Real Estate Investor Competition Heating Up – Sharpen Your Deal Pencil

Real estate investors have had a great ride for a half dozen years now.  The glut of foreclosures after the crash that began in 2007 provided over a million bargain basement deals, most ending up in the portfolios of rental property investors large and small.  Fix & flip and wholesale investors filled the supply line with rental properties, and rental demand is still quite high nationally.

When the big players like Blackstone Group jumped into the fray, thousands of properties went in block purchases and were converted to rental units.  All of this investment prosperity and activity has created a bit of a bubble in prices for the properties investors most desire.  Competition is heated in many markets, and this means higher prices.  Higher prices make it more difficult to make the rental cash flow work.  Today’s real estate investor, whether a wholesaler, fix & flip, or rental property investor, will need to sharpen their deal pencil and their negotiation skills as well.

Market Research

Knowing your market inside and out is a must.  Since markets are constantly evolving, market research is an ongoing activity.  Even real estate wholesalers and fix & flip investors need this information, because most of their customers will be rental property real estate investors.  Survey the rental market, call like a tenant prospect, and compare properties you’re considering to the current rental inventory.  Keep abreast of the local economy, major changes in business or industry, and the demographics of the average tenant who is a prospect for your unit.  Keep track of incentives being offered, as giving away a month’s free rent definitely takes down the annual cash flow.

Drive a Harder Bargain or Get There First

This is an “if you can” statement.  Competition is in the mix, so better marketing for distressed sellers could give you an early edge over competitors.  Working pre-foreclosures can help with a timing edge, but they’re well-covered at websites and in publications.  Getting the absolute best upfront price will help not only with cash flow but also with overall ROI when you sell.  One way to help in negotiations with distressed sellers is to have a firm handle on your financing so you can offer a fast close without hassles for a homeowner who is seeking escape from their situation.

Be Careful of Condition & Future Repair Budget

Many of the opportunities available in current local markets are older homes in well-established and popular neighborhoods close to city centers.  This is fertile ground for the real estate investor, but older homes require more maintenance and major improvements may need to be in the planning budget.  One sure way to get to the end of a rental property’s investment life and be disappointed in the overall ROI is to have spent more for repairs and rehab than anticipated through the live of the investment.

Build Rent Increases into Leases

Inflation never ends, though it can ease a bit for short periods.  Sure, you can just surprise your tenants with a coming rent increase, but that can backfire on you with move-outs and vacancy cost increases.  If you put a rent increase percentage into your lease, your tenants will expect it, which yields two advantages.  1) You can let it stand and offset inflation in your costs, or 2) To keep a good tenant you can offer to decrease or eliminate it for a renewal of their lease.  The key here is to have a good handle on your costs to rehab a unit between tenants and a good idea of how long it will be empty and not generating rent.

Expect Property Tax Increases

Rental property owners hold their investments for years, and governments over-spend every year.  Local government deficits will eventually lead to increases in property taxes, so a wise real estate investor will consider them in their budgeting and future need for increases in rent.

Don’t Be Discouraged

Rental demand is higher than at any time in recent history, and it’s still rising.  If you offer tenants good location, nice amenities, and competitive rent, you’ll enjoy near full-time occupancy and nice cash flow.  It’s just best to plan for cost increases and possible rent incentives you may not need now.  The rental property real estate investor enjoys tax advantages and generally lower risk than investors in other asset classes, so just get out there and make it happen!

MainStreet Realty Services is here to help both the experienced and the entry level real estate investor.

How to Value a Rental Property

There are three common formulas for valuating a rental property, and they are as follows:

Gross Rent Multiplier 

The Gross Rental Multiplier (GRM) is the ratio of the price of a real estate investment to its annual rental income before expenses.  The GRM is easy to calculate, but isn’t a very precise tool for ascertaining value since it does not take into account either expenses or financing. It is, however, an excellent first quick value assessment tool to see if further more detailed analysis is warranted. In other words, if the GRM is too high or low compared to recent comparable sold properties, it probably indicates a problem with the property or gross over-pricing.

The formula here is Cost divided by Gross Operating Income = Gross Multiplier

So take the cost (or Sales Price) of the property and divide that number by the Gross Operating Income (annual income less vacancy rate) and you have your GRM.


Capitalization Rate (or Cap Rate)

By using other properties’ operating income and recent sold prices, the capitalization rate is determined and then applied to the property in question to determine current value based on income.

The formula here is Net Operating Income divided by Cost = Cap Rate

The Cap Rate needs to be higher than your loan amount to help ensure you are in a financial position to afford your mortgage.  The Cap Rate method is better than the Gross Rent Multiplier Method because it takes expenses into account.  This formula, however, is good for those Triangle Real Estate Investors who will be purchasing the property in cash.


Cash-on-Cash Formula (my personal favorite)

The Cash-on-Cash rate of return provides an easy way for real estate investors to compare the profitability of similar income-producing properties, or as a way to gauge one investment opportunity against another quickly

Cash-on-cash return measures the ratio between anticipated “first-year cash flow” to the amount of “initial cash investment” made by the real estate investor to purchase the rental property. Hence, cash on cash is always expressed as a percentage.

Terms

Cash Flow Before Taxes (CFBT) is the amount of money the property is expected to generate during the first year of operation (less real estate taxes).

The initial cash investment (sometimes called the cost of acquisition) is the total amount of cash invested by the investor to acquire the property such as down payment, loan points, escrow and title fees, appraisal, and inspection costs

The formula here is Cash Flow Before Taxes (CFBT) divided by Cash Invested = Cash on Cash

CFBT is the annual rent, less vacancy rate, less operating expenses and less annual debt service.

One shortcoming is the fact that cash on cash does not take into account time value of money.  As such, the return must be restricted to simply measuring an income property’s first year cash flow, and not its future year’s cash flows.

If the cashflow is good enough, all other factors should equal out.

Financial Benefits to Owning Triangle Real Estate Investment Properties

There are basically four financial benefits to owning Triangle Real Estate Investment Properties:

1) Income by CFBT, or Cash Flow Before Taxes

2) Principal Reduction

3) Tax Savings by Depreciation

4) Appreciation

I will address each individually below.

1.  CFBT/Cash Flow Before Taxes:  To calculate the CFBT, you first need to know what your Gross Operating Income is.

Gross Operating Income (GOI) = Annual Rent (based upon the unit being 100% leased for the year), less your vacancy rate.
So if your unit leases for $1,000 per month and you historically have a vacancy rate of 5%, then your Gross Operating Income will be:

$1,000,00 x 12 months = $12,000.00
$12,000.00 x 5% = $600.00
$12,000.00 – $600.00  = $11,400.00
GOI = $11,400.00

Now that you know your GOI (Gross Operating Income), you subtract from that your Operating Expenses.  Operating Expenses can include such costs as:

  • real estate taxes
  • repairs
  • homeowner association dues
  • leasing fees
  • management fees
  • homeowner insurance
  • utilities
  • advertising
  • supplies
  • miscellaneous (anything else).

Let’s now say that your annual operating expenses will run about $5,400.00 per year.

So, you take your $11,400.00 (GOI) and subtract the $5,400.00 (Operating Expenses), you now have $6,000.00…and this is known as your Net Operating Income.

From your Net Operating Income, you will now subtract your Debt Service.  Debt Service is just a fancy term for your mortgage.  It includes your mortgage (principal and interest) over a 12 month period.

Presuming you pay $3,600.00 per year in Debt Service (that’s $300.00 per month x 12 months), you will subtract that $3,600.00 from your Net Operating Income of $6,000.00 and you now have $2,400.00.  Another term for this $2,400.00 is your Cash Flow Before Taxes.

2.  Principal Reduction:  This is the decrease in the principal amount you owe on your loan.  When you make a payment to your lender every month, part of that payment is allocated to the principal, and part of it to the interest that the lender is charging you. So therefore you are ‘paying down’ or ‘reducing’ the amount of the loan each month with each payment.

3.  Tax Savings by Depreciation:  We will get into depreciation a little more in a different blog post, but basically, you are able to write off the Personal Property Value, Building Value and Land Improvement Value of your property over ‘x’ amount of time.  The ‘x’ amount is determinant upon each category.  So with this depreciation, you SHOULD be able to save money on your taxes each year.

4)  Appreciation:  This is where the value of your real estate investment increases each year.  The percentage amount has been kinda screwy these last couple of years, but once things settle down, the appreciation of your real estate investment should equate to at least 2% annually.