What is a Deal Worth?
“I cannot find a deal!” “Everyone is bidding crazy prices!” “I am just sitting on the sidelines until prices come down.”
We have heard statements like these for a few years now. So how is it that people are continuing to make massive profits in real estate?
At EZ Financial Independence University, we believe everything starts with a “Why” and followed with “How can I?” When you understand your investment goal and are armed with knowledge, you can make a profit in virtually any market.
Today we want to share different ways to structure the same deal which yields different profits. Practicing these different scenarios will expand your thinking on making a deal work with your situation and goals. This is why we believe that each market has a deal that is perfect for someone.
Sample deal:
Unit mix: All 2/1 (2 bedrooms, 1 bathroom)
Unit numbers: 40 units
Asking price: $5 Million
Price per unit: $125,000
Current Annual Income: $500,000 ($1000/unit/month)
Current Annual Expense: $230,000 ($500/unit/month)
Net Operating Income (Annual Income subtracted by Annual Expenses): $250,000
Current Cap Rate: 5%
Market Cap Rate: 4.75%
Scenario 1: Investing for Cashflow with Buy and Hold
If your goal is to generate cash flow with a yield play, you should be focusing on your monthly cash flow goal. The only variables that should affect decision making are your loan terms, monthly payment and monthly yield.
If you were able to secure a 30-year amortized loan with a 30% down payment ($1,500,000) at an interest rate of 5% for 10 years, your monthly payment for debt service is likely going to be $18,789. That is $225,468 a year.
Potential profit will be $24,532 a year after the annual debt service is subtracted from your Net Operating Income. Cash Flow is $2,044.33 a month. That is 1.6% annual return on investment.
This monthly cash flow will continue until the loan is paid off. Then you are yielding this at 5% annual return on investment. I don’t know about you, but this is not very appealing to me.
If you invested in standard index fund, you are looking at about 8% average cash on cash return over the course of 10 years. To make your investment worthwhile, we usually use that as a measure if a deal is good or not. In order to generate over 8% cash-on-cash return, one has to look for a 7% cap rate property assuming the same debt structure. This pretty much eliminates properties in more desirable locations and puts you either in a location that is not as nice or a smaller market that has flat growth. However, if cash flow is your focus and you don’t want to do additional construction work, going into a smaller market with a higher cap rate is likely going to be your best bet.
Scenario 2: Investing for Appreciation with Buy and Hold
Why would you invest in a deal in a growth market at all at 5% Cap Rate? A lot of foreign investors will tell you that it is because they are investing with the hopes of appreciation.
When we looked at Moody’s Report on apartment building valuation growth, we noticed a 10 year comparison between 2007 (peak of the market) and 2017 price differences. It yields approximately 60% profit in valuation alone, on average in the US. From 2010 (bottom of the market) to 2017, the recorded average was 150% profit in valuation. That is 6% per year, on average, between 2007 to 2017 and 18.75% of return per year, on average, between 2010 to 2017.
This looks a lot better. The caveat is that the market and the cycle you invest in need to be appreciating. You will need to time the market, which has certain risks. If we look at 2007 to 2010, you are losing money...Big time!
During these lean years, ensure that you have enough cash reserves or cash flow to support the property so it won’t go under. Then appreciation makes money. So for a long-term investor who has a lot of cash and does not need to access it, the investment always makes sense as long as s/he can afford to hold the property, rain or shine.
So if the person is looking for appreciation and is investing at the bottom of the market and selling at the top of the market, then the profit including the 1.6% cashflow would be the sum of 18.75% and 1.6%, which is 20.35%. Not too bad! However, at the top of the market, it would not be a great idea. Also, if the deal is never sold, the equity is not realized, thus, there is no profit.
Scenario 3: Investing for Cashflow with a Value-Add Strategy
While a deal may not be great for cash flow today, it could be a value-add money maker if it’s fixed up and rents are increased. You would want to do this to undervalued units in a growth market.
Using the same example in scenario 1, if you could spend $5,000 to upgrade a unit and generate a $100 rent increase per unit per month, then the return will be much better. So this deal may mean more to you than the person who does not want to do any rehab work.
Let’s see how this will play out in numbers. Adding $100/unit/month in rent will result in a $1100/unit/month rent. The annual income is now $528,000. Assuming expenses and vacancy are all the same, the net operating income is now $298,000. Debt service is also the same at $225,468 a year. Cash flow is now $72,532.
Update expenditures are $5000/unit. That is $200,000 total in addition to your initial investment of $1,500,000. This yields a 4.3% cash-on-cash return. Not the best, but much better than 1.6%.
Do you see the power of a value-add approach in a growth market? So maybe you can get better leverage or yield an even greater rent increase. If that is the case, this will be a great deal for you.
Scenario 4: Investing for Appreciation with a Value-Add Strategy
For most of us, 4.6% is still not a great return. After all, the stock market yields an 8% annual average over the course of 10 years. If you happen to be investing in an appreciating market and decide to sell it for appreciation, this might be the last bit you needed on the deal.
Let’s just say you are investing in the height of the market and it’s sold 10 years later. While the market is going down, you have enough margin to hold the property as it is positively cash flowing. Using 2007-2017 appreciation data, you gained an average 6% annual return each year. Adding that to your cash flow yield, you are now at 10.6% annual average return. This is now considerable as a deal. The key here is still cash reserves and raining day funds. The downfall to this approach is not having enough cash to pass the downturn economics. During downturn economics, rents could go down. If you are not increasing rents, you could be in a tight cash flow scenario and getting into the same situation as scenario 1 or worse as your initial investment has increased.
Scenario 5: Investing with 1031 Exchange Money
We’ve all heard people’s comments on “crazy 1031 money.” What is a 1031 Exchange? It is a vehicle through which one can defer capital tax gains by selling a property, putting its profit into another deal. You can learn more about this through my interview with William Exeter, CEO of Exeter Exchange.
It is hard to predict someone’s tax situation. While investing in real estate, taxes are a big benefit in the US for a US citizen. Let’s say a person has done several 1031 exchanges. Their initial investment before they started was $300,000, for example. To get to $1,500,000, the profit he/she made throughout the years would be $1,200,000. That amount taxed at 15% capital gain tax rate is $180,000. Who wants that $180,000 just to disappear? No one. As investors, we’d rather use it to our benefit. The net effect of this extra $180,000 deferred tax is that your cash-on-cash return is now about 1% better. At 5.5% cash-on-cash return and the thought of not losing $180,000 in cash, someone may want to buy the property.
Sometimes, people will do a cash-out refinance on their properties. If the property is then sold and capital gains taxes are paid, the profits could potentially be less that what was owed in taxes. In that situation, the homeowner would most likely pay more for a property to just defer the taxes. So the deal is worth way more at that point. A buyer would essentially overpay for a property to avoid paying the taxes right away.
The downside to 1031 exchange money is that you don’t get access to the money if you don’t want to continue to defer taxes. Often, you could end up in an equity-rich and cash-poor situation as you keep on kicking money into other deals without taking money out other than the distribution. This is great for leaving a family legacy for your children.
Truth be told, I can go on for days about different ways to evaluate a deal. The most important thing is to have independent thinking and know exactly what you want out of an investment. How that investment serves your life goals determines how you move forward.
For example, if you want to quit your job, then invest in deals that have cash flow by the time you retire. If you want to create wealth, invest and evaluate deals that have equity gains. If you want to create a family legacy, then use a 1031 strategy to your heart’s content.