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AlexanderGonta.com Online> How-To Articles > How to Calculate Cash Flow

Income Approach

Are you thinking of house flipping or landlording?  The personality of the person that desires fast results is different from the person that wants to hold property for a long time for income and equity growth. Decide what kind of investor you want to be. The "buy-and-hold" approach is what is being described herein.  To understand an income property potential as a long term hold, you need to evaluate it's income generation potential over the long haul. You need to understand what is called the "income" approach. Terms like "cap-rate", and "cash-on-cash return" and "return on investment' are terms you need to understand if you wish to hold a property over the long haul.   Your tenants will pay off your mortgage and cover your fixed operating expenses, while you enjoy tax advantages and long term appreciation. A hold period of 15 to 20 years is a safe assumption. Or holding several lower performing income properties in your portfolio and then trading up to larger properties is another consideration.  But what makes a property a "good buy" vs another property?  What is the "income approach" ? 

 Appraisers use three different methods to estimate the value of real estate.  They are the income approach, the sales comparison approach and the cost approach. The sales comparison approach is considered the best method
for appraising single family homes. The cost approach is used to appraise  special purpose buildings such as churches, schools and public buildings.  The income approach is used to estimate the market value of income producing properties such as office buildings, warehouses, apartment
buildings and shopping centers. When adequate financial data for recent sales of similar income producing properties is unavailable, appraisers may utilize all three approaches.

The following is a brief and simplified summary of the income approach.  The income approach is used when reliable financial data is available for recent sales of similar income properties in a given market place. A  property's net operating income and sales price are used to calculate a
capitalization rate for the sale of each similar property in a given area or market place. If sufficient sales of similar income properties are available, a market cap rate can be determined by averaging the cap rate values from
the individual sales. Appraisers will sometimes use a market gross rent multiplier or gross income multiplier instead of a cap rate to estimate the value of single-family rentals and 2 units.

Income Approach Summary - Net operating income is calculated like this.

1) The appraiser first estimates the annual potential gross income for a property. This involves estimating how much rent each unit could generate in the current market place. The rental rates being charged by the current owner may be too low and may not reflect potential market rental rates. Appraisers study the current market place to
estimate potential rental rates.

2) The appraiser then calculates an effective gross income for the property by reducing the annual potential gross income by a vacancy allowance amount. The vacancy allowance amount is determined by current market rental conditions for the type of property being analyzed.

3) Miscellaneous income such as parking fees, laundry and vending receipts are added to the income.

4) Operating expenses are deducted from the effective gross income to determine the annual net operating income for the property.

Income
Gross Rents Possible     $  100,000
Other Income                $     3,000
Potential Gross Income   $  103,000
Less Vacancy Amount     $     2,000
Effective Gross Income    $  101,000
Less Operating Expenses $   31,000
Net Operating Income      $   70,000


Once the net operating income is determined, a capitalization rate is  calculated for the property. If the above property sold for $670,000 , the cap rate is calculated like this.

NOI 70,000
Capitalization Rate $70,000/$669,856 X 100 = 10.45 Rounded
Sales Price=670,000

So NOI devided by $Price=Cap Rate%

Or NOI devided by Cap Rate%=$Price

We have several other similar income properties that have recently sold in the same area. There financial data is summarized below.

Comparable No. Sales Price Net Operating Income Cap Rate
1 670,000 70,000 10.45
2 730,000 75,000 10.27
3 625,000 65,000 10.40
4 705,000 77,000 10.92
5 780,000 80,000 10.25


We calculate a market cap rate by averaging the individual cap rate data. The market cap rate for the above data equals 10.46 rounded. The appraiser would estimate the value of a similar income property like this. He would
go through the procedure above to calculate the net operating income for the property in question. Lets assume that the net operating income is equal to 73,000. He would use the following formula to calculate the market value

Net Operating Income 73,000
Estimated Market Value = 73,000/0.1046--- = $697,897
Capitalization Rate .1046

It should be noted that recent sales of similar property types may be unavailable or very infrequent. For example, it may be difficult to calculate a market cap rate for shopping centers since there may be no recent sales.  The income property investor should have a good understanding of the income approach and how a market cap rate is calculated.

Cash on Cash Return

Cash on Cash Return is a percentage that measures the return on cash invested in an income producing property. It is calculated by dividing before-tax cash flow by the amount of cash invested (down payment amount) and is expressed  as a percentage. Let's assume we have a property for $1million with  a $200,000 downpayment. If before-tax cash flow for an investment property is equal to $30,000 and our cash invested in the property is $200,000,cash on cash return is equal to 15%.

Before-Tax Cash Flow $30,000
Cash on Cash Return = ------------------------------ ---- x100 or: ------------------ X 100 = 15%
Cash Invested $200,000

The following shows how before-tax cash flow is derived.

Gross Income $119,900
Less Vacancy Amount $5,500
Gross Operating Income 114,400
Less Operating Expenses $34,000
Net Operating Income $80,400
Less Annual Debt Service $50,400
Before-Tax Cash Flow $30,000

The Cash on Cash Return is is used to evaluate the profitability of income producing properties. It is an important analysis tool when comparing multiple income properties. The property with the largest cash on cash return generates the greatest return on each dollar invested. It does however have some limitations. It doesn't take into account an investor's individual income tax situation and it doesn't consider the wealth building potential of a property via appreciation. A property in one area of a city may have a better Cash on Cash Return then a property in another location, but it may not appreciate as  fast because of it's location. One location may be more desirable than the other. 

Before buying any income property, be sure to evaluate its income potential and pay for the property based on what it produces for you, the investor.

Article is Reprinted with Permission from CREONLINE.COM

Material is Copyrighted

CRE Online > How-To Articles > Real Estate Bubble Theory is Full of Hot Air

A lot of hoopla has been floating around the news media lately about the "bubble" theory of real estate. That is, the theory that the real estate market is going to burst. In my opinion, the theory has no merit.

First, understand that there are three basic premises that undermine the discussion of a real estate bubble:

1. There is no national real estate market
2. The real estate market doesn't explode or crash
3. The market has limited relevancy to the shrewd investor

The real estate "market" is based on local economies

When people speak of the real estate economy, they are using nationally-based statistics. For example, Fortune magazine reported recently that since the early 1960s, average residential real estate values have never had a down year. This statement is true. But while these numbers are measurable, they do not reflect the intricacies of local real estate markets.

The stock market is based on the national, even the world economy. The real estate market is based on local, and, in many cases, micro-local economies. What's happening in Los Angeles does not directly affect what's happening in Toledo.

True, certain factors such as interest rates affect all the markets. There really is no broad barometer to measure the entire housing industry in the U.S. Average prices, average new homes sold, and average homes built nationally have little relevance to your market.

And, within a particular city that is doing well, there may be certain neighborhoods doing poorly for a variety of reasons, such as over-building of new homes.

So while statistics, calculations, and economic factors are relevant, so is common sense: Take a look around and see what's really happening. Talk to real estate agents, investors, and lenders in your area for a better picture of what is going on.

Don't look at broad nationwide, statewide, or even city-wide statistics. Be concerned with the average prices in the particular neighborhoods in which you buy houses, the average time on the market, and the changes in sales prices from last year to this year.

Real estate markets do not "crash"

We all remember October 19, 1987, known as "Black Monday." The stock market lost 22% of its value in one day--what investors call a "crash."

There have been times when real estate values have taken 22% hits in certain cities and in pockets within cities. However, no real estate market dropped 22% in one day, one week, or even one month. In fact, the real estate "crash" of the late 1980s took several years to bottom out in most markets.

Some people are theorizing the collapse of housing market by comparing it to the stock market. Robert Shiller, author of Irrational Exuberance, claims that the same mentality that caused the rise and collapse of the high-tech market will likely follow in the real estate market. Let's consider that argument for a moment...

At its core, the housing market, like the stock market, is all about supply and demand; when more people want to buy than sell, prices go up, and vice-versa. However, the stock market is much more whimsical than the real estate market. People often buy into stocks at the top of the market based on future potential, not inherent value.

True, people are buying some properties in some markets for top dollar hoping it will go even higher, but real estate still has inherent value because you or someone else can live in it.

If the neighborhood in which you live goes down 10% in value, are you going to move? Not likely, you'll just be bummed about it. The transaction cost and headache involved in moving is not worth it for most people. Contrast the stock market where a zillion investors can sell off in minutes by a click on their computers.

Supply and demand also work differently in the housing market. Right now, demand outstrips supply in some hot real estate markets like Los Angeles and New York City. But, people are starting to realize that even if they sell for top dollar, they will have to pay top dollar to stay in the same market, so why bother?

This phenomenon is causing limited supply and even HIGHER prices. In other words, the price increases are not necessarily about "irrational" demand, but rather limited supply. While the old expression, "Trees can't grow in the sky" is applicable, so is the old adage, "They ain't making any more of it."

More people are moving into the U.S. than moving out, and so long as that trend continues, we're eventually going to run out of room. Likewise, if your city has limited space and more influx than out, prices are likely to stay where they are.

Finally, there's the possibility that the traditional economic theories of bust and boom are simply flawed and no longer applicable. In other words, just because things have been going up in the housing market for so long, doesn't necessarily mean they will drop accordingly.

Economic trends causing the market to remain strong

Immigration. Millions are immigrants are moving into the U.S. every year. If the government creates an amnesty program, we now have millions more potential home buyers who can legally show income and qualify for a loan. More demand, means higher prices.

Migration Trends. Face it, baby boomers can't live on social security and pay the property taxes on their expensive homes any more. They've got three choices: continue working, take out reverse mortgages, or sell and move to a cheaper area.

This mass-exodus is likely to increase demand in the cheaper retirement communities over the next ten years. Though prices have skyrocketed in South Florida, Phoenix, and Las Vegas, it's still a whole lot cheaper than Boston or New York City.

Marriage Trends. People are getting married later, causing more single people to buy houses and condos.

Easy to get a loan. Interest rates being so low for so long doesn't hurt either. But, it's more than low interest rates; it's how EASY it is to get a loan.

Lenders figured out over the last fifteen years that instead of lending only to people with good credit, they can make money by lending to people with bad credit. Also, the Internet has led to fierce competition among lenders making it extremely easy and cheap to borrow money.

What about rising interest rates?

A lot of people are worrying about how rising interest rates will affect the market. Certainly, a rapid rise in interest rates may affect prices, since the higher the interest rate, the less house a buyer can afford. But, interest rates alone do not determine prices, but rather supply and demand.

So long as a particular area has more buyers than sellers, the values will remain strong. And, the Federal Reserve is well aware of the interest rates will impact the housing market. Interestingly, while the rise in interest rates in the U.K. has "cooled off" the housing market, there's been no collapse as predicted.

Finally, keep in mind that even if a real estate market is reaching a peak within a particular area, it doesn't necessary mean it will necessarily collapse. The fact that real estate values in your city have climbed at twice the rate of inflation last year yet only half the rate of inflation this year doesn't mean the bottom is falling out.

It is inevitable that the "boom" markets like San Diego, Las Vegas, and Phoenix will cool down. But, there's no evidence to justify a rapid decline in prices. Most experts agree that the likely scenario will be a "cooling off" where prices will remain flat, appreciating just above average inflation.

The Federal Deposit Insurance Corporation (FDIC), which regulates banks that hold 30% of the credit risk on outstanding U.S. mortgages, doesn't appear concerned.

In fact, FDIC researchers examined data from fifty-five metropolitan areas that saw a "boom" at various times between 1978 and 2004 and found only nine instances of a bust that followed.And, many of those busts were related to local market factors such as the oil market crash in Houston and Denver in the 1980s.

Finally, keep in mind that just because your city’s average real estate values or home sales went down, doesn't mean it went down everywhere in the city. The problem is, people see headlines like "Average Real Estate Prices Falling" and panic.

Declining values of $1,000,000 homes skew the average, so you can't pay attention to broad numbers. You need to look specifically in the price range and location of houses you are buying.

The mass overbuilding of $500,000 homes in many markets won't generally affect the older $150,000 homes that average investors work. Much of the new home building across the country has NOT been low-end homes.

The market has limited relevancy to the investor

If you buy and hold for the long term (fifteen or more years), you aren't likely to lose. Real estate values generally go up in the long run, with few exceptions. The same is probably true of the stock market in the long run, but there's one problem: There's no guarantee any company you invest in will be in business in fifteen years--not even Xerox, IBM or AOL!

If you buy and flip properties quickly,
the market appreciation or decline is
not all that relevant to your profit.

I had this discussion when I appeared CNBC recently: If the local real estate market is "hot," you can sell a property quickly, but you can't buy it as cheap. If the local real estate market is weak, you can steal properties, but you have to account for a longer hold period when you resell.

It is relevant to know where your market is currently going (up or down), but don't worry too much about the "bubble" bursting; real estate markets DO NOT collapse in 3 to 6 months.

Danger in interest-only loans?

A lot of people are worried that if interest rates rise, many people who bought with interest-only or adjustable rate loans will lose their homes. Certainly, there are some people who are playing a very dangerous game with buying more house than they can afford. However, the entire mentality of the market may actually be changing to adapt to changing interest rates.

Many people are buying homes with adjustable or interest-only loans knowing full well that in five years they will either move or that their house may have no equity. People are starting to treat their homes like car leases, caring only how much it costs monthly to have the best they can afford.

On the other hand, if you are buying investment properties with negative cash flow and expect the values to increase over two to three years, shame on you! What if the values decrease? What's your backup plan? Can you rent it for break-even cash flow? Can you sustain negative cash flow until the market rebounds?

If so, then don't sweat it. You'll also pick up a whole bunch more properties at the bottom of the real estate cycle. If not, then you are a speculator, not an investor, and you are at the whim of factors beyond your control.

Such activity is very risky, to say the least, and it is disturbing to see that many investors are doing just that in some of the hottest markets. And, they are doing so with interest-only loans, with no "Plan B."

The bottom line is, the real estate market may go up, and then again, it may go down. So what? Don't bank on appreciation; buy properties below market, and have a "plan B" if it doesn't work out. Do this, and the you will see that the "bubble theory" is full of hot air.

[For more information on the Real Estate Market, read Bill's article, How to Investing in a Changing Real Estate Market.]

About the author...

William Bronchick, J.D. is an author and attorney who regularly presents workshops and do-it-yourself seminars at real estate and landlord associations around the country. He is the president and co-founder of the Colorado Association of Real Estate Investors. Bill specializes in all forms of asset protection and is the author of several great home study courses:

· Flipping Properties

· Big Profits with Lease Options

· Alternative Real Estate Financing

· Secrets of a Real Estate Attorney

· How to Create a Bulletproof Corporation

· Your Step-By-Step Guide to Land Trusts

· How to Form Your Limited Liability Companies

· Wealth Protection Strategies

· Complete Wealth Protection Library

Article reprinted with permission from CREONLINE.COM

So often, beginning real estate investors focus on techniques that they lose sight of the important issue: Is this a good deal? Learning to recognize a good deal takes research, education and, above all, experience. Here's a good formula to determine whether a potential real estate purchase is a deal. It's a simple acronym called C.L.E.A.R.

Cash flow

"Will this property cash flow?" Well, that depends on a lot of factors, such as the strength of the local rental market, the interest rate on the financing, and how much of a down payment you make. It also depends on whether it is a single-family or multi-family dwelling. All of these factors considered, ask yourself, "Will this property provide income?"

Then ask the question, "How will this property cash flow compared to other potential properties?" For example, a $150,000 house that rents for $1,000/month has a better income potential than a $300,000 house that rents for $1,600/month. A four-unit building that costs $400,000 may bring in $3,000/month in the same neighborhood.

Now, of course, whether the property will provide income to you begs the question of whether income is important to you. Is it? Do you earn other income? Do you need more income now, or is future equity growth more important? There's no right answer to these questions, but are all factors to consider when looking at a potential purchase.

Leverage

Leverage is important for investors because the less cash you put down on each property, the more properties you can buy. If the properties go up in value, your rate of return goes up exponentially. However, if the properties go down in value and you have a lot of debt on the property, this can result in negative cash flow (see above).

Since real estate is generally cyclical, negative cash flow is only a short-term problem and can be handled if you have other income or a cash reserve to handle the negative. "Nothing down" investing is very attractive for the high-leverage investor, but should be approached with caution.

If you are a long-term player, leverage will generally work in your favor if the markets in which you invest appreciate in the long run and your income from the properties can pay for most of the monthly debt service.

Equity

Does the property you are purchasing have equity? Equity can take a number of forms, such as:

• A discounted price
• A potential fixer upper
• A rezoning opportunity
• A poorly managed property
• A foreclosure

There are many ways to create equity, but buying into equity is your best bet. Find a motivated seller who wants out of his property and is willing to give up his equity for less than full value. Or, buy a property that needs work that can be done for 50 cents on the dollar or less.

In other words, if the property needs $10,000 in work, make sure you get a $20,000 discount on the price or better.

Appreciation

Buying in the right neighborhoods in the right stage of a real estate cycle will result in appreciation and profit. However, timing a real estate cycle is difficult and is speculative. If you buy properties without equity or cash flow solely for short-term appreciation, you are engaging in a very risky investment.

Buying for moderate, long-term (10 to 20 years) appreciation is safer and easier. Look at long-term neighborhood and city-wide trends to pick areas that will hold their values and grow at an average 5% to 7% pace. Combine this tactic with reasonable cash flow and buying into equity, and you will be a smart investor.

Risk

Risk is a consideration that too few investors consider. Now ask yourself, "What if my assumptions are wrong?" In other words, do you have a "plan B"? If you bought for appreciation and the property did not appreciate in value, can you rent for positive cash flow?

If you buy with an adjustable rate loan and the rates go up, will this put you out of business? If you have a few vacancies, can you handle the negative cash flow or will it break the bank for you? Expect the best, but prepare for the worst. And remember, whenever you look at a property to purchase, think CLEAR: Cash flow, leverage, equity, appreciation, and risk.

About the author...

William Bronchick, J.D. is an author and attorney who regularly presents workshops and do-it-yourself seminars at real estate and landlord associations around the country. He is the president and co-founder of the Colorado Association of Real Estate Investors. Bill specializes in all forms of asset protection and is the author of several great home study courses. His courses can be seen on http://www.creonline.com