18 - CAP RATE & CASH FLOW concepts

What would you pay for a property?

Everyone has an opinion but at the end of the day the only opinion that counts is yours…how you feel and how you can sleep at night with what you feel.

In real estate world we take those feelings and make dollars and cents of them with a goal of maximizing your resources of money and time to create something of value at the end of the day.

This “end of the day” is considered in chunks of time…like dollars flowing through the hourglass.  For most we look at one (1) year increments as a basis to establish, compare and evaluate “what is value” and so “what is it worth” and “what am I willing to pay” for a place in a space for a period of time.

This is a quick way of understanding WHAT YOU WOULD be willing to pay.

You take WHAT YOU WOULD PAY = Net operating income / CAP RATE

Pretend for a second you are the BANK. AS the BANK you want to make a certain amount of interest on an investment. A good example is you maybe happy to make 8 percent on your money, (At the end of each year, for every $100 in the bank, you make $8).

So say you find a duplex for sale (two apartments in a building). After the landlord pays the water bill and handyman, etc. they make $500 a month on each unit.  In one month they make $1000 a month and in a year they make $12000 a year. So their NET OPERATING INCOME is $12000.

So you have cash in the bank making almost no money, (low interest rate) and you are considering investing in real estate.  You have read all the trials and tribulations and say to yourself, “what the heck…if I can make an 8% return on my money I will pull it out of savings and invest in a duplex.

So HOW MUCH would you be willing to pay for any duplex or investment property? 

In this case it is NOI/CAP I WANT = 12000/.08

Which is $150,000.00.

So no matter WHAT the seller is asking, that is the most you will spend.

d. The other very important factors not included in this simplified equation are taxes, insurance, mortgage interest, bank charges, and what is called “stupid stuff” such as the cost of tenant drama costs (evictions and vacancies).  

e. The “stupid stuff” is more commonly referred to as “risk”

f. This “risk” generally adds another 3-5% consistently to the equation so always aim to base your CAP rate higher to take care of the unexpected expenses later.

At the end of the day the only real value of a property is a combination of its cash flow and what it means to you and depreciation (not considered here). You need to have your own personal monthly and yearly money in and money out calendar of life.  With this calendar you sit down with your accountant/ financial advisor to consider the real pros and cons before you look at any property or even talk to a Realtor® about what you want to do.

Why every penny counts!  Count certain pennies to not spend dollars.  When one looks at the big picture, you can see saving $100 here and there over a period of time can save you thousands and mean a higher return on your investment / CAP rate, money on your money or whatever you wish to call it.  This is why you have to keep what you spend and how you spend money in context. If you know a metal widget will last 10 times as long as the plastic one, spend the extra dollar….install and pay for labor one time...that money will add up.

Why cheap fixes will always cost you more

Unless you plan on flipping a property (selling within 90 days or less) a cheap fix rarely works out to your benefit…cheap locks break or don’t install right, cheap toilets leak wasting water and causing collateral damage elsewhere and so on.  Plan your business around spending a few dollars and if you don’t spend them one year, stockpile for the next.