You buy a property with a problem and fix it, provided you don't over improve the property greater than it's market value after the improvements. This adds appreciation value in the process optimistically greater than the sum of the acquisition and the improvements, and return to the market for a sale usually in 30 to 60 days. There is no cash flows that the property can generate. The mathematics are simple - cost basis of acquisition, plus improvement costs equals new adjusted base cost. In an up market, aka a sellers' market, you can more easily generate a profit, although very modest, since there is very little discount to be had on the initial purchase contrary to popular belief. The goal is to repeat the process or to flip/convert a few properties concurrently.
The biggest problems are that investors choose the wrong property in the wrong location, failure to evaluate the target property for the depth of its condition, not properly evaluate the improvements costs, failure to understand that an improvement does not necessarily give you a return of 100% on its cost, skipping major details, the types of improvements to maximize value, the flaws in the finished product, and focusing on the margin way too much resulting in being blindsided rather then the marketability of the property - the goal is the total package and how to put it together.
Appreciation In Value
Many people buy a property, and their main criteria or investment analysis is that it will go up in value over time. This is probably the most common way that buyers evaluate real estate. The problem with this method is that it doesn’t take into account the cash flows the property can generate. And you need to beware of those negative cash flows, as noted below. The best way to have a true investment property is to have it generate positive cash flows, and it should cash flow almost immediately from the day of acquisition.
Essentially, the leveraged approach is a combination of both the appreciation in value and cash-on-cash. Leverage is the biggest secret to growing your investment and to wealth building. Because it takes into account the rate of return, liquidity, risk, cash flows, operating income, marketability, taxation, and depreciation.
I use a special formula to calculate the FMRR. I'd say that for the top three approaches, it requires accurate prediction of future values. Generally speaking, not unusual to generate returns of at least 10 to 15% post taxes.
Cash-on-cash return is calculated by taking your estimated, or proforma, cash flows and dividing them by the amount of cash equity you invest to purchase the property. For example, if I invested $40,000 into a property and earned $4,000 per year in free cash flow, that’s a 10 percent cash-on-cash return — and a very good deal if those numbers come true.
You can also buy properties that have negative cash flows, typically fancy prize high-rise condos or properties in the most expensive areas of town. I don’t recommend buying these because it could be several decades before they truly turn positive, and all those years you will be covering that negative cash flow via investing additional equity. Note that positive cash flow properties pay you, while negative ones keep taking additional money out of your bank account.
Internal Rate Of Return And Net Present Value
Two other common methods for evaluating real estate investments are internal rate of return and net present value. Both take into account the time value of money theory, and both are more complicated than I can explain here. However, although these are well-known and heavily used in commercial real estate, in my opinion they have one fatal flaw: Both of these calculate a rate of return based heavily on a future sale of the property and an estimated price that the property sale will generate. There’s the problem, the “estimation” factor. So someone can estimate whatever outrageous sale amount they project for 7-10 years down the road, and it will make either of these two measures show the property to be a great deal! The question is: Will those projections come true? Often they do not.
Gross Rents Multiplier
There is also gross rents multiplier (GRM), which takes the property price and divides it by the gross rents the property can generate. So if the price is $100,000 and the annual rental income is $10,000, the GRM is 10. You would compare this to other properties in the area to see how they fare against those. While these may be a good rule of thumb, they don’t show a true picture. Different properties can have different expenses, and GRM does not account for those differences. So you may end up making a decision based on an incomplete analysis.
As noted above, you are the only one who can truly determine how good an investment deal you will get when you buy property. Always be conservative in your estimates of rents and expenses because rarely does a property financially perform as well as the original investors estimated or penciled out.
The flip/ quick cash conversion is probably the easiest because it takes place in 30 to 60 days, but also the riskiest. Often investors and project managers are not on the same agenda or the same page. That can be a problem.
However, the leveraged approach with conservative estimates is likely by far the best way to help you make better long term wealth building decisions since the risk is spread over a longer period of time, thus the appreciation is greater, and so are the cash flows.
So in my opinion, the leveraged approach is your best bet. If the near-term financials look good, and you manage the property well and do the proper due diligence before and during your ownership, the future will hopefully be bright. And hopefully filled with more and more future positive cash flows that you can take to the bank!
Richard Bazinet PLLC, MBA, ABR, CRS, is a professional Realtor with Realty ONE Group in Scottsdale, Arizona.