This post is a continuation of Chapter 3 from the book Empower Your Inner Millionaire.
Evaluating Investment Options
The capitalization or cap rate is the net amount of income that the property generates divided by the cost. If a property is selling for a million dollars and it generates $100,000 after expenses, 100,000/1,000,000 = .10 or 10%. The higher the cap rate, the more bang for your buck. The cap rate should give you an idea of the risk. By comparing similar properties in comparable locations, you would expect that the one with the higher cap rate would have some variable–the age of the property, for example–that makes that purchase riskier. Don’t assume that one seller has just priced her property too low. Although that could be true, look for the variable that supports the difference in cap rates. If there isn’t one, then you’ve probably found a great deal!
You should also be considering future potential. When comparing cap rates, it may make sense to do two calculations. One using market rents and one using the rents that are currently being charged. That way you won’t miss out on a great deal just because the owner is charging low rents. Be sure that you understand what investment is needed to get market rent in the building. Sometimes it’s just a coat of paint, sometimes you’ll need to update kitchens or baths or add air conditioning, for example. Add that expense to the cost of the property in your cap rate calculation.
The concept that you make your money when buying a property is especially true when you’re hoping to sell fairly soon after buying. If you’re planning to hold for ten years or more, the market cycle shouldn’t matter much beyond saving money every month when you make your mortgage payment. Getting an idea of what you can expect for appreciation will help you compare the potential future value of a property. Remember, your goal is to compare two or more potential investments, so your analysis is more the difference in expected appreciation between your various options. Does the potential of one location exceed the potential of another? Is one type of property–commercial vs residential–expected to fare better in the area?
Even if you plan to keep the asset forever, future value is important as your plans may change unexpectedly or you may want to take out a loan or line-of-credit on the property. Your real estate agent can help you understand past trends and how they relate to future appreciation or you can use online resources like tax assessments to get a rough idea of the market cycle in the area. See EYIMBook.com for more information on this type of research.
OVERALL RATE OF RETURN
Understanding the potential future value can help make a property with a lower cap rate more attractive than one with a higher rate. Adding the Cap Rate to the Appreciation Rate will give you the Overall Rate of Return for a longer-term look at the investment. For example, you are comparing a restaurant in Georgetown with an apartment building on the same street. The Cap Rates are both 5% but you see a trend of similar apartment buildings being converted to condos. The appreciation rate on the apartment/condos would be 10% while the restaurant would increase at the area average of 3%, making the apartment building a better investment, 15% for the apartment building versus 8% for the restaurant.
If you’re having a lot of fun with this math stuff, you can take it one step further to figure out whether it makes more sense to leverage the property or buy with cash–or rather whether it makes sense to buy the property if you can’t pay cash. Doing this is easy, just subtract the interest rate you’d pay from the overall rate of return. If the number is negative, don’t do it. You’ll lose more on interest than you’ll gain in the short term. You’ll find spreadsheets with this and other helpful formulas HERE.
I bought my first investment property when I was 23-years old. It was a triple-decker in Lawrence, Mass. I knew about as much as your average 23-year-old about being a landlady and investing and I didn’t have a real estate agent, attorney or mentor representing or advising me. I didn’t ask to see leases, applications or payment history on the tenants that were in place at the time and made no provisions in the offer for occupancy or condition of the property at closing. By the time I took ownership, the seller had moved the paying tenants to another of his properties, leaving me with two vacant units and one deadbeat tenant. I had bought at the top of the market and the property started losing value almost immediately. Within two years, the building was completely vacant, the copper pipes had been stolen and the property was in foreclosure.
Not a very auspicious beginning to a real estate empire. Many people think that it’s easy to make money in real estate but the opportunities to make mistakes are many and varied. So why am I encouraging you to invest in real estate? Because luckily, the reverse is also true and because there are ways to make money in every market if you are paying attention.
It’s What You Know and Who You Know
With so much potential for mistakes when buying your first investment, how can you possibly get it right? Reading about my rocky entry to real estate, it sounds like I made tons of mistakes, but I only made one: I didn’t ask for help. I failed to admit that I didn’t have a clue what I was doing and just kept walking deeper and deeper into the muck.
Luckily, you’re much smarter than I was at 23 and you have already proven that you’re clever enough to ask for help because you’re reading a book on how to do it right. Later, we’ll learn how to hire a team of trusted advisors who will bridge the gaps in your knowledge until you become an expert.
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