New Client Orientation - Analytics and Reports

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It's About Numbers

Successful real estate investing is not about luck, gurus, or feelings. It's all about numbers. This guide will overview:

Estimating return
The limitation of return calculations
Comparing properties
Depreciation
Investor Tool
Property Information Report
Maximizing cash flow
Minimizing total capital required

Estimating Return

One of the best tools for evaluating properties is the estimated return. However, before explaining how to estimate return, it's important to understand the limitations of all return calculations.

Return Estimate Limitations

ROI and similar metrics only provide an estimate of how a property is likely to perform on the first day of a lifetime hold under ideal conditions. However, they do not provide any information on how the property is likely to perform in the real world or in the future. Your financial independence is tied to the long-term economic growth of the city where you purchase properties. Therefore, what happens in the future is more important than what happens on the first day or even in the first year.

Estimated Return Is Not Your Actual Return

The benefits you receive from depreciation and other tax deductions depend on various factors, including your income and the passive income you receive from other real estate investments.

Best Use of Return Calculations

While return calculations do not accurately represent your actual return, they are useful for comparing properties. For example, suppose you are considering two properties. One has an estimated return of 6%, while the other has an estimated return of 4%. The property with the 6% estimated return will perform better, regardless of taxes.

Apparent Return vs. Probable Return

Return calculations only provide the apparent return. They do not take into account factors such as vacancy costs. The show the impact of vacancy costs, I will use information about the three major tenant pool segments in Las Vegas.

Below is a diagram showing the three major segments, and some information about each segment.

For convenience, I assigned names to each segment based on the average length of stay.

Transient: <1Yr data-preserve-html-node="true"
Permanent: >5Yrs
Transitional: <2Yrs data-preserve-html-node="true"

Vacancy costs are a function of:

The tenant pool segment the property attracts
Length of tenant stay <<< data-preserve-html-node="true" This is the most important factor.
Time to rent
Debt service
The skill of the property manager in selecting good tenants
Construction materials
Renovation cost

Vacancy cost is calculated as follows:

Vacancy cost = monthly-carrying-cost x months-the-property-is-vacant + renovation-cost + tenant-acquisition-cost

In order to demonstrate the impact of the length of tenant stay, I will assume that the vacancy cost for all three scenarios is $6000. This is not true but it enables me to isolate the effect of length of tenant stay and keeps the example simple.

Assuming a cost of $6,000 for each time the property is vacant, I can calculate the annual vacancy cost by dividing the total vacancy cost by the length of stay.

Transient: $6,000/1Yr = $6,000/Yr
Permanent: $6,000/5Yrs =$1,200/Yr
Transitional: $6,000/2Yrs = $3,000/Yr

This means that in order to achieve the same annual cash flow, a property targeting the Transient segment must generate $4,800 ($6,000 - $1,200) more per year than a property targeting the Permanent segment. Vacancy costs can turn what appears to be a cash cow into a money pit.

Estimating Return

In a separate guide (How We Calculate Return ), I provide details about how we calculate return so I will be brief here.

There are many different formulas for estimating returns. Some leave out significant costs, while others include unrealized gains like principal pay-down and appreciation as income. And, others include fictitious amounts for maintenance and vacancy costs. The formulas below provide a reasonable estimate of what our clients see in their bank accounts.

Cash Flow

Cash Flow = (Rent - DebtService - ManagementFee - Insurance - RealEstateTax - PeriodicFees - MaintenanceCost - VacancyCost) x (1 - StateIncomeTax)

Because the primary use of return calculations is to compare properties, leaving out unknown costs such as vacancy and maintenance, does not affect the difference in return between two properties. Below is the simplified formula for cash flow which is what we use.

Cash Flow = (Rent - DebtService - ManagementFee - Insurance - RealEstateTax - PeriodicFees) x (1 - StateIncomeTax)

ROI

ROI = (Rent - DebtService - ManagementFee - Insurance - RealEstateTax - PeriodicFees - MaintenanceCost - VacancyCost) x (1 - StateIncomeTax) / ( DownPayment + ClosingCosts + RenovationCosts)

Leaving out maintenance and vacancy costs as well as renovation costs, the formula is simplified as follows:

ROI = (Rent - DebtService - ManagementFee - Insurance - RealEstateTax - StateIncomeTax) x (1 - StateIncomeTax) / ( DownPayment + ClosingCosts)

Example Calculation

So you can see how it all fits together, below is an example showing the return calculation.

Purchase price: $300,000
Rent: $1,800/Mo. or $21,600/Yr.
Financing: 30-year, fixed rate of 5.5%, with 25% down. DebtService is $1,277/Mo or $15,324/Yr. DownPayment is $300,000 x 25% = $75,000.
DownPayment: 25% x 300000 = $75,000
ManagementFee: 8% x 21,600/Yr = $1,728/Yr.
Insurance: $500/Yr
RealEstateTax: $1,650/Yr
Association fees (PeriodicFees): $20/Mo. or $240/Yr.
StateIncomeTax: 0%
Closing costs: $300,000 x 2% = $6,000

Plugging the values into the formulas

ROI

ROI = (Rent - DebtService - ManagementFee - Insurance - RealEstateTax - PeriodicFees) x (1 - StateIncomeTax) / ( DownPayment + ClosingCosts)
ROI = ($21,600 - $15,324 - $1,728 - $500 - $1,650 - $240) x (1 - 0) / ( $75,000 + $6,000)
ROI = 2.7%

Cash Flow

Cash Flow = (Rent - DebtService - ManagementFee - Insurance - RealEstateTax - PeriodicFees) x (1 - StateIncomeTax)
Cash Flow = ($21,600 - $15,324 - $1,728 - $500 - $1,650 - $240) x (1 - 0)
Cash Flow = $2,158/Yr

Comparing Properties in Different Locations

Return calculations also work well for comparing properties in different locations. It is important that you include all significant recurring costs. For example, below are two properties. One is in Austin and the other is in Las Vegas. Based on the information below, which one is the better investment?

Financing assumptions

30-year, fixed rate of 5.5%
25% down.
2% closing costs
8% management
0% state income tax

Calculations for the Austin property

Cash Flow = ($20,400 - $12,903 - $1,632 - $1,625 - $6,022 - 0) x (1 - 0)
Cash Flow = -$1,782
ROI = ($20,400 - $12,903 - $1,632 - $1,625 - $6,022 - 0) x (1 - 0) / ( $63,125 + $5,050)
ROI = -2.6%

Calculations for the Las Vegas property

Cash Flow = ($17,880 - $13,030 - $1,430 - $450 - $1,151 - 0) x (1 - 0)
Cash Flow = $1,819
ROI = ($17,880 - $13,030 - $1,430 - $450 - $1,151 - 0) x (1 - 0)/ ( $$63,750 + $5,100)
ROI = 2.6%

If you ignore taxes and insurance costs, the Austin property appears to be the better investment. It is essential to include all significant recurring costs to accurately compare the properties.

I often hear people talking about comparing rent to price ratios. Below are the calculations for the Austin in Las Vegas property.

Austin = $1700 x 12 / $252500 = 8.1%
Las Vegas = $1490 x 12 / $255000 = 7.0%

Because the rent price ratio does not include costs, it incorrectly indicates that the Austin property is the better investment.

Never use the rent price ratio because it always fails.

Depreciation

I am not a tax advisor, attorney, CPA, or any kind of financial person. This is not tax advice and you should consult your tax advisor. Below is how an engineer believes depreciation works.

Taxes are a major consideration in any investment because it's not just about how much you gross, is how much you net. Fortunately, investment real estate has excellent tax treatment, which increases your effective return.

What is depreciation? Depreciation is a reduction in the value of an asset with the passage of time, due to wear and tear. The IRS has published useful lives for many items. Including residential investment properties. The IRS requires residential property improvements to be depreciated over 27.5 years. Below is an example of how depreciation is calculated.

Suppose you paid $250,000 for a property. If I assume 80% (a common assumption for single-family in Las Vegas) of the purchase price is for the structures (the "Improvements") and 20% for the land, you would calculate the annual depreciation as follows:

Annual depreciation = ($250,000 x 80%) / 27.5 = $9,090/Yr
Purchase price: $250,000
Rent: $1,400/Mo. or $16,800/Yr
Management fee (8% of Collected Rent): $1,344/Yr
Property taxes: $1,250/Yr
Landlord insurance: $400/Yr
Debt service (30Yr, 25% Down, 5%): $1,000/Mo or $12,000/Yr
The interest portion of debt service: $9,312/Yr (only the interest is deductible, the principal portion is not deductible)

Let's look at compare IRS sees the property and your actual income from the property.

IRS View

Income: $16,800
Deductible Expenses
- Management: -1344
- Property Taxes: -1250
- Insurance: -400
- Debt Interest/Payment: -9312
- Depreciation: -9090
Gain/Loss: -$4,596

Cash Flow View

Income: $16,800
Actual Expenses:
- Management: -1344
- Property Taxes: -1250
- Insurance: -400
- Debt Interest/Payment: -12000
Gain/Loss: 1806

To the IRS, your property lost $4596/Yr, which, depending on your tax situation, could shield $4596 of your other taxable income. In reality, you deposited $1,806 in your bank account.

Investor Tool

MLS data sheets have little value for investors. To make informed decisions, you need information such as probable rent, time to rent, and return on investment. Our data mining software provides this information through what we call the Investor Tool, which is shown below.

Here is a video walk-through of the Investor Tool. Here is a sample Investor Tool. We send a link to a new set of properties to active clients every 3 or 4 days.

Our data mining software searches all available properties and selects the few that meet all our requirements. The result is a small set of candidate properties. Just because they are candidates does not mean they are good investment properties.

Every property of interest must pass a multi-step validation process. Only properties that pass every step are considered. Below are the process steps before the property is under contract.

Once the property is under contract, validation continues.

Property Information Report

We provide useful information through what we call a Property Report. Here is a sample Property Information report.

Property Report Considerations

The initial report is generated when we manually evaluate the property. As the property moves through the validation process, more is added to the report.
Creating the Property Information Report takes considerable time and effort. We only generate the report for properties of interest to you.
Most properties will be rejected before completing the validation process.
Previously published information will be updated as more information becomes available.

How Do You Make the Most Money?

In this example, I will compare the amount of investable cash available after 5 years for both appreciation and cash flow strategies. To isolate the impact of cash flow and appreciation, I ignored all other factors, including loan costs, down payment, closing costs, renovation costs, vacancy costs, maintenance costs, management fees, rate increases, and inflation.

Assumptions:

Property A appreciates at 7% annually but has zero cash flow.
Property B has a 7% cash/cash return but zero appreciation.
Purchase price: $400,000.
Down: 25%
Acquisition cost: $100,000 (25% X $400,000)

Below is a table comparing the 5-year result between cash flow and appreciation.

As you can see, appreciation plus cash-out refinance provides for more cash than accumulated cash flow. This is why investing in higher appreciation markets is critical.

Minimizing Total Capital Required

In this section, I will compare the cost of buying two properties. One in a low-appreciation market and the other in a high-appreciation market like Las Vegas. I will only consider the down payment to simplify the example.

Assumptions:

Purchase price of both properties: $400,000
Down percent: 25%
Marginal tax rate: 30%

Below is the total cash required for down payments for the two properties.

Low Appreciation Market - The down payment for each property is $100,000 so the $200,000 for down payments comes from your savings. Total down payment cost for the two properties: $200,000.
High-Appreciation Markets - The down payment for the first property comes from your savings and is $100,000. However, you can use cash-out refinance for the down payment on the second property. Total down payment cost for the two properties: $100,000.

Prices and rents are driven by market demand. Where there is little demand for housing, prices are low and there is little appreciation. In this case, every investment dollar will come from your savings.

In a high-appreciation market, a significant amount of your total capital investment comes from cash-out refinance.

This is why low-cost markets are actually the most expensive way to accumulate multiple investment properties.

Summary

This guide provided a high-level overview of the topics we will discuss in the Analytics and Reports session. However, the session is not limited to analytics and reports. We can discuss anything of interest to you.

Thank you for taking the time to read this guide.

See you soon,

…Eric

Eric Fernwood Eric@Fernwood.Tea

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