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6 Rules of Thumb For Every Real Estate Investor
Those of you who follow my newsletters and articles know that I emphasize increasing your chances of success by understanding investment property metrics. I am not telling you that you will become rich by thinking positively, building your confidence and fearlessly hitting the ground running. Instead I urge you to learn about the financial dynamics at work in income-producing real estate. Whether you’re evaluating a piece of property you own, want to sell, or choose to buy or develop one, you need to master metrics. Numbers are always important.
And so here are my six rules of thumb for every real estate investor.
1. Vacancy – Let’s start with an easy one. What percentage of the property’s total potential gross income is being lost due to vacancy? Start by gathering some market data so you know what’s typical for that type of property in that particular location. Is the property you own or buy very different from the norm? Of course, too much empty space isn’t good news, and you’ll want to find out why. But if a property’s vacancy rate is well below market spec, that could mean rents are too low. If you are an owner, this is a problem you must deal with. If you are a potential buyer, this may represent an opportunity to acquire a property and generate higher rental value later.
2. Loan-to-Value Ratio (LTV) — When financial markets return to some normalcy, they will likely return to their traditional standards for underwriting. One of those standards is the debt-to-value ratio. A typical lender is usually willing to finance between 60% – 80% of the property’s purchase price or its appraised value. Conventional wisdom has always held that leverage is a good thing — that is, using “other people’s money” is smart.
A word of caution here is to beware of too much of a good thing. The higher the LTV on a particular deal, the riskier the loan. In the post-meltdown period, it doesn’t take much imagination to recognize that the cost of the loan in terms of interest rates, points, fees, etc., can rise exponentially as risk increases. Having more equity in the deal may be the best, or perhaps only, way to secure reasonable financing. If you don’t have enough cash to make a substantial down payment, consider getting a group of partners together so you can acquire properties with lower LTVs and therefore optimal terms.
3. Debt Coverage Ratio (DCR) — DCR is the ratio of an asset’s net operating income (NOI) to annual debt service. NOI is the total potential income of your property less vacancies and credit losses and less operating expenses. If your NOI is enough to pay off your mortgage, then your NOI and debt service are equal and therefore have a ratio of 1.00. In real life, no responsible lender is likely to provide financing if the property is believed to have only 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 your net operating income must be at least 20% higher than your debt service. For certain property types or in certain locations, the requirement may be higher, but it is unlikely to ever decrease.
4. Capitalization rate — Capitalization rate expresses the ratio between the net operating income of an asset and its value. It’s usually a market-driven percentage that shows what investors in a given market for a particular type of asset are achieving on their investment dollars. In other words, it is the prevailing rate of return in that market. Appraisers use cap rates to estimate the value of an income property. If other investors are getting a 10% return, at what value would a subject property get a 10% return today?
First remember that the cap rate is a market-driven rate so you need to check with some appraisers and professional brokers to find out what rate is common in your market today for the type of property you are dealing with. But you also need to recognize that cap rates can vary depending on market conditions. Over our long and checkered career we have seen rates as low as 4-5% (corresponding to very high valuations) and as high as the teens (very low valuations), the historical average is probably closer to 8-10%. . If you’re investing for the long term and the cap rate in your market is currently pushing the top or bottom of the range, you need to consider the possibility that the rate won’t last forever. Look at some historical data for your market and take that into account when you estimate the cap rate that a new buyer might expect over ten years.
5. Internal Rate of Return (IRR) — IRR is the metric of choice for many real estate investors because it takes into account both time and cash flows and proceeds from sales. It can be a bit difficult to calculate, you may want to use software or a financial 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 smart you are at selecting and managing assets, real estate investing has its risks — and you should expect returns commensurate with those risks. There’s no magic number for a “good” IRR, but from my years of talking to investors, I think some people will be happy with anything less than a double-digit IRR, and most will need something in the teens. At the same time, remember the “too good to be true” principle. If you’re projecting an incredibly strong IRR, you need to revisit your underlying data and your assumptions. Are rent and operating costs reasonable? Is the proposed financing feasible?
6. Cash flow — Cash is king. If you can first project that your property will have strong positive cash flow, you can take a breather and start looking at whether other metrics suggest that it will have satisfactory long-term results.
Negative cash flow means reaching into one’s own pocket to cover the shortfall. It’s not fun to find that your income doesn’t support you, rather you have to support your assets. On the other hand, if you have a strong positive cash flow, you can usually weather any market ups and downs. 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 for the right time to sell.
Overambitious financing is a common cause of poor cash flow. Too much leverage, resulting in higher cost of debt and higher debt service may not mark the tipping point from good cash flow at all. Above, revisit LTV and DCR. We’re all thumbs so to speak, and so I hope these rules help guide you to more successful real estate investing.
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