Real Estate Philosophy
Top 5 Reasons
Top 5 Reasons
With endless options ranging from stocks, bonds, commodities, and mutual funds, how do you know where to put your money? Over the years, only one vehicle has consistently offered stability, diversification, and the ability to see massive returns: real estate.
Diversifying a portion of your investment portfolio into real estate investments yields steady cash flows and returns through a tangible and unique asset; it is your next step in ensuring that your journey to financial freedom and security is a successful and prosperous one.
Real estate is more than numbers changing on a computer screen. It is a tangible, hard asset, providing a secure investment with a unique, emotional connection. And it has been historically inaccessible for the majority. Here are the top five reasons people protect this powerful investment:
Real estate is one of the few ways to protect yourself against the existing, never-ending inflation. Prices constantly increase, your dollar becoming worth less and less every year. However, in real estate, lease rates typically keep pace with inflation, providing protection against the weakening dollar.
Whether you are purchasing stock in a business or investing in mutual funds with stable returns, you have no real control in your investment. Businesses or mutual funds will not take your personal insights into account. However, with real estate, you control every aspect of your investment. Real estate is tangible and physical; you can make renovations and protect yourself through insurance. Your investment also has various exit strategies. This control, from beginning to end, is what makes real estate special.
3. Cash Flow
Investments that yield constant and steady cash flows are vital to financial freedom. Real estate ownership is the best way to achieve that desired cash flow. The cash you earn in excess of your debt will protect you against large economic downturns. You will continue to receive a constant cash flow, which absorbs the hit from economic meltdown or stagnation, while still owning property.
4. Tax Benefits
Everyone wants ways to reduce their taxes. Parking money in real estate generates profits and reduces taxes paid. Real estate receives certain tax benefits such as writing off depreciation of a property as a tax deduction every year. Furthermore, the interest accrued on monthly mortgage payments, in most cases, can also be written off as tax deductions, potentially saving you thousands of dollars in taxes paid every year.
Through various financing options available to common buyers in the real estate market, a buyer can find himself purchasing a home for as low as 3.5% of the total value of the property. Although utilizing leverage is considered very risky when investing in other financial instruments, in real estate investing, you have a stable cash flow in place and full control over your property to protect yourself from the risks of leveraging. With proper and clever financing, you can find yourself increasing your annual returns by 5-10% without necessarily increasing your risk.
Top 10 Terms
The Internal Rate of Return (IRR) is one of the most important numbers in real estate. It measures the return of an investment. The higher the IRR is, the more attractive an investment is to potential investors. If an IRR is perceived as lower than other projects or is lower than another type of investment, investors will not invest.
To understand the IRR we must understand the discount rate, which is the return rate that money will receive if invested. In addition, the longer you wait to collect your money, the less it is worth today. Furthermore, the value of the actual cash investment you make in a deal is by definition the present value of the future cash flows. By setting the Net Present Value (NPV) of your future cash flows to 0, you can find your IRR, which is the expected rate of growth of the project.
This is too difficult to calculate by hand, so you can use Excel or a Financial Calculator.
Cash-on-Cash return is the ratio of annual cash flow to the total cash investment, independent of debt. In other words, if a property is worth $1,000,000 but you only put down 10% ($100,000), and the property is yielding $8,000 cash a year, the cash-on-cash return is 8%.
3. Net Operating Income
Net Operating Income (NOI) is all of your revenues less all of your expenses. Revenues include rent, laundry, parking, and vending. Expenses include property tax, insurance, repairs, utilities, and maintenance.
Equity is the difference between the current market value of a property and the amount the owner still owes on the mortgage. In other words, it is also the initial cash investment. If a property is purchased for $1,000,000 at a 10% total down payment, then the equity is $100,000.
5. Equity Multiple
The equity multiple is (Total Net Profit + Max. Equity Invested) divided by Max. Equity Invested. In other words, for every dollar invested in equity, how much net profit is there? The higher the equity multiple is, the more attractive the investment.
6. Cap Rates
Cap rates are another metric of the returns of an investment. The cap rate is the ratio of the Net Operating Income to the value of the property. In other words, if NOI is $100,000 and the property is worth $1,000,000, our cap rate is 10%. When purchasing a property, you want to exit at a lower cap rate than you entered.
7. Debt Service Coverage Ratio
Debt Service Coverage Ratio (DSCR) is the ratio of NOI to Total Debt Service. In other words, it is the ratio of cash flows to annual payments that need to be made. A bank uses this metric to assess its risk. A DSCR of <1 would mean negative cash flow.
Loan-To-Value and Loan-To-Cost (LTV and LTC) are ratios used for a bank to assess their returns. LTC is the ratio of the loan amount to the Cost of the Project. LTV is the ratio of the loan amount to the Value of the Project. The lower both ratios are, the less risky the loan for the bank.
A monthly loan payment is comprised of principal (the “face value” amount of the loan) and interest (the bank’s profit). A loan is paid mostly interest first, and as time goes on, the ratio of principal to the monthly payment increases.
Sensitivity is the practice of changing crucial numbers in a real estate deal (purchase price, cash flows, sale price) to examine the changes on your potential returns. Even the slightest changes in these numbers can entirely change the feasibility of a deal. Testing sensitivity is also known as conducting a sensitivity analysis.