With the last recession in 2008 in the real estate market, many people forgot what a good investment property can do for your finances. It’s true that some real estate investors were burned by some of the properties they bought. But for those who only buy using sound ROI principles, real estate remains a great investment.
Today, investing in an REO investment property may make sense if you buy right. Here are some key factors to help you buy “right.”
1) Positive cash-flow?
2) Cash-on-cash return?
3) Pay-back period?
4) Exit strategy windows?
Let’s start with number 1) Positive cash-flow. The simple equation is income from rent minus expenses. If you can rent your investment property for $1,000 per month and your mortgage is $510 per month, then your cash-flow is $500 per month. You would still need to subtract insurance, property taxes, any utilities, and a vacancy reserve.
* Insurance = $70 per month* Property taxes = $100 per month* Utilities = $30 per month* Vacancy at 2 months per year = 2 * $510 = $1,020 per year = $85 per month
Total expenses outside of mortgage = $285
Total expenses = $510 mortgage + $285 = $795.
Cash-flow = $1,000 – $795 = $205 per month.
So in this example, the investment property passes our cash-flow test. We would earn $205 per month in cash-flow.
Now let’s check number 2) Cash-on-cash return. For our example, we are looking at a $100,000 house with 20% down or $20,000.
The cash-on-cash (COC) is ($205*12)/$20,000 = 12% per year
COC doesn’t mean much when you take it in a vacuum. So we compare it to what you would get had you put your money in a “safe” investment like a T-bill. Today’s 10 year T-bill rate is 3.5% according to the US Treasury. Our 12% looks pretty good compared to 3.5%. But investing in real estate is riskier than putting our money in a T-bill. So to take it one step further, we figure out our “risk-adjusted return” or RAR.
RAR = 12% – 3.5% = 9.5%
So does this pass our cash-on-cash test? This also depends. But if we have a rule for ourselves to expect a 2-times return on the additional risk that we take then yes, this passes our test…
2 times 3.5% = 7%.
Since our RAR of 9.5% is greater than 7%, we pass our criteria.
Let’s move on to number 3) Pay-back period. A real estate investment property is a long term play. You saw that we compared our RAR to a 10-year T-bill. Expect to hold the investment for many, many years.
However, we do want to know when we will get our initial investment of $20,000 back. Based on the projected net cash-flow of $205 per month, we would get back $2,460 per year. In a little over 8 years, we will get our $20,000 initial investment back. So our payback period is 8 years. Since this is less than the 10-year T-bill maturity, I would say that we’re okay with the pay-back period test.
Our last test, number 4) Exit strategy windows is also important. Even though we may have all the right intention to hold our investment for the long-term, 8 years in this example, something can come up that would require us to shed our investment earlier than planned. Is there a way to sell the investment property without incurring a loss? Is there a way to sell it for a profit?
Ideally, you would be able to answer yes to the two questions above. Luckily, since the property passed tests 1 to 3, it will almost always be easy to sell. Why is that? Let’s take a look…
The historic rate of return that has investors excited has been 10%. Our investment yields a COC of 12%.
We can safely expect our investment property to go up 2% per year due to inflation. This makes it a better value over time.
If we reinvest our cash-flow in a T-bill, we would accelerate our pay-back period. This is slightly cheating, but earning income is earned income.
This property passed test number 4.
So if real estate is such an attractive investment, why did so many people get burned?
… They violated tests 1-4.
But for investors who do follow the rules, what can they do with the $205 per month cash-flow? …
How about using that money to lease a car like a Toyota Camry? For free? For as long as they want?
Isn’t that nice? Having the right REO investment property makes this possible.