Real Estate Investing 101: Cash Flow
The market in Beverly, Massachusetts
In this blog post I am going to discuss the basics of real estate investing. I emphasize basics, because it is important for people to do their homework before investing. Yes, real estate can make you rich, but it can also go wrong; and understanding the risks are as important as understanding the rewards. A good rule in investing is, if it seems too good to be true, it probably is. No Instagram influencer has the 4 tips that are going to make you rich overnight. In this post I am going to cover 3 basics to investing: Why invest in real estate, why not to invest in real estate, and a quick numbers overview. At the end of this blog post I will provide links to a few books that I believe are a good way to continue educating yourself on investing and learning the basics. As always, please reach out if you have any questions. The multi-family market is particularly hot in Beverly, Massachusetts right now, and I love to help buy and sell investment properties.
Why invest in Real Estate?
Cash Flow
Most people invest in real estate because of the positive cash flow from rental income, and the long term gain of holding a property that gains value over time. Taking out several 'bubble bursts' and economic downturns, real estate typically gains value over time. If you can have someone else pay for your mortgage, earn extra cash, and then cash out for more than you paid....this ends up being a great investment. A way to measure the 'someone else pay your mortgage' part is typically known as Debt Service Coverage or Debt Coverage Ratio among investors. Debt Service ratio is calculated by NOI (net operating income or the revenue generated after expenses) divided by your mortgage payments; you better plan to make more than you borrow.
Diversification
Investing in real estate can be a good way to diversify your entire portfolio. Real estate can have low correlation to other investments, and investing in real estate can round out your overall portfolio.
Value over Time
The graph below shows real estate values over the past 36 years. You can see for the most part, it is up and to the right...a good thing when you are investing. The green line is the Boston area, and you can see how that has outpaced the U.S. market which has also steadily increased over the last decades. This graph is an index, with Boston starting at 100 and and reaching close to 800 in 2016, which means if you bought a home in 1980 for $100,000 it would be worth $800,000 today. Read more and see more graphs in this Economist article.
A few reasons not to invest in Real Estate:
It is not a liquid asset
If you ever run into any personal issues or need money fast, you cannot just cash out of your investment property. It takes time to sell a home, and to get the most value, you want to sell at the right time. If you hold a home for too short a period you may end up losing money. Real estate is a long-term play.
Being a landlord isn't always fun
Tenants can be difficult and can cause headaches for landlords. Remember as a landlord, if someone doesn't pay the rent you have to be the one to ask for it. If someone leaves the home a mess when their lease is up, you are the one that needs to clean it. It has its rewards, but it is not for everyone. Before jumping in, ask yourself "Am I up for the challenges"
Numbers you should care about
We have already covered DCR which if you haven't paid attention to, your lender certainly will. A few other numbers you should know about before investing: capitalization (cap rate), Net Operating Income (NOI), & local rents
Net Operating Income (NOI)
The net operating income, known as NOI, is the income after your expenses. To calculate net operating income, take the gross income (typically from rent) and subtract expenses (maintenance, insurance, utilities, taxes, vacancy, water/sewer etc) to get NOI.
Cap rate:
The capitalization rate (known as cap rate) is one of the most common numbers in real estate investing. The cap rate essentially tells you how much money you will make on the property compared to how much you are going to pay for it. To calculate the cap rate, take the NOI divided by the cost of property or the value of the property. So, if you are looking to buy a multi family for $1,000,000 and the NOI is $100,000, the cap rate is 10%. What is a good cap rate is a bit more difficult to capture in a blog post. A low cap rate could mean that the rents are below market value (which means it is your responsible to bring those rents up to market value), or the property is overpriced; if a high cap rate has rents below market value (you are getting a steal). It is important to look at the entire picture of a property and its value. *Property condition does matte
Local rents:
Understanding local rents is extremely important when buying an investment property. You may look at a property with low NOI, low Cap rate, but if you know their rents are under market value..you may have a steal on your hands. On the flip side, if a property has a high Cap rate, make sure those rents are actual market value and no one is inflating rents trying to pull a fast one.
More Reading
OK, so now you have the basics, and remember...basics! Please feel free to reach out to me if you would like to learn more, or here are a few books that I believe are useful to new investors:
The Wall Street Journal. Complete Real-Estate Investing Guidebook
What Every Real Estate Investor Needs to Know About Cash Flow
The Snowball: Warren Buffett and the Business of Life (This one isn't about real estate but a great read for anyone who wants to learn anything about investing)