules for all real estate investors
Those of you who follow my newsletters and articles know that I emphasize maximizing your chances of success by understanding investment property metrics. I am not telling you that you will get rich by thinking positive thoughts, increasing your self-confidence, and fearlessly entering the fray. Instead, I urge you to learn about the financial dynamics at work in income-producing real estate. Whether you’re looking at a property you already own, one you want to sell, or one you may choose to buy or develop, you need to master the metrics. Numbers always matter.
And here are my Six General Rules for every real estate investor.
1. Vacancy — Let’s start with a simple one. What percentage of the property’s total potential gross income is being lost due to vacancy? Start by collecting some market data, so you know what is typical for that type of property in that particular location. Does the property you own or can buy differ a lot from the norm? Obviously, a much higher vacancy is not good news and you want to know why. But if the availability of a property is much less than what is typical in the market, that may mean that the rents are too low. If you are the owner, this is an issue you need to deal with. If you are a potential buyer, this may indicate an opportunity to acquire the property and then create value through higher rents.
2. Loan-to-Value Ratio (LTV) — When financial markets return to some semblance of normality, they will likely return to their traditional underwriting standards as well. One of those standards is the loan-to-value ratio. The typical lender is generally willing to finance between 60% and 80% of the purchase price of the property or its appraised value, whichever is less. Conventional wisdom has always held that leverage is a good thing, that it’s smart to use “other people’s money.”
The caution here is to be careful with too much of a good thing. The higher the LTV of a particular trade, the riskier the loan. It doesn’t take much imagination to recognize that in the post-crash era, the cost of a loan in terms of interest rate, points, fees, etc. it can increase exponentially as risk increases. Having more equity in the deal may be the best or perhaps the only way to ensure reasonable financing. If you don’t have enough cash to make a substantial down payment, consider bringing together a group of partners so you can purchase the property at a low LTV and therefore optimal terms.
3. Debt Coverage Ratio (RCD) — DCR is the ratio of a property’s net operating income (NOI) to its annual debt service. NOI is your property’s total potential income minus vacancy and credit loss and minus operating expenses. If your NOI is enough to pay your mortgage, then your NOI and debt service are equal, so your ratio is 1.00. In real life, no responsible lender is likely to provide financing if it looks like the property will have barely enough net income to cover the mortgage payments. You should assume that the property you want to finance must show a DCR of at least 1.20, which means that your net operating income must be at least 20% more than your debt service. For certain types of properties or in certain locations, the requirement may be even higher, but it is unlikely to be less.
4. Capitalization Rate — The Capitalization Rate expresses the relationship between the Net Operating Result of a property and its value. It is typically a market-driven percentage that represents what investors in a given market are achieving with their investment dollars for a particular type of property. In other words, it is the prevailing rate of return in that market. Appraisers use capitalization rates to estimate the value of an income property. If other investors earn a 10% return, at what value would a property in question earn a 10% return today?
Remember first that the cap rate is a market-driven rate, so you should question some commercial appraisers and brokers to find out what rate is common today in your market for the type of property you are dealing with. But you should also recognize that cap rates can change with market conditions. In our long, tested careers, we’ve seen rates ranging from 4-5% (corresponding to very high ratings) to mid-teens (corresponding to very low ratings), with historical averages probably closer to 8-10%. . If you are investing for the long term, and if the cap rate in your market is currently pushing towards the top or bottom of the range, then you should consider the possibility that the rate may not stay there forever. Look at some historical data for your market and take that into account when calculating the rate of cap rate a new buyer can expect ten years from now.
5. Internal Rate of Return (IRR) — IRR is the metric of choice for many real estate investors because it takes into account both the timing and size of cash flows and proceeds from the sale. It can be a bit difficult to calculate, you may want to use a financial software or calculator to make it easier. Once you have your estimated IRR for a given holding period, what should you do with it? No matter how talented you are at choosing and managing property, real estate investing has its risks, and you should expect a return commensurate with those risks. There is no magic number for a “good” IRR, but based on my years of talking to investors, I think few would be happy with anything less than a double-digit IRR, and most would require something in their teens. At the same time, keep in mind the “too good to be true” principle. If you’re projecting an astonishingly strong IRR, then you need to review your underlying data and your assumptions. Are the rents and operating expenses correct? Is the proposed financing possible?
6. Cash flow — Cash is king. If you can first project that his property will have strong positive cash flow, then you can exhale and start looking at the other metrics to see if they suggest satisfactory long-term results.
Negative cash flow means reaching into your own pocket to make up the shortfall. There’s no joy in finding out that your income property doesn’t support you, but instead you have to maintain your property. On the other hand, if you have a strong cash flow positive, you can usually ride out the ups and downs that can occur in any market. An unexpected vacancy or repair is much less likely to push you to the brink of default, and you can sit on the sidelines during a market downturn, waiting until the time is right to sell.
Overly ambitious financing tends to be a common cause of weak cash flow. Too much leverage, resulting in higher borrowing costs and higher debt service can mark the tipping point from good cash flow to none at all. Please refer back to LTV and DCR, above. We’re all thumbs, if you will, so I hope you’ll find these rules will help guide you to more successful real estate investments.