March 2012

How do you add $200,000 or more in value overnight on your investment property? Easy! Just sprinkle on some magic fairy dust! But if you are like me and used up the last of your fairy dust on your last flight to never-never land with Peter, you are in luck. You can still add incredible amounts of equity on your property, without magic, by using cap rates.

What Is A Cap Rate?

A cap rate is a tool used to discover the value of an income producing investment property. They are needed because, unlike single-family homes, most multifamily and commercial buildings vary significantly from one another – making it difficult to compare apples-to-apples. For example, it is fairly easy to determine the value of a remodeled 1200 square foot three bedroom, two bathroom home by simply looking at what other similar homes have sold for recently. However, trying to find similar sales of a 24-unit apartment building with a jumbled mix of one-bedroom and two-bedroom units in a low-income area proves to be too difficult. There are simply too many variables to use comparable sales as a means to determining value. Enter the cap rate.

The Cap Rate is a formula which lets us know the relationship between value and the amount of income a property delivers. I know this sounds confusing, and I’ll try not to throw too much math at you – but if you bear with me for two more minutes you will see why this is such an important piece of knowledge. Lets look at the formula (written three different ways) for determining a cap rate:

 

A.) Cap Rate = NOI / Market Value.

Or

B.) Market Value = NOI / Cap Rate

Or

C.) NOI = Cap Rate x Market Value

 

Let me explain. The NOI is the Net Operating Income. This is a term you will hear often which simply means the annual income left over after all the bills – except the mortgage – are paid. So, if a property makes $120,000 per year in rental income, and has $50,000 per year in non-mortgage bills (utilities, taxes, insurance, vacancy rate, etc), the “NOI” for the property would be $70,000.

Remember how earlier I mentioned that houses are compared with each other to determine value? With multifamily and commercial investments, it is the cap rate that is compared. If a nice apartment complex in Seattle recently sold at a 6.5% cap rate, it is safe to assume that other nice apartment complexes in Seattle will sell around a 6.5% cap rate. Generally ranging between 5% and 12%, the cap rate changes significantly from one location to another.  In general, the higher the cap rate, the higher the cashflow.

If you want to determine the average cap rate for your area, ask a seasoned real estate sales agent that specializes in commercial or multifamily properties in your town or use the above equations to determine the number for yourself. It is best to analyze a number of properties and determine their cap rates and average your results.  To help make this concept clearer, lets look at a possible scenario as an example.

The Example of Farmer Fred

Farmer Fred is trying to determine the value of his 24 unit apartment building. Last year, he collected $154,500 in rents and spent $75,000 in bills (not counting his mortgage payments). Therefore, he knows that his net operating income (NOI) was $74,500 last year. To find the value of his property, Farmer Fred must first find the cap rate. To do this, he looks at another property that has recently sold:

Property X recently sold for $1,500,000. It’s NOI is $100,000. Therefore, using Equation A above, (Cap Rate = NOI / Market Value) we find that $100,000/1,500,000 =.0667. Farmer Fred has now discovered that Property X sold at a 6.67% Cap Rate.

Fred analyzes four other properties and knows that this cap rate is the average for his area and his style of property, so he uses this number to determine his value. Using equation B above, Farmer Fred knows that the market value of a property = NOI/ Cap Rate. Therefore, Farmer Fred computes  $74,500  / .0667  to find that his apartment complex is currently worth $1,116, 941.53.

So How Does This Help Me?

Earlier I described cap rates as the magic fairy dust of a real estate investment – sprinkle them on and whatch your investment fly! Okay, they may not physically lift off the ground but they will take you to new heights nevertheless. Here’s how:

You do not have a lot of control over a cap rate, but you do have a lot of control over your NOI (net operating income). Remember, your NOI is the amount of income that comes in during a year minus your operating expenses (but not counting your mortgage payment). Changing your NOI can dramatically change the equation, resulting in a much different market value. How do you change your NOI? There are two ways:

      1. Decrease Expenses

There are many ways to decrease expenses. Effective management, better marketing, fewer vacancies, lower utility costs, use a resident manager instead of high-cost property management, etc. Most properties are not run at their highest efficiencies, and many times there is dramatic room for improvement.

      1. Increase Income.

Often times, rents can be increased without negatively affecting your vacancy. If so, do it. If not, there are other ways to increase income. Enforce fees more effectively, rent out storage rooms for extra income, or increase prices on (or add) laundry services.

Simply put, when your expenses decrease or your income increases, you end up with more money in your pocket. More extra money means a higher NOI, which means the value of your property is increased. 

Adding $200,000 in equity overnight:

 Let’s look back at our example of Farmer Fred. Fred looks at the property he just bought and notices several things. He is currently paying $15,000 per year for property management. He knows that an on-sight resident manager can do the job in exchange for free rent, saving him $8,000 per year. He also decides that his rents are a little below average for the area, so he increases his rent by just $25 per month per unit, bringing in an extra $300 per unit, per year or $7,200 in extra income per year total.

Doing just those two small acts, Farmer Fred immediately begins keeping an extra $15,200 per year. To Farmer Fred’s wallet, this is awesome; but even better, in investment lingo, his net operating income just increased by $15,200. His old NOI was $74,500, but now is $89,700. Now, keeping the same cap rate from before and using the new NOI value, Equation B (NOI/Cap Rate = Market Value) now shows:

$89,700/.0667 = 1,344,827.59. Farmer Fred has increased the value of his property from $1,116,941.53 to $1,344,827.59, a total change of over $200,000.

Even if you do not yet own a piece of real estate, imagine how powerful cap rates can be on a property that is under-performing because of poor management.   You are in a terrific position to purchase the property at a discount, improve the property, and resell it some day for the new value that you have created.  While harnessing the power of cap rates may not be magic, the results can nevertheless do wonders for both your future and your bank account.

I do not like nuts. Pecans, almonds, peanuts, walnuts, cashews, and all other nuts make me cringe. So when I open up a gift box of assorted chocolates, I tend to panic a bit, desperately desiring the milk chocolate goodness with the soft caramel inside but fearing the dreaded trojan horse filled with nuts and evil. When I choose wrong, I spend the next hour spitting tiny shards of nuts out of my teeth and vowing never to eat another chocolate from the mystery box again. For those who know me, though, that is a short-lived promise.

Real Estate Investments are like a box of chocolates. No, not in the Forest-Gump-Never-Know-Whatcha-Gonna-Get kind of way. Rather, there are many different types of investments all within the same “investment box”. Some might appeal to one type of person, some might appeal to another type of person. However, each investment uses most of the same basic principles and fundamentals.

Just as I tend to focus in on the caramel-filled chocolates in the box, I also have focused in on my niche in the field of real estate investments – small multifamily properties. However, you might be different. Your background, relationship to risk, family life, and your location may all affect which area of real estate you will begin investing in. The following is a brief summary of the nine major types of real estate investments.

Types of Real Estate Investments:

  • Raw Land –This is as “raw” as it gets (see what I just did there!). Purchasing land usually does not produce cashflow, but can be improved to add value. Land can also be subdivided and sold as well for profit.
  • Water/Mineral/Oil/Gas Rights – The cousin of investing in raw land, this is the process of buying and selling a person’s (or company’s) right to use the minerals (or water, oil, gas, etc) on a property.
  • Single-Family Homes – This is the most common investment for most first time investors. Single-family homes are easy to rent, easy to sell, and easy to finance. Single-family homes may be more difficult to cashflow, and can take a significant amount of time and effort to purchase just one unit.
  • Duplex/Triplex/Quads- Small multifamily properties (2-4 units) such as these are one of my favorite investment routes. These property types combine the financing and easy purchasing benefits of a single-family home with the cashflow benefits and less competition found in larger investments. Best of all, these properties can serve as both a solid investment as well as a personal residence for the smart investor. See “Getting Started Investing in Real Estate – Part 3: Creating Criteria” for more information.
  • Small Apartments - Another favorite of mine, small apartment buildings are made up of between 5-50 units. These properties can be more difficult to finance, as they rely on commercial lending standards instead of residential lending standards. However, these properties are excellent in terms of cashflow. They are too small for large, professional REIT’s to invest in (see below) but too large for most novice real estate investors. Additionally, the value of these properties are based on the income they bring in. This creates a huge opportunity for adding value by increasing rent, decreasing expenses, and managing effectively. These properties are a great place to utilize on-sight managers who manage and perform maintenance in exchange for free or decreased rent. At this level, real estate can truly become 90% passive.
  • Large Apartments - These buildings are the larger, nicer complexes you see all around the country, often times in upper-middle class neighborhoods in the suburbs. They often include pools, work-out rooms, full time staff, and high advertising budgets. These properties cost tens of millions of dollars to buy but can produce solid returns with minimal hassle.
  • REITs- REIT stand for a Real Estate Investment Trust. At the risk of oversimplifying, a REIT is to a real estate property as a mutual fund is to a stock. Many investors pool their funds together, forming a REIT, and allow the REIT to purchase large investments such as shopping malls, large apartment complexes, and skyscrapers. The REIT then distributes profits to investors. This is one of the most hands-off approach to investing in Real Estate, but do not expect the returns found in hands-on investing.
  • Commercial- Commercial investments can vary significantly in both size and style, but ultimately involve leasing property to businesses. Many commercial investors lease buildings to small local businesses, while others rent large spaces to supermarkets or big box superstores. While commercial properties often provide good cashflow and consistent payments, they also have much longer holding periods during times of vacancies. While most residential properties can be rented within weeks, commercial property can sit empty for months or even years. New investors should avoid these types of investments until they have significant cash reserves to weather the vacancy storms.
  • Notes - Investing in “notes” involves the buying and selling of paper mortgages. Often times an owner of a property may choose to offer financing and “carry the mortgage”. In this case, a “note” would be created which spells out the terms of the contract. For example, an apartment owner decides to sell his property for one million dollars. He offers to carry the full note and the new buyer will make payments of 8% per year for thirty years, until the full one-million dollars is paid off. If that owner suddenly needed to get the full balance of the loan, he might choose to sell that mortgage to a “note buyer” for a discount. That note buyer will then begin collecting the monthly payments and decide if they will keep the note or try to sell it for profit.

As you can see, there are a lot of different types of investments and within each type there are sub-types as well and different roles within those sub-types. This may seem daunting, but the wide variety of different types of investments is actually a great thing, as there is a type of real estate that appeals to almost everyone.  For me, I love finding under-developed small multifamily properties and adding value to increase cashflow and equity. That is my chocolate with caramel.  What is yours?

Today is the final post in my four part series discussing the steps necessary to begin a venture into the real estate investing game. In step one I discussed the necessity of gaining a solid educational foundation before doing any investing. In step two I explained the process for formulating an investment plan that will free you from the evils of the 9-5 rat race. In step three I discussed why choosing to invest with a small multifamily property makes the best first investment. Finally, today we are going to look at the nuts and bolts in actually purchasing your first property.

Meet With a Mortgage Professional:

Before searching for the exact property you want, you need to know what you will be able to afford. A mortgage lender will help you determine exactly what you can expect in terms of financing. However, while most financial institutions abide by the same lending standards and rules, all lenders are not created equal.  You need to find a lender who is punctual, professional, and resourceful. The best way to do this? Call up several local real estate agents and ask them for their recommendations for who can close a loan the best in your town/county.  Real Estate agents rely on good lenders to get loans through to closing, so you can usually trust that the best lenders consistently get the best referrals from agents.

Once you are confident in a lender, have a sit down meeting with them. The meeting is free and painless, and you will leave with a much greater understanding of where to go next and what you can afford. Remember that the best lenders are also usually the busiest, so be punctual and prepared. Find out what they need you to bring to the meeting and be as organized as possible.

Meet with a Real Estate Agent:

A Real Estate Agent should be your best friend when deciding what property to buy, and the best part – they are generally paid by the house seller – which means, for you, they are free!  They will help you sort through the thousands of listing and (hopefully) find you a property that fits perfectly with your needs.   To find a good agent, ask around for referrals and then actually interview the agents. Find out if you click well with their personality, learn how many properties they have helped buyers purchase in the past, what kind of investing they do, what kind of schedule they work during, etc.  Meet with at least three agents and choose one that you think will best suit your needs.

The agent will guide you through to the end of the process. A good agent will:

  • Take you on a personal tour of any home that is for sale.
  • Prepare detailed analysis’ of homes that have been listed, sold, or pending.
  • Not be pushy or try to sell you something you don’t want/need.
  • Draft and submit offers for you when you find the perfect property.
  • Be willing to submit many offers, knowing most will be rejected for being too low.
  • Help you negotiate with the seller to get you the best price.
  • Walk you through to closing and handle any hiccups that might occur.
  • Get you connected with the Title and Escrow Closing Company or Lawyer (depending on your state’s process).

While your agent is your best friend in finding a house, there is one more buddy that is just as important – the internet. Once you have your criteria in place and know how much you can afford, you can spend all the time you’d like searching for your new home online. Sites like Realtor.com and Redfin.com are excellent sites that will help sort through the glut of homes and find ones that might be good possibilities. Then, call your agent with the list of homes you have compiled and have them arrange tours. It really is as simple as that.

Close the Deal

After your offer has been accepted by the seller, you will have usually 4-6 weeks until “closing”. During this time you will perform your “due diligence” (inspections, solidifying financing, checking out the properties financial records, etc) and the closing agent will prepare the legal documents necessary to close. Depending on what state you live in, a lawyer may perform these tasks or a Title and Escrow company may perform them. Either way, the process is similar.  Once the wait is over, financing in place, signatures signed, and the title recorded at the county – you will collect the keys, collect the security deposits (if tenants currently rent) and begin collecting the rent. Congratulations! You have now begun your new career as a real estate investor.  You are now one step closer to financial freedom and living the life you want to live.

 

This article is part three in a four part series on Getting Started Investing In Real Estate (to read part one, click here or to read part two click here) I first explored the importance of gaining an educational foundation before anything else in real estate. Next, I explained the necessity of creating a plan so you are not wandering like the Old Testament Hebrews in the desert. Today, it’s time to formulate the criteria for the house you will be searching for.

What Your First Investment Should Look Like

Your first purchase should be your own home. However, in the words of Robert Kiyosaki and his Rich Dad Poor Dad book, “Your home is not an asset. It is a liability”.  In other words, a typical home – while it may increase in value over time – is not an investment.  It will usually end up taking money out of your pocket, not putting money into it.  That’s not to say it isn’t important, but how can you combine the need for shelter with an investment that makes sense?

Simply, don’t follow the blind masses and go search for that perfect home with the white picket fence that pushes the bounds of what you can afford.  You will have plenty of life ahead of you for that home and much more if you desire.  However, if you want to build a solid foundation for using real estate to fund your life adventures, you need to buy the correct house that is an asset to you and fits with your investment plan.

What should I buy?

I recommend that you look into a small multifamily building such as a duplex, triplex, or 4-plex.

Why?

A small multifamily property has several distinct reasons for making it the ideal first purchase.

  1. Easy To Finance: Multifamily properties with 2-4 units are as easy to finance as single-family homes. You can get into a home for around 3.5% down payment and ask the bank to pay the closing costs. If the property is already filled with tenants, you will also receive the security deposits from the existing tenants when you take over.
  2. Easy to Gain Experience: Multifamily properties will get your feet wet in the landlord business. I’m not saying you need to be the one fixing toilets at 3 a.m. (see my 5 Tips for Hassle-Free Tenant Management). However, the experience you gain from these small units will translate into a lifetime of headache saving skills.
  3. Easy to Cashflow: When starting out in Real Estate, your goal should be to get your cashflow as high as possible. This means the money that goes out in bills must be much less than the money coming in. As landlord – you get to keep the difference. This is cashflow.  Multifamily homes are generally much easier to get good positive cashflow on, thus they are the perfect tool to get you out of your day job and on with your life.
  4. Less Competition:  Small multifamily houses are outside the radar to most home buyers, so the law of supply and demand is on your side in getting a killer deal. Less competition = a better deal for you.

Are you going to fail miserably if you go out and buy a typical single family home as your first purchase? No. However, the financial benefits of a multifamily home will put you far ahead in your investing career and set you up for a higher likelihood of success. Tomorrow’s post will be the last in this series and will focus on the actual steps to purchase your first home.

Leave a comment below and then click here to go to part four in this series “Getting Started Investing in Real Estate”

This article is part two in a four part series on Getting Started Investing In Real Estate (to read part one, click here).  Last time I discussed the important of building upon a solid foundation before jumping into the investing game.  I cannot stress enough the value of getting a firm grasp on real estate fundamentals before buying your first property.  However, you don’t want to live in a perpetual state of learning forever. Education is only as good as the results it produces. It’s time to make a detailed plan on how to put that education into action.

Many investors skip step two and instead just jump right into buying their first property. This is not only a decision that will cause years of aimless wandering and untold headaches, but also marital stress, wasted money, and financial bankruptcy. Do not skip step two. Instead, grab some paper and a pen and lets get started. Yes, literally go grab that pen and paper. I’ll be here when you get back.  Five years from now you will thank me.

Defining Your Goal:

Answer for yourself the following question:

How much money would you need to live comfortably if you didn’t have a job? _________

The answer to this question is your minimum monthly income.  This is the amount of money you need to quit your job and begin living life on your terms.  To define your investment plan, you need to divide this number by 100 (more on why later). This is your minimum number of units you will need to obtain.  For example, if I needed $5000 a month to live comfortably (the average US Household makes around $4250 per month), I would divide $5000 by 100 to discover I need 50 units to live comfortably. This number is now my minimum number of units.

Write out the following statement on your paper: 

My Investment Goal is to Produce __________ in monthly passive cashflow by purchasing _______ units over the next _______ years.

This is your goal. It is Specific, Measurable, Attainable, Relevant, and Timely (SMART).

Defining Your Criteria:

Why do we divide by 100?  This is the minimum amount of positive cashflow per unit you need each month in order to justify a potential property.  This is your most basic criteria when determining what separates a “good deal” from a “bad deal”.  Does the property produce $100 per month in income after all expenses are paid out?  This includes the percentage set aside for when the unit is vacant, in need of repairs, evictions are required, etc.

For example, one of my properties is a triplex (three units). The total monthly payment on the mortgage is just under $500 per month including taxes and insurance.  Other expenses (such as a 5% vacancy rate, repairs, lawn care, property management, etc) add an additional $300 per month in expenses for total expenses of $800 per month. Total income on this property is around $1300 per month, leaving $500 per month in positive cashflow. This equates to $166.66 per unit per month in cashflow. Does it meet my minimum requirement? In the words of my Minnesota heritage, “Ya, sure, ya betcha!”.

“But I could never find a deal this good!” Depending on where you live in the country, this minimum criteria may be easy or difficult to obtain. In my area of Western Washington State, this number is easily attainable and often times investors require $200 per month cashflow. If you live in an area where prices are significantly higher (such as Southern California, Seattle, Boston, Chicago, or other major metropolitan areas) you can still find properties that meet this criteria. You will just need to search harder, make more offers, and look outside the city a little further.

This is it. Of course, your investment plan will grow as you determine more and more of what you are interested (or not interested) in. Do you like two-bedroom apartments or studios? Do you like new construction or remodeling? Do you want to manage your own properties or hire a property manager? These are important questions, but broken down to it’s most basic parts, your goal is to produce enough income to free yourself. Its your job to now make your plan a reality.  Its time to purchase your first property.

Leave me a comment below and then click here to read part three of “Getting Started Investing in Real Estate.”

Investing in Real Estate at a young age requires a different approach, style, and skillset than investing at an older age. However, the principles behind sound investing do not change whether you are twenty or eighty.  This article is part one of a four part series on how to begin investing in real estate at a young age. If you only read one article – let it be this one.

My brother recently received his tax rebate check of over $1000 and asked me, “I want to invest this money – how should I start?”.

He expected me to tell him the secret to buying a house with a minimal down payment or a hot new tip on investing in gold (which I am adamantly opposed to, but that is topic for another post). Instead, I told him to use that $1000 to gain education.  No, I don’t mean college or a cheesy seminar with a so-called “guru”.  In fact, I suggested he use his money to take a week off work and spend a week at the beach reading books.

Education is the first step to any investment dream and congratulations, by reading this blog you have already taken that first step.

There are numerous ways to learn how to invest, most which are free.  The technique you use to learn greatly depends on your learning style.  The following is a list of just a few. I encourage you to check out as many as you can to determine your favorite way to learn.

  • Books – This learning method goes without saying, but I would like to emphasize the power of public libraries in gaining free education.  This technique resonates most with my personal learning style. During the first year after I decided to get into real estate investing at twenty-one years old, I checked out every book in my library’s regional collection dealing with real estate investing – well over a hundred – and read each one cover to cover.
  • Blogs – These are an amazing source of information, written by people living in the trenches of real estate. Websites such as http://www.BiggerPockets.com offer hundreds and hundreds of articles, forums, and blog posts teaching every conceivable aspect of real estate investing.
  • Mentors – If I were to go back and start over, I would have started earlier with this technique. People love to share what they know, and seasoned real estate investors are no difference.  Get to know who the major players in your town (ask any real estate agent or join your local real estate investment club) and offer to take them to coffee. It is amazing the number of pitfalls and regrets you will avoid by simply learning from those who have been there. In addition – these contacts you make will help you in more ways than one in developing you into a world class investor.
  • Podcasts – A recent innovation in the real estate investor world, there have been a number of great Podcasts that have emerged in the last few years. My current favorite is the Real Estate Guys Radio show. If you have an iPod or Iphone, you can listen to over a HUNDRED hour long shows covering a wide variety of real estate topics whenever you want – for free.

What are your favorite inexpensive or free ways to learn?

Leave me a comment below and then click here to read part two of “Getting Started Investing In Real Estate.”

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