By Frank Rizzo Real Estate Broker | President Cornerstone Realty
Throughout my career I have seen many individuals who have invested money into the real estate market in an attempt to “get rich quick” by buying property in a “hot area” with the expectation of something happening that will then as a result create appreciation for their investment. There’s nothing wrong with this approach, per se, as long as you know that there is a difference between real estate speculation and real estate investing. When you speculate, anything can happen and forces beyond your control can change the premise of your entire “investment”. If the value of your real estate investment is not based on cash flow, it’s a gamble. That risk may be good for a small portion of your investment dollars, but as any good asset manager will tell you, to truly build wealth over the long term, you have to focus on creating value and increasing cash flow.
When you invest in real estate, you are in essence investing in a money machine. If you were to actually purchase a money machine, the two questions you would ask are 1) How much money does it make? and 2) How fast can it make it?
With that in mind, when evaluating where to invest in real estate, understanding the cash flow and cash on cash return concept is essential. Cash on cash returns is simply the rate of return on the cash (or equity) invested in the property based on the cash received from the property. In order to fully understand cash on cash returns, we need to review the three elements that make up a real estate purchase; the income, the expenses and the financing. Just like a triangle, the strongest and most structurally stable shape, knowing these three elements will create the strongest foundation for your real estate investment.
The income analysis should be based on the actual rents collected or verified rents in the area. Too often we see projections and anticipations of some future rents that have not been established in a location, and for us, that is just too risky. I tend to look for properties where the rents are below current and true market prices where we can add value by guiding rent to market prices over time. The income analysis should also include a vacancy and credit loss. If the owner (or agent) does not factor that into their analysis than either the rents are too low or they are not being completely forthcoming.
Some expenses are easy to research and find such as real estate taxes and property insurance premiums. Simple enough. The challenge is when we have to rely on the owner or agent to provide actual expenses for maintenance and capital improvements. This is usually where things begin to get interesting and where we typically receive estimates rather than hard numbers. How do we know if they are estimates? Every line item ends with a zero. Generally people like round numbers. The problem with rounding numbers is that they usually round the income UP and they round the expenses DOWN. If you want an average return, then you can go with it, but if you want something a little extra than the ordinary, something extraordinary, you should obtain the specifics; this will get you on the track to establishing and hitting your goals.
The third and final factor to consider is the financing that you may need to acquire the property. If utilized correctly, your leverage will increase the cash on cash return on your investment and will continue to bring home double digit returns for you. Not factored correctly, your returns can be less than anticipated and leave you with an under-performing asset. Do you have your financing lined up before you enter your Letter of Intent? Is your seller willing to offer financing on the acquisition? Having your numbers together allows you the ability to stick to your goals and insure that your investment is producing the returns you expect.
While we consider and perform all of this due diligence prior to acquiring a property, it is vital to remember that real estate is not a static investment. As Sam Zell, one of the world’s premier real estate investors has said, “Every day you are choosing not to sell an asset in your portfolio, you are choosing to buy it.” Every year, the same analysis of your assets should be done, to ensure that you are receiving the same rate of return or better that you targeted at acquisition. Utilizing these tools will help you continue to grow your cash flow and investments.
If you need assistance in researching and conducting an equity analysis on your property to evaluate your cash on cash returns or if you are interested in learning more about cash flow investing, please feel free to contact our office at 718-447-8100. Frank Rizzo is a NYS Real Estate Broker for Cornerstone Realty and a Managing Partner for Private Real Estate Funds with a focus on value-add opportunities.