What is a Rule of Thumb and How Can it Help your Real Estate Investing
When it comes to investing in real estate, it’s not as complicated as some make it out to be. Investopedia defines a rule of thumb as “a guideline that provides simplified advice regarding a particular subject,” and we’re here to show you that by adhering to several rules of thumb, you can be on your way to a successful career in real estate.
It’s important for beginner investors to learn certain investing criteria and formulas in order to properly analyze investment properties. Using rules of thumb will give investors an idea if the property is worth consideration. For example, our rule of thumb pertaining to cash-on-cash returns is that it must be producing a 10% return or more, which means that if the investment is only producing a 4% cash-on-cash return, it’s a big red flag to us that the asset is under-performing.
We’ll still examine the deal, but proceed with extreme caution. On the other hand, if the cash-on-cash return is 12%, then the investment meets our criteria and warrants further serious investigation. Keep in mind that each circumstance is different, so use each rule of thumb only as a guide.
The term “rule of thumb” is said to have originated with carpenters who used the width of their thumb to measure things. The term has also been associated with farmers who used their thumbs as a measurement to plant seeds the proper depth. In either case, you can see that the rule of thumb is an approximation, or a quick way to estimate a value. This technique can be translated into real estate in a way that you can shorten the amount of time you take to analyze a deal while still not rushing into a decision that isn’t right for you.
In this article, we are going to discuss the top three Rules of Thumb that we use to analyze deals. The first rule of thumb is Cash on Cash Return. A cash on cash return is simply the return an investor receives on the amount of “cash” that is invested in the deal. To calculate this figure, take the annual cash flow from the property and divide by the TOTAL cash invested. For example, if you receive $10,000 in cash flow and you invested $100,000 in cash, then your return would be $10,000/$100,000 = 10%.
We strive to put in as little of our capital as possible in order to obtain the highest return of capital back as quickly as possible. The goal of any real estate investor is to control as many properties with as little money invested in each deal as possible. This strategy will explode your wealth because each property “should” be cash flowing, and each property will be appreciating in value. Our number one rule is to buy properties that cash flow every month. We will never purchase a property that has a negative cash flow. Investors call these properties alligators because they will eat you alive, just like an alligator.
Our rule of thumb for cash on cash return is that we strive for a 10% return or greater, based on actual performance. ALWAYS analyze properties based on actual numbers, not some seller’s rosy proforma figures. If the property has the potential to generate substantially higher returns once it is repositioned, then we are willing to drop that figure to 7-8%. Just make sure that you can raise the income or lower expenses to raise the return.
The second rule of thumb we use is Debt Service Coverage Ratio. Calculating the DSCR is vital when applying for financing with a bank. It’s the ratio between a property’s Net operating income (NOI) and the total annual debt service of the property. NOI is calculated as the total revenue of the property less operating expenses.
It’s calculated as follows: DSCR= NOI/Annual Debt
Example: If the DSCR on a property is 1.0, then the property is generating just enough money to pay the mortgage. There will be nothing left over to pay any expenses. The rule of thumb is that banks are looking for a DSCR of at least 1.2, and we strive for a DSCR of 1.3. At that point, the property is producing 30% more revenue than the cost of the mortgage, practically guaranteeing that you’ll meet all of your obligations and have cash flow left over. You can tell when the market is reaching a bubble when banks drop their DSCR below 1.2.
The third rule of thumb we use is called the Capitalization Rate, which is defined as the rate of return you can expect to receive on a property, excluding any debt service. The cap rate is used to determine the asset’s current value. It’s just one way of determining value without any leverage on the asset.
The Cap rate is calculated as follows: Cap Rate =NOI / value
Example: If a building has an NOI of $50,000 and it was selling for $500,000, then the cap rate would be 50,000/500,000=.10 or 10%.
You can also calculate the value by doing: Value = NOI/cap rate
Example: If a building with a $100,000 NOI has a cap rate of 10%, then it would have a value of $1 million dollars as calculated by doing 100,000/.1= $1,000,000.
Cap rates have an inverse relationship. A higher cap rate denotes a lower value and vice versa. In the example above, if the cap rate was 11% and you had an NOI of $100,000, then the value would calculate to 100,000/.11= 909,000. A cap rate of 9% would yield a value of $1,111,111.
Remember, the less you pay for a property, the higher the rate of return on your investment; the more you pay, the lower your return. Markets that are considered “hot” tend to have lower cap rates.
Our rule of thumb for cap rates is that we purchase assets with at least an 8 cap. Location and property type affect the cap rates of an apartment building, but we see no sense in investing in an asset that yields less than an 8 cap because there is too much work involved. You need to be compensated properly for the additional risk and work involved in managing the asset. In a normal market, cap rates hover anywhere from a 7 to a 12 cap.
We hope you’ve enjoyed this article on Rules of Thumb. In our next article, we are going to delve into more rules of thumb. Let us know if you use any rules of thumb when analyzing deals.