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What to Know About Investing in Real Estate
Investing in real estate can be complicated with so many different property types and ways to invest. By understanding the process, you can become a professional real estate investor.
Finding a Project
As an investor, first it is important to know what deals you are looking for. Find a niche within real estate like single family homes or fixer uppers that you want to build your portfolio around. Real estate brokers and the MLS are great resources to search for deals.
There are two main ways to finance a project: leverage or all-cash. Leveraging utilizes debt by receiving a loan from a bank or a lender. There are many different types of loans like construction loans and home loans that aid in each part of the project. All-cash means the project is paid with only cash. By buying the property outright, you avoid taking on debt and paying interest.
Analyzing a Project
Once a project has been found and the financing planned, you must analyze the project to determine profitability. This is where understanding financial metrics is useful. By calculating the financial metrics for a project, you can figure out the potential returns and costs for the project.
Internal Rate of Return (IRR)
IRR in real estate is simply the annualized rate of return during the lifetime of an investment. In other words, if an investor owned an asset that distributes the same amount of capital and held it for the same time period, the yearly percent change would be the IRR.
In mathematical terms, IRR is the discount rate for which the net present value is 0.
The concept of a "good" IRR for a project fails to occur due to the variation in property types, geographic location, market conditions, and investor. If those factors are accounted for, you can estimate a reasonable IRR.
Capitalization rate, also known as cap rate, is a metric of the anticipated return on investment for a specific year if no debt is used. In other words, the expected annualized unlevered return on investment.
The cap rate formula is defined as anticipated net operating income divided by current market value:
Cap rate is a useful metric in comparative analysis of real estate investments due to the simplicity of the formula. Finding a "good" cap rate is subjective due to the variety of factors that affect cap rates. Industry leaders believe below 8% is a reasonable cap rate in most markets.
Net Operating Income (NOI)
NOI is a calculation to determine the profitability of a real estate property. Net operating income compares the income generated with the cost of maintaining and operating the property.
The net operating income formula is:
Cash on cash return
Cash-on-cash return describes the rate of return for the total cash flow during a period over the total cash initially invested. In the real estate context, cash-on-cash return is the ratio of the investor's equity divided by the investor's return from the property after expenses and debt.
Most of the time, real estate investors will calculate total cash flow on an annual basis to standardize the revenues and expenses.
Cash-on-cash return formula looks like:
General Rules for Investing
Here are some rules that real estate investors use to earn profitable returns:
- Comparative analysis: To best utilize the financial metrics, compare the project's metrics to projects with similar type or location. For instance, if you are buying a single family home that has a 7% IRR, you might compare the IRR of another single family home on the street. You want to see if you are buying a good investment through comparative analysis for each financial metric. You can ask your brokers or contractors about past projects that they have been involved in to acquire the numbers.
- 50% rule: Operating expenses can be estimated to be 50% of total revenue a project earns. For example, if a duplex makes $20,000 per year, you can anticipate the operating expenses to be $10,000 per year. This rule is useful in net operating income calculations.
- 2% rule: The monthly rent revenue should be 2% of the purchase price. If you buy an apartment building for $200,000, you should earn $4,000 in rent per month. This rule is subjective and varies by property type and region. In Arizona, the average price of a home is $450,629 and average monthly rent is $1,547, which is way lower than 2%.