Shared Top Border
sdcia_head3.jpg (14795 bytes)
SDCIA Message Board
Sign up Latest Topics
 
 
 


Reply
  Author   Comment  
rickencin

Avatar / Picture

Senior Member
Registered:
Posts: 1,062
Reply with quote  #1 

Boring definitions given below.  Let’s get right to the results:

Break Even Cash Flow without a mortgage: NOI = 0, income = expenses

Break Even Cash Flow with a mortgage: CAP = AMP/Price (less than X)

(X is defined to be AMP/LA)

When CAP  = ROI, then CAP = ROI = X

ROI = (CAP–X)L + X     (ROI is good when CAP>X and multiplied by the leverage)

CAP = ROI/L + X((L-1)/L)

 

Definitions and Comments

Annual Mortgage Payment = AMP

Net Operating Income = NOI = Income – Expenses other than mortgage

Return On Investment = ROI

Leverage = L = Price/Down Payment

Loan Amount = LA

CAP = NOI/Price (or Price + closing cost + whatever)

ROI = (NOI – AMP)/DP

Down Payment = DP = Price/L

Loan Amount = Price(L-1)/L

Price = Down Payment + Loan Amount

X is defined to be AMP/LA

If you plot CAP and ROI vs rent, the lines will cross at “X”

I’ve skipped pages of algebra.  If you disagree it is very likely that your definitions are different than mine.  It is useless to argue over correct definitions.  I consider the whole mortgage payment to be a recurring expense.  The IRS says only the interest payment is a deductible expense. I consider principal to be a one time asset when you sell. 


__________________
Rick
javipa

Avatar / Picture

Senior Member
Registered:
Posts: 3,380
Reply with quote  #2 
Okay, I love the summary, and can't argue with the definitions, but why did you post this?




__________________

"Obstacles are those frightful things you see when you take your eyes off your goals." --- Henry Ford "

"149 Ways (Plus One) To Find Motivated Sellers and Get Them To Find You" >>>Click Here To Download 

rickencin

Avatar / Picture

Senior Member
Registered:
Posts: 1,062
Reply with quote  #3 
Fair enough question!
When evaluating deals I use X all the time.
X is a familiar number. Annual Mortgage Payment/Loan Amount
This could be called the Mortgage Payment Rate (I hesitate to call it this (X=MPR), knowing newbies will confuse it with the similarly named Interest Rate)
Everybody knows interest rate, interest payment/loan balance (there is always a 12 lurking to convert between monthly and annual, monthly payment, annual interest rate) 
Annual Mortgage Payment/Loan Amount includes principal repayment as well as interest payment and magically is the same every month (well, year).
Lets say you have a $100,000 house, $10,000 down payment (creative, right?), 4% interest rate, 30 year fixed, mortgage payment $430. Stupid simple, figures rounded off.
Your Annual Mortgage Payment/Loan Amount is $430*12/$90,000 = 5.73%

If your rent is $778 a month and you have other expenses of $300 a month you have a CAP rate (NOI/Price = 12*(778-300)/100,000) of 5.73%
Your ROI, (NOI - AMP)/Down Payment = 12*(778-300-430)/10,000 = 5.73%
CAP = ROI = AMP/Loan Amount

Let's say your rent goes up to $900
CAP = 7.2%, ROI = 20.4%, your leverage of 10 is helping you get a high ROI

Let's say your rent goes down to $730.
Break Even Cash Flow with a mortgage: CAP = AMP/Price
= 5.16%, ROI = 0%.

Let's say your rent goes down to $700.
CAP = 4.8%, ROI = -3.5%, your leverage of 10 is hurting you, getting a negative ROI.

If your CAP rate is above X (=MPR=AMP/LA) life is good.
If your CAP rate is below X, life is bad
If your CAP rate is AMP/Price you are at break even cash flow, ROI = 0%.

This corresponds well to the old advice that rent should be 1% of the purchase price (not happening in San Diego).
Low income, high CAP rate properties will make you rich, high income, low CAP rate properties will keep you poor.
See, landlords DO love low income renters!


__________________
Rick
javipa

Avatar / Picture

Senior Member
Registered:
Posts: 3,380
Reply with quote  #4 

I see what you're attempting to accomplish now.

Rent/Price ratio of 1% is a traditionally accepted criteria. 

The issue I have with that ratio is that it doesn't allow for property management and maintenance overhead (assuming 10% down).

In fact, until the ratio reaches about 2%, there's little room for management and maintenance, without putting up bigger down payments, which lowers the ROI. 

Meantime, investors are forced to donate their time and more money to the cause, until the rents do climb to that 2% level. 

Of course, that also doesn't account for the equity profits accumulating from both inflation and appreciation in the meantime...


----------------------

As an experienced, single-family investor, I can say with confidence that it's rare that single-family investments will cash-flow anytime soon, following traditional guidelines.  That is, without either buying an extreme bargain, and/or putting up a huge down payment.  Never mind the affects of financing rates and terms.  

Someone asked me how to reduce the risk of negative cash flow, and I said, "Buy the loan down to the equivalent of 2% of the rent/price ratio.  That is, if the rents are $2,500/mo, than the loan should be no more than $125,000, regardless of the price." 

Well, after that, they stop asking me for advice.  Pffft.

*** I also recommend that the investor assume a 50% overhead cost (based on the market rent), that includes management, maintenance, vacancy and replacements, etc.  This assumption just eliminates all sorts of potential surprises in the short and long run.

 


__________________

"Obstacles are those frightful things you see when you take your eyes off your goals." --- Henry Ford "

"149 Ways (Plus One) To Find Motivated Sellers and Get Them To Find You" >>>Click Here To Download 

rickencin

Avatar / Picture

Senior Member
Registered:
Posts: 1,062
Reply with quote  #5 
I could have titled this "What Is a Good Rent?" but I wanted to prepare people for the horror of equations.
Once  you have figured out all the expenses, the CAP rate is proportional to the rent.  A 10% increase in rent causes a 10% increase in CAP rate (or decrease).
A  CAP rate of at least the Mortgage Payment Rate is good.  You can include property management fees in the expenses.  You can use my handy-dandy formula to convert CAP to ROI if you are a cash-on-cash kind of guy. CAP and ROI are both useful metrics.
I happen to like closed form solutions. Everyone knows their monthly mortgage payment, purchase price and down payment.  Mortgage Payment Rate = (12* monthly mortgage payment)/loan amount.  Even a California public school graduate can do a multiply and divide.
Jay, you seem to be happy with numerical values.  That is fine, especially if your experience has shown it to be what you want.  The important thing is that you analyze before you buy so that you know what to expect IF your assumptions are correct. No one knows the future.
Money is a number, if everyone else hates math, more numbers for me!

__________________
Rick
javipa

Avatar / Picture

Senior Member
Registered:
Posts: 3,380
Reply with quote  #6 
Quote:
Originally Posted by RobertCampbell


Jay, most people don't want to hear the truth - or a view that conflicts with their own.

What they want to hear is what they already believe.

It's called confirmation bias.  



True.  It also comes down to an inability to actually follow my advice.  Most investor wanna-bees are coming into investing on a shoe-string; don't have a lot of resources; are like camels putting their head in the tent, and gradually trying to climb all the way in; with the hopes that things will turn out.  And that's the braver ones. 

The rest sit on the sidelines, waiting for real estate prices to come back down to 1990 levels.  Odd, because in 1990 they were waiting for prices to come down to 1970 levels.  Hope springs eternal.


__________________

"Obstacles are those frightful things you see when you take your eyes off your goals." --- Henry Ford "

"149 Ways (Plus One) To Find Motivated Sellers and Get Them To Find You" >>>Click Here To Download 

Previous Topic | Next Topic
Print
Reply

Quick Navigation:

Easily create a Forum Website with Website Toolbox.

Policy