First, we will need to collect some information about the property and how you wish to finance it. If you’re looking at the sheet, every cell that requires an input is blue. Here are our inputs, how to find them, and what we will use for this training scenario:
Purchase Price = self-explanatory, we will use $100k
Repair Estimate = we will assume no repairs needed. Estimating the rehab budget is outside of the scope of this post.
Rent Estimate = let’s assume $1000/mo. Estimating market rents is also outside the scope of this post, though it is obviously very important. The best way to do this is just to check comps on Zillow or speak to local property managers and landlords.
After-repair Value (ARV) = let’s assume our ARV is $105,000. This means we are buying a bit under fair market value at our current purchase price of $100k – which is no easy task in today’s market but it’s not impossible. Usually we use the term ARV when referring to a property that will need substantial repairs- it refers to the value of the property after repairs are completed.
Yearly appreciation = let’s assume the property will appreciate 3% per year. This is a fairly standard assumption and somewhat conservative in my market of Savannah, GA.
Financing inputs: This is where we dive into the kind of loan we are using. You should be able to get estimates for these numbers by getting quotes from a few different lenders.
If you will be buying all-cash, just fill out 0% in the LTV cell. I have pre-populated some numbers that investors are seeing with conventional investment property loans, keeping in mind that market conditions are changing all the time.
If you do not know the type of loan you are using, let’s fill out some standard rates and terms I’m seeing on 30- year loans going to well- qualified investors who are private buyers: 75% LTV, 30 year term, 4% interest rate, and 1 point.
A point is basically prepaid interest that the lender collects up front. Some loans have points, some don’t, and often you can get a lower rate if you buy some points. One point is equal to 1% of the loan amount. If you plan to hold the loan for a long time, often it makes sense to pay points to get a lower rate.
Please note that your total closing costs will likely be much higher than the $3,250 shown in cell D7. T – this is because your lender will also have you prepay your first year of insurance and fund an escrow account with a few months of insurance and property taxes. We do not include these closing costs in this cell because those costs are reflected in the expense inputs, which we will discuss in a moment.
Property tax rate.- This can be found on your city or county website, typically in a “tax assessor” section. In the city of Savannah, the rate is 44 mils. A mil is a thousandth of a percent, so 44 mils equals a tax rate of .044%. This millage rate is then applied to the assessed value that the tax assessor determines your property to be worth. Assessed values can also be found on your city or county’s tax assessor website. In the city of Savannah, they will determine a “market value”, which is often adjusted to reflect the sale price when a property sells, then calculate the assessed value by multiplying that market value by .4 or 40%. Then, they will apply the millage rate to that assessed value. In this case, if the purchase price is $100k, we can assume that the tax assessor will likely update the market value to $100k. This brings the assessed value to $40,000. Then, they will apply the millage rate to that number (44 mils or .044) to determine the tax rate, which will be $1,760/yr.
Insurance – the only way to know your insurance for sure will be to get a quote. I’ve done this enough to know though that I’ll typically be paying about $700/yr to insure a $100k house in Savannah. If it was in a flood zone, it would be more expensive. I assume a house in Pittsburgh would be cheaper to insure given there’s no hurricanes there. You get the idea.
Maintenance – for an older house that I didn’t just completely renovate, I typically budget $1,500/yr for maintenance and capex. For older multi-family homes, I typically do $1,500/yr/unit. If it’s something I just renovated or purchased relatively new (1990s and newer), I’ll assume $1000/yr.
Vacancy – I assume 5% vacancy loss per year. This means the house is vacant 5% of the year. In reality, my vacancy per year is typically lower. During the deepest part of the last recession (global financial crisis, I don’t really count the COVID recession), the vacancy rate in Savannah was closer to 10% for a bit. Here’s a thing about vacancy – your place won’t be vacant for long if you price it right and take quality photos/market well.
Property management is typically 10%. I recommend modeling property management even if you intend to self manage because you want to make sure your numbers will still be acceptable if you decide to move away.
Alright! Now that we have all of the inputs we need to run the model, let’s take a look at what our model spits out! Let’s check out some metrics mentioned above.
Gross Rent Multiple (GRM) and Capitalization Rate are what we call valuation metrics. They are used to determine if an investment property is priced according to the market conditions. These metrics act independently of financing options you might use to acquire a property and allow us to get apples to apples comparisons to other options on the market.
Cap Rate = NOI/(Purchase Price + Rehab)
Cap rate is important because it allows us to get apples to apples comparisons for different properties. Large investment properties are valued almost solely by their cap rate. An investor or broker might say “A class office space in this city typically trades at a 4 cap”, meaning that a pristine office building in the city will sell at a capitalization rate of 4%.
How does this then affect the purchase price? When investors value an investment property they are looking at the operating income that the property brings in, and use the cap rate formula to extrapolate an appropriate purchase price. If the office building we referenced should be selling at a 4 cap, and it brings in $1,000,000 of net operating income per year, then we rearrange the cap rate formula to solve for purchase price (hint: divide NOI by cap rate). Doing this gives us a purchase price of $25,000,000.
The market determines what an appropriate cap rate is for a given type property. But the owner of a property can influence NOI, and with an investment property, this is how an owner can make their property more (or less) valuable. If you do rehab and bump rents, you get more NOI, which means you get a higher sale price for the same cap rate.
We can still look at cap rates for single family properties or small multi-fam, but for these smaller properties it’s also important to look at comparable sales because these kinds of investment properties also compete with owner-occupied sales, which are not driven by NOI for their valuations.
Cap rate also tells us what the cash-on-cash return on investment (sometimes called yield) would be if we bought a property straight cash. This is important because we can totally change an investment’s outcome depending on what kind of financing we can secure. A dogshit investment can turn into a great one if someone is willing to lend us money at a low- enough rate and long- enough term (term is the period of time we get to pay off the loan.)
A lower cap rate means that the property will return less. A higher one means it will return more. Why do some properties command a lower cap rate (meaning they are more valuable)?
Investors are willing to purchase a property at a lower cap rate if it is deemed to be a safer investment, basically. This makes sense right? If you had the choice between a single family home in great condition that’s in a great neighborhood, wouldn’t you be willing to pay a little bit more than a dumpy house in the middle of nowhere? One is a safer investment so investors are willing to make less profit, another presents a greater risk so they want to see a greater return.
I’ve spent about five paragraphs talking about cap rates. Before I move on, let’s look at a quick practical example using the numbers from our spreadsheet. This property is showing a cap rate of 6.3%. That means if you bought this with $100,000 in cash, you would get a NOI of $6,300, and that NOI would be your cash flow at the end of the year. Sure beats savings bonds, right? In the Savannah market, you can expect to buy single family homes at that kind of cap rate in a C neighborhood, and the house would probably be a little bit dumpy. A house in a nice suburb would be going for closer to 4 cap. A slumlord special would be selling around an 8 cap.
Gross Rent Multiple (GRM)
GRM is similar to the cap rate but it just looks at the gross rents coming in instead of the net operating income.
GRM = (purchase price + rehab cost) / gross annual rents
Note: typically, I’ll look at the MARKET rent when evaluating GRM, not current rent.
This is the official formula used for GRM, but I prefer to use monthly rents in the denominator because typically, on a listing, you’ll see monthly rent listed. We typically use GRM as more of a rule of thumb metric when we want to quickly evaluate whether or not a deal deserves further analysis.
You hear a lot about the “1% rule” when looking at rental properties. The 1% rule just means that the monthly rent should be equal to or greater than 1% of the purchase price. If you flip this rule around, you could call it the 100x rule – meaning that purchase price should be 100x or less of monthly rent. This is the GRM. The more desirable the location, the higher a GRM a property can command for a given market rent rate.
Funny side note: It used to be called the “2% rule” back in 2012 when real estate was cheap, but gradually became the 1% rule as prices went up and folks realized that you could never find a 2% property again. I suspect soon folks will start to call it the .75% rule as it becomes exceedingly difficult to find 1% rule conforming properties, unless you’re buying in C class areas or worse, or Iowa.
In reference to the spreadsheet, we factor in free equity and appreciation in our valuation calculations that we will use for some of our return metrics. They aren’t really valuation metrics but I thought it would fit in well here.
Debt metrics are where we start to factor in the debt we will be using to finance the transaction. We will be adding up standard payments seen on mortgages to calculate some of our return metrics. (see cells A24: E27 for formulas)
Return metrics (Return on Investment (ROI), Cash-on-cash ROI, sometimes called yield, Return on Equity (ROE)) are used to see how much money our investment will return, and these do change depending on how we finance a purchase. This is where we factor in our debt and bring the whole thing together!
Cash flow = NOI – (principle + interest payments)
In the case of our example sheet, this comes out to $1,963 of cash flow per year.
Total return = cash flow + appreciation + mortgage principle pay-down + free equity
In our sheet, our year- one total return is $11,450. Keep in mind, though, that in our example, we have $5,000 in “free equity”. So for the second year, our yearly return will likely be a bit less. Total return is like the unrealized gain you see in stocks; just because your stocks go up in value does not mean you’ve really “made” that money – you only make the profit when you sell. Same thing with houses. Your yearly cash flow is like the dividend you get on a stock, and the total return factors in cash flow and those unrealized gains, which you will only ever realize when you sell.
There are also selling costs involved with selling a house that are not accounted for in this calculation. As we learn more about investing we can build more detailed models that factor this in, but for this one it’s not really important – if you’re buying a rental property, we can probably assume you’ll be holding it for more than a couple of years.
Cash invested =down payment + closing costs. We do not include the portion of closing costs that we use to start our escrow account. Most lenders will open up an escrow account and use that to pay your property taxes and insurance. You will usually pay a few grand at closing to start this account, and, after that, will pay into it as part of your monthly payment. Even though this cash comes out of your pocket at closing, it is not really a closing cost – it is just prepaid expenses that we factor in later in the model. We don’t want to account for these expenses twice. I digress.
Equity includes our down payment, rehab expenses (if any), and free equity. Equity does not include closing costs.
Now that we know how much cash we have invested in the deal and how much equity we have in the deal, we can calculate our return on investment and return on equity.
Cash ROI = cash flow/cash invested
This is my favorite metric, and it should be yours too if you’re primarily interested in building up passive income NOW. In this case our cash ROI is 6.95%, only marginally higher than our cap rate of 6.3%. I’ll be honest, a cash ROI of 6.95% doesn’t excite me, but I spend a lot of time hunting the best possible deals, and most of my best investments are places that I spend a lot of time and money fixing up. But, if you’re just looking for an easy, turnkey rental that you don’t have to think about, this isn’t bad.
How do we bump up our ROI numbers? Either we need to get a bigger number in the numerator (that means more cash flow), or get a smaller number in the denominator (that means less cash invested in the deal).
Obviously, it’s nice to get more cash flow and this is the preferred way to bump up our ROI numbers. Fix up the unit, market the rental better, and you can command a higher rent. But it’s fun to play with the denominator of that equation too – how do we invest less cash into the deal?
Leverage. The more debt we take out, the less of our own money we have in the deal. Most lenders are asking for 20 to 25% down payments right now for investment properties, and our model uses a 25% down payment. If we change our down payment to 20%, with everything else staying exactly the same, here’s how it changes our numbers:
Yearly debt service (principle and interest payments) increases from $4,337 to $4,626
Cash flow decreases from $1,963 to $1,674
Cash invested decreases from $28,250 to $23,300
Cash ROI increases from 6.95% to 7.18%
As we can see, even though our cash flow is smaller, our cash ROI is greater because we have much less cash invested into the deal. How can we get even more leverage?
By executing what’s called a BRRR: Buy, Rehab, Rent, Refinance. I just did one of these and closed the refinance this week. We purchased a property in December for $98k, spent about $65k in rehab, and had about $42k of cash invested in the deal. Then, we found a renter for the property at $1800/mo and executed a refinance on the property to pull out cash. At closing for that refinance, we received a check for $48k.
That’s right – we got paid to buy a rental property. We have absolutely no money in this deal and, the denominator of our ROI equation is zero – meaning our return on investment is infinite. Now we have $48k to invest into another deal, all while still collecting about $5,000 in yearly cash flow off that property. Plus appreciation. Plus mortgage principle pay-down. THIS is what I love about real estate!
Not all deals are like this, and doing a deal like this requires a good amount of risk – in this case we had to close on the property in less than a week and didn’t have time to conduct any inspections. We went massively over budget and almost didn’t pay back the initial lender in time – but it worked out and we were rewarded for the risk we took. My first- ever deal got me a cash on cash of about 12%. I invested in a deal with a cash on cash of 6%, but, in that case, we had a ton of free equity because we bought it under market value. We just sold that deal for a 100% return on investment – we doubled our initial investment. If I was less interested in risk and more interested in an easy and safe return, I’d probably be perfectly happy with a 6-8% cash ROI. It all depends on what we’re most interested in and comfortable with.
We’ve talked about Cash ROI – there’s also total ROI.
Total ROI = total return / cash invested
This one is much higher because it includes free equity, appreciation, and principle pay- down in addition to cash flow. Total ROI is best expressed over the expected life of the investment and in annualized terms, and that metric is called Internal Rate of Return (IRR) – we’ll talk about that one in a later blog post.
Return on Equity (ROE) = cash flow/ total equity
ROE is not super important when we analyze our entrance into an investment, but it becomes important as we hold the investment and our equity in the deal grows. We increase equity by paying down the principle on our loan and by appreciation, either natural appreciation that occurs over time, or by conducting improvements to the asset.
As our equity in the deal increases, our ROE will typically decrease unless we somehow get much more return (maybe rents grow faster than appreciation). As ROE decreases, eventually our equity will be better placed into new investments.
Take the example in our sheet. When we buy the property with a loan at a 25% down payment, our equity in the deal is about $30k, and our cash ROE is about 6.5%. After we’ve paid down half of the loan balance and seen a few years of appreciation, we will have much more equity into the deal, but our cash flow will not be too much more. If we double our equity and get the same cash flow, our ROE will decrease to 3.25%. As our ROE decreases, it starts to make sense to free up that equity so that we can put it to use elsewhere, earning a higher ROE.
How do we free up equity? Either a cash- out refinance or a sale. When I’m thinking about doing a cash- out refi or a sale I’ll run the numbers on the asset I own just like I would run them on a purchase. If I can do a refinance and like the numbers, I’ll hold the asset and refinance. If I don’t like the numbers, I might sell and look to find a better asset. If I do sell, I’ll make sure to do a 1031 exchange so I don’t have to pay capital gains tax! More on that in a later blog post.
This stuff is much easier to explain in person or on the phone. We’d love it if you would want to set up a meeting to learn more, or check out our video training where we discuss everything I just went over in the blog!