When real estate investors get started in the business, they often are hindered in their trek toward success by preconceived notions about the “right” kinds of deals and markets. Think Realty sat down with John Tesh, a former commercial photographer who has found he has an “eye” for real estate and more than two decades’ experience investing, and asked him to break down a crucial part of building long-term wealth that many investors overlook: identifying the “deal-breakers.”
“It’s almost always, not always, but almost always, a numbers issue,” Tesh explained, adding, “There is power in the numbers whether you are rehabbing, renting, flipping, or wholesaling. Get all the expert advice you want, but never forget the numbers.”
Think Realty Magazine: Let’s dive right into those numbers, then! Can you give me an example of a time the numbers worked in your favor?
John Tesh: Well, I have to preface this by telling you that when I started investing in real estate in the 1990s, the numbers helped me set my direction. I reached out to a lot of people about my long-term goals, basically long-term wealth-building, and those people who I trusted and liked immensely confirmed what the numbers had already told me: rental property is the key for that specific real estate goal. So they worked in my favor by setting me on what has been a highly successful, lucrative path over the past 20 years or so!
TRM: Those are some powerful numbers. Please give us an example!
JT: Now to get into specifics, I will talk about how to look at any property to determine to the greatest extent possible before you do the deal whether that property is a good investment for you.
First things first: cash flow is the name of the game for rentals. After I deduct all of the expenses from the rental income, I want a minimum of $250.00 a month positive income or the investment simply is not going to work. However, that’s just the beginning.
When you look at a property to determine how much it is really going to “cost” you to get it to that cash-flowing point, you are doing a valuation. There are a number of ways to perform valuations, and other people do it differently than I do. However, I will say that my process has worked for me, so you should at least give it some serious consideration.
I use this quick, easy “rule of thumb” to determine right off the bat if a property is worth the time it will take me to dig deeper into the numbers:
A property in a “nice” neighborhood may be assumed (for the purposes of weeding out deal-breakers only) to be worth 100 times what it will collect in rent under current market conditions, and a property in a “rougher” neighborhood may be assumed (for the purposes of weeding out deal-breakers only) to be worth 60 times what it will collect in rent under current market conditions. So if a property in a nice neighborhood is collecting $1,000 a month, then it may be assumed to be worth $100,000 minus the cost of any outstanding repairs. In a rougher neighborhood, that property may be assumed to be worth about $60,000 minus any outstanding repairs.
Of course, that is just the first elimination round! You cannot make assumptions about a property just using a standardized rule of thumb. You will need to look far deeper into the numbers before you make a final purchase decision.
TRM: Where do those numbers lead you next?
JT: Well, there are three really key calculations that you must be able to do for every property to determine if it is a viable rental investment. I’m sticking with rentals, here, because that is my specialty, but no matter what sector of real estate you prefer, you need to know these calculations.
First, NOI (Net Operating Income):
NOI is a calculation used to analyze investment property that generates income. Take all the expenses associated with that property away from the income to arrive at that number. If you continue with our current $100,000 example in the nice neighborhood that we mentioned earlier, then your numbers might look like this:
Purchase price: $100,000
Down Payment (20%): $20,000
Financing of remaining $80,000: 6% interest
Rent: $1,200 a month (the previous owner wasn’t charging as much as he should have been!)
Those are not all the numbers you need, though. You also need to know (by year):
Principal and Interest Payments: $5,916
Property Management Fees: $900
Maintenance Costs: $450
Taxes: $600
Insurance: $500
Total Expenses: $8,566
As you might imagine, these numbers will vary depending on the specifics of your deal.
Once you have all of this information, calculate your gross income by multiplying monthly rents by 12: $14,400 per year.
Now, subtract those expenses from the gross income: $14,400-$8,566 = $5,834.00. This means your annual NOI is $5,834. Using my personal benchmark of $250 or more of positive cash flow each month ($5,834/12=$486.00), I’m sold!
But don’t get too excited yet. Yes, I’m ready to buy this property, but only if the last two potential deal-breakers work out in my favor and if a few intangibles line up as well.
Next, let’s tackle Net Return on Investment (Net ROI or NROI). This is the return on the money you spend out of pocket on a deal. In our example, here, you only had to spend $20,000 on the down payment because the home was in great condition (and we’re trying to keep things simple). To get NROI, divide your annual Net Operating Income (NOI) by the amount you spent out of pocket on the home. In this case: $5,834/$20,000=29.17 percent. Again, not bad, but you are also still not done.
Finally, you will need to figure out your Capitalization Rate, or “Cap Rate.” A lot of times this number will play a big role in the sales pitch for commercial properties and larger multifamily properties, but single-family residential investors and vendors often use it to help them compare different properties to each other in a standardized way. You need to know exactly what it means and, furthermore, always ask them what values they used in order to get it.
Sticking with our example, we will determine Cap Rate by dividing the gross annual income: ($14,400) minus NOI excepting the mortgage ($8,566-$5,916=$2,450) by the purchase price of the property ($100,000). That gives you this equation:
($14,400-$2,450)/$100,000 = 11.95 percent Cap Rate
TRM: That’s a lot of math! Are we done yet?
JT: Not quite. There are a few “intangibles” that can also be deal-breakers. I make it a policy to avoid really bad neighborhoods, the “war zones.” Also, I steer clear of homeowners’ associations (HOAs) whenever possible because they tend to not be particularly “investor-friendly” and they not only charge annual fees but can change those fees pretty much at-will, which makes an investment less predictable. Sometimes the fees end up being more than the mortgage! If you do buy in an HOA neighborhood, do due diligence on the HOA as well as the property to determine how stable that association is: there should be money in a reserve account for unforeseen expenses and no major renovations on the horizon. Imagine if you bought a great condo only to learn that you were about to owe an extra $10,000 for a new roof on the building. That would change the numbers very quickly, and not for the better.
The final thing I would say is a potential deal-breaker is if you do not have a good team in place to manage your investment. That means you need an investor-friendly real estate agent, a good property manager, and a real estate attorney whose expertise is in the field, not in some other area of law. If you do not have the expertise or the time to handle these important facets of a deal on your own and you also do not have these team members in place, in my opinion that is a deal-breaker.
Don’t forget that “deal-breaker” means exactly what it sounds like: no deal. No matter how much you like the idea of doing a particular deal, if these factors do not hold up the odds are good you will regret your involvement in it.
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