Dan John, the brilliant athletic coach, sometimes refers to the Jim Gaffigan riff on Mexican food as a way to understand the basic principles of, well, almost anything.
“Mexican food’s great, but it’s essentially all the same ingredients, so there’s a way you’d have to deal with all these stupid questions. “What is nachos?”. . . “Nachos? It’s tortilla with cheese, meat, and vegetables.”. . . “Oh, well then what is a burrito?”. . . “Tortilla with cheese, meat, and vegetables.” . . . “Well then what is a tostada?” . . . “Tortilla with cheese, meat, and vegetables.”
As with Mexican food, no matter what the investment might be the same fundamentals continue to appear: (1) cash flow and (2) gain on sale. Both figures are typically (a) annualized and (b) expressed as a percentage of the owner’s contribution (normally, the down payment and closing costs).
Before Tax Cash Flow (BTCF) consists of the annual income left over after all building related expenses are deducted from the rent received before any net tax benefits (depreciation).
Depreciation: You can’t count depreciation benefits at 100 cents on the dollar because nobody is yet taxed at 100%. Just apply your marginal tax bracket to that year’s depreciation figure and that’ll be the tax benefits applicable to cash flow.
For example, if you take $50,000 in depreciation allowance and your tax bracket is 30%, then $50,000 x 0.30 equals $15,000 of additional cash flow due to tax benefits. That $50,000 you wrote off saved you $15,000 in hard dollars. It’s fair to add the cash savings from tax benefits to the building’s net cash flow to get After Tax Cash Flow (ATCF). If you deduct for depreciation on your tax returns, ATCF is almost always bigger than Before Tax Cash Flow.
Cash Flow (BTCF): Assume a 10 unit building with each apartment rented for $1,500 monthly. Before Tax Cash Flow is estimated by the following:
Gross Scheduled Income (GSI) = $180,000
GSI reflects the gross income the building should generate if each unit were rented every day of the year for the rent indicated on the “schedule”.
Less vacancy & credit losses = (9,000)
Vacancy (empty units) and credit losses (bounced checks; deadbeat tenants) are largely – but not always – at least partially management dependent so we try to estimate using a “best guess” neighborhood average. In this case we used an arbitrary 5%.
Effective Gross Income (EGI) = $171,000
EGI is the amount actually received.
Less Fixed & Variable Expenses = (65,000)
Fixed expenses are those bills that must be paid even if the building sat empty. Things like real estate taxes, landscaping, and exterior maintenance come to mind. A variable expense fluctuates with the building’s population. Interior maintenance and the water bill will be higher if the college student who just rented your unit decides to move his entire fraternity in with him. A proper allowance for expenses would include an annual reserve for capital improvements. In terms of reserves, most lenders right now seem to think that $300 (+/-) per unit is appropriate. That means that a properly reserved ten unit building, if no capital improvements were charged against the reserves, would accumulate $30,000 over 10 years. This would be included in the line item “Reserves”. Capital improvements are those things that are expected to last more than one year. Cleaning the oven is not a capital improvement; replacing the oven is. The mnemonic for expenses is TUMMI (Taxes, Utilities, Management, Maintenance, and Insurance). You have to remember “Reserves” by yourself, and some people forget that part. In this example we used a total expense ratio of 38% of EGI (includes reserves).
Net Operating Income (NOI) = $111,000
The NOI is probably the most important number in the investing process because (a) it’s what you could put in your purse if you’d paid cash for the building; (b) if you don’t pay cash, the NOI determines the maximum loan the building will support, and (c) the NOI is the denominator in the capitalization formula. The capitalization process changes a stream of income into a value. It doesn’t make any difference whether you’re a buyer or a seller or even the heir, everyone is interested in value.
Let’s assign a hypothetical value of $2,250,000 to this 10 unit building ($225,000 per unit). A cash purchase would generate a cap rate of 4.9% ($111,000 divided by $2,250,000). It’s important to remember that a cap rate assumes an all-cash purchase. That takes leverage out of the picture and makes it possible to compare different streams of income. The 4.9% cap rate could reasonably be one of the metrics used to decide between competing investments. “This building promises a 4.9%, but that one on the river offers only 4.3%. Or I could just buy bonds. The U.S. Corporate Bond Index is pretty much management free and won’t interrupt my acting classes, but it offers only 3.04%. What’s a girl to do?” If we didn’t have the cap rate metric, there’d be no sound way to decide between apples and oranges, but the cap rate standardizes investment yield. It reduces every investment to a yield on the Before Tax Cash Flow. The cap rate, like Google, is your friend.
Still, it’s only one metric and your main interest may not be in maximizing your yield. I know. Sounds silly, doesn’t it? But what if you really, really don’t want tenants calling during your acting classes, or especially when Angus comes over? You may postpone the units and choose a bond fund, at least temporarily, because you’d be free to learn acting and available for Angus. Not every investment choice is cap rate based.
What would happen if you mortgaged the property? Say the purchase price was $2,250,000 and you put $750,000 (33%) down and borrowed the remaining $1,500,000. What then?
Your cap rate is still 4.9%. The cap rate doesn’t change just because you decide to spend some of the Net Operating Income on mortgage payments instead of Jimmy Choo’s. The NOI is still the denominator and the purchase price (or value) remains the numerator. Nothing changes there. But since the building is now leveraged, your actual yield will no longer be the same as the cap rate. Determining the new yield takes three steps.
- First Step: NOI divided by a debt service ratio of 1.20 equals $92,500 available for loan payments. The DCR just tells us how much the lender will permit for principal and interest payments. If rates go up, the loan amount will go down.
- Second Step: NOI minus Debt Service equals Before Tax Cash Flow ($111,000 minus $92,500 equals $18,500).
- Third Step: Cash Flow divided by down payment ($18,500 divided by $750,000) = 2.5% cash flow yield. That doesn’t sound too good, does it? Wait. That 2.5% will grow over time. Besides, we’re talking total return here, and that’s only the cash flow yield. There’s also equity build up and tax benefits. We’re noting that tax benefits exist, but will not include them in Cash Flow because people’s tax brackets vary widely.
Every month as your tenants make your mortgage payment, a little of it goes towards principal. After 30 years the amount borrowed will be paid off. So, in this example, we borrowed $1,500,000 for 30 years, or an average pay-down (equity build-up) of $50,000 annually. Equity build-up divided by the original down payment ($50,000 divided by $750,000) indicates an equity build-up (not including appreciation) yield of 6.7%. So far the total return in this example averages over 9% (2.5% plus 6.7%). It’ll probably increase as your Cash Flow grows over time.
OK. So now you’ve had the building for thirty years and it’s time to move on. What happens when you sell it? Let’s assume the cap rate trends sideways for the next three decades, which means that you’ll sell it at exactly the same cap rate you paid for it. Inflation, however, averages 4% annually and your NOI compounds with inflation. After 30 years your loan is finally paid off and – that same afternoon – you sell the property. Over time, the original $111,000 NOI grew to $360,000. Capitalized at 4.9% that $360,000 stream of income would be worth about $7,300,000 ($360,000 divided by 0.049). Pretend the buyer absorbs all the closing costs. You’ve now turned your original down payment of $750,000 into $7,300,000 in 30 years, for an average return of 7.88% per year (compounded). Don’t you love that? You can spend all the cash flow and your principal still compounds nicely.
Total Return reflects after tax cash flow (ATCF) plus gain on sale. Gain on sale is composed of appreciation and equity buildup. After Tax Cash Flow includes Cash Flow plus the cash value of whatever tax benefits you received. Because tax benefits are, ahem, subject to change we tend to weight them a little less.
Rental properties usually have all four investment benefits (review: appreciation, depreciation, equity build-up, before tax cash flow). Other investments may (probably?) have fewer. Some of those four components could even be “zero”. Perhaps you paid cash for the property (no equity build-up) or you got an interest only loan (again, no equity build-up).
Playing off Jim Gaffigan and his riff on Mexican food . . . “Investments are great, but it’s essentially just two ingredients, so answering the questions are easy.
“How do I figure what I’ll make on that stock?”. . . “Stock returns? Add After Tax Cash Flow and gain on sale” . . . “How do I figure what I’ll make on that bond?”. . . “Bond returns? Add ATCF and gain on sale”. . . “How do I figure what I’ll make on that investment property?” . . . “Investment property? Add ATCF and gain on sale”.
Sidebar: I hope you remember that we’ve written that a good location is where a lot of rich people live and that these places are often characterized by lack of buildable land. We have a low hurdle for what “rich” is. For our purposes, it’s having an “above average income”. If you want to compete with existing apartments in Manhattan, you’ve got to buy an existing building and tear it down before your construction can start. By the time that little bagatelle is built into the sale price, only people with above average income (and possibly an inheritance) can afford to live there. On our coast, it’s similar in many desirable areas. Pretty much anywhere rich people hang out, there’s a shortage of empty lots. That is so common that it might be another way to look at “location, location, location”: buy where there are few or no empty lots.
It isn’t that every lot has to be already built on. It’s that no more lots will be available. There’s a difference. Thomas Sowell recently referred to huge amounts of land standing vacant in the San Francisco area because local “open space” regulations forbid development.
In those areas, existing property owners can make out quite well. “One couple”, Sowell writes, “lived in their 1,200 square foot house in Palo Alto for 20 years (before they) decided to sell it, and posted an asking price of $1.3 million. Competition for that house forced the selling price up to $1.7 million.” For perspective, a 1,200 square foot house is about the size of three two-car garages. Next time you’re at the mall look at the space occupied by six parked cars.
Disclaimer: This article is for informational purposes only and is not intended as professional advice. For specific circumstances, please contact an appropriately licensed professional.
Klarise Yahya is a Commercial Mortgage Broker. If you are thinking of refinancing or purchasing five units or more, Klarise Yahya can probably help. Find out how much you can borrow. For a complimentary mortgage analysis, please call her at (818) 414-7830 or email [email protected].
If you’ve missed some of the prior articles, basic beginner guidelines on successful investing are in my book “Stairway to Wealth” available at www.LuLu.com.