Last month we look at the overall concept of investing in income properties. Today we are going to examine actual data and look at the three approaches I use to evaluate the potential value of an income property.
I decided to run some figures and quantify in numbers what I was trying to say in English. Words are ambiguous, and numbers aren’t.
In the safe investment community of Beverly Hills, the ROI (return on investment) is lower because the risk is lower. Cap Rates are rarely above 6%, and properties require a longer period of negative cash flow before they start turning a profit (cash on cash). Over the past six months, only 8 income properties were sold under $5.0M, averaging $2,571,050 each, and that’s only 2% off the average listed price. Not much room for negotiation here. That’s expensive for an average 4 unit building. Ouch, that’s also expensive, because most banks will require a 25% down payment on investment properties, so your capital investment is substantially higher than other areas, and thus your ROI is lower because that capital is sitting idle until you start generating positive cash flow. Average $/Sq Ft Under roof was $618.85, which compares to $353.43/sq ft in Palms and Mar Vista, where the risk is higher but the returns are better.
Where does Palms and Mar Vista fit into this whole picture? I like those areas because they’re areas in transition, on the positive side. They’re close enough that I can keep track and easily manage my properties, and they still have good value over there. I prefer investment properties that are tilted on the side of early ROI rather than safer deferred appreciation. Three of us bought a 12 bedroom / 4 unit income property out of federal bankruptcy this past February for $1,560,000, generating about $9,400 in monthly rents. After some adjustments on the rents and putting in around $50,000 in capital improvements, the monthly rental income is $10,500 (and climbing), it’s 100% rented and it looks 100% better from the street than before. Since the GRMs are moving upward, at a conservative GRM of 18 the property shows value at $2,268,000. Even more at 20; it shows well at $2,520,000. But we’re not selling. Even at the selling price of $350.56/sq ft based on 4,450 sq ft, it still comes well under the current comps in the area. The 9 unit building just down the block on the same side of the street listed at $402.55/sq ft. Run the math for six months. That’s a 14.8% increase in six months or 29.66% in one year, or a $462,696 increase in value. With our down payment in cash of $460,000, that’s a 100% ROI cash on cash, before tax. But that’s why God invented Section 1031 of the IRS code.
This is not the way to evaluate income properties. At these numbers, spreadsheets need to be employed and Cap rates generated along with rent rolls and pro forma P&L statements. It becomes much more involved, but you get the idea. Just remember to look at potential purchases in all three analytical approaches; (from Investopedia)
DEFINITION of ‘Capitalization Rate’
A rate of return on a real estate investment property based on the expected income that the property will generate. Capitalization rate is used to estimate the investor’s potential return on his or her investment. This is done by dividing the income the property will generate (after fixed costs and variable costs) by the total value of the property. If you want to get technical, it is basically the discount rate of a perpetuity.
DEFINITION Capitalization Rate = Yearly Income/Total Value
Also known as “cap rate”.
DEFINITION of ‘Cash-On-Cash Return’
A rate of return often used in real estate transactions. The calculation determines the cash income on the cash invested. Calculated as:
DEFINITION of ‘Return On Investment – ROI’
A performance measure used to evaluate the efficiency of an investment or to compare the efficiency of a number of different investments. To calculate ROI, the benefit (return) of an investment is divided by the cost of the investment; the result is expressed as a percentage or a ratio.
The return on investment formula: In the above formula “gains from investment”, refers to the proceeds obtained from selling the investment of interest. Return on investment is a very popular metric because of its versatility and simplicity. That is, if an investment does not have a positive ROI, or if there are other opportunities with a higher ROI, then the investment should be not be undertaken.
Give this some consideration, whether you have your own agent or want to talk to us. Rents are going to continue to climb in Los Angeles and the surrounding areas, and good properties are limited. I love the dynamics that come with owning income producing real estate, the benefits of managing your own investment and the potential for increased income exceeding inflation. More than anything else, it fits perfectly in long term retirement plans as long as you and your partners agree on one thing; no one is taking any money out of the deal until you’re all retired or at retirement age.
Call me and we can discuss more.
