Finance & Credit Factory

Before we go any further, I want to point out that if after your analysis you don’t think the property is a good investment, in other words, if the net cash flow is too low, then you may need to walk away from the deal or offer a much lower price to make the numbers work. These numbers don’t lie and unless your math is wrong, the estimates you arrived at are factual. It is perfectly okay to walk away, although you may feel like you did a lot of work for nothing. But remember, every step in this process is a learning experience, and with every exercise, every calculation, every building walk-through, you are getting smarter. The next time you’ll be twice as fast and three times more thorough. Learning is never a waste of time.

These five steps—the Five Step Property Evaluation—are the most important concepts in this book. They give you the ability to evaluate property investments like the pros do. They give you power and confidence. They give you realistic, fact-based bench¬marks to make the best property choices. They give you the basis from which to have reasonable conversations with the seller. And they give you peace of mind that you are not getting into something that may not pan out.

If you spend the time gathering the income and expense infor¬mation clearly prescribed in this chapter, you’ll know what it will take to run this property and how much money you can expect to make from it. You’ll be well informed before you even talk to the seller again and certainly before you ever make an offer. I buy all my rental properties this way using these exact same five steps. I would never dream of doing it any other way. I like sleeping at night too much.

The very last step is to find out your actual profit by subtracting your loan payment from your projected net operating income. Using the net operating income of $22,368 and subtracting the loan payment of $20,010, the projected profit on this property is $2,358. Is that good or bad? Well here’s how you know. You calculate your cash on cash, which you recall, is a lot like return on investment.

To calculate cash on cash, divide your profit of $2,358 by the down payment of $25,600. For this deal, your cash on cash return is 9.2 percent. Not a bad return.

Assuming you and the seller agree to the price of $256,000, now is time to figure out what the loan payment might be. This is where your finance team member or broker could step in, but I did it myself in a matter of seconds. I just went online and typed into my Google search engine the words “mortgage payment,” and up popped numerous mortgage calculators. I entered two numbers, the loan amount and the interest rate. Instantaneously the mortgage payment schedule appeared! I love the twenty-first century.

Back to our real-world example. The numbers I used were based on our offer price and 10 percent or $25,600 down and the same interest rate of 7.5 percent. The mortgage calculator churned out a loan payment of $20,010. Certainly a more palatable number when you consider your projected net operating income, which is $22,368.

We’ve arrived! We have an offer price! But there’s something missing. Oh, yes, you’re probably wondering what the seller’s asking price was on this property. I won’t keep you in suspense. The asking price was $338,000. Of course, you’re thinking that sounds really high. Here’s an indication of just how high that price is. If you purchased the property with a down payment of 10 percent this would have equated to a loan payment of $25,524 using a 7.5 percent interest rate. Remember our projected net operating income? Let me refresh your memory: it was $22,368. Can you see the problem with this? The income falls well short of even covering your loan, let alone anything else. Had you bought this property at the list price of $338,000 or even at $300,000 you would have been in a negative cash flow situation immediately.

To determine how much the property is actually worth—in other words the property’s valuation—you just divide the net operating income by the capitalization rate. The number you arrive at is the valuation. It was called purchase price in the previous formula. And the valuation is your initial offer.

Property Value and Offer Price = NOI + Capitalization Rate

So let’s continue with our real-world example. The capitalization rate used in the Phoenix property pro forma was .74 percent, a standard rate used by the broker. At this stage, I’ll just use the capitalization rate provided. There’s no point going through a lot of effort to do otherwise until much later, if at all. So we’ll divide our NOI by our capitalization rate, and in doing so, we arrive at a property value and offer price of $255,926.

$22,368 – .0874percent = $255,926 The offer should be no more than $256,000.

Because your compromise budget is (in theory, at least) a budget that will work for you and move you toward your goals, we’ve got to make sure it gets put into action. The spending plan you are now going to construct is going to be based on the amounts you’ve used in your compromise budget.

While you could try to figure out a way to separate single expenditures, so that all your gourmet coffee is tracked under one part of the spending plan and all your groceries under another, I’d like to suggest an easier format. It actually goes back to the formula you learned for discretionary income, where you had three real simple budget pieces.

What I’d suggest is finding a way to have all your fixed expenses come out of one pile of money, and all your variable expenses out of another. Remember, this is based on the premise that for the most part you don’t act impulsively when it comes to paying your car payment or electric bill (both fixed expenses). More often, your discretionary income is chipped away by the total effect of your variable expenses.

Investing has social costs as well as financial costs. Every period has its popular investments and its forgotten asset classes. Fashion changes, fads fade, and no one can keep up with all the latest hot new things. Inevitably, there will be regrets and resentments.

Even if you are in the right investment class, you might pick the wrong investment. Tech investors who bought IBM in 1988 regret they did not buy Microsoft instead. Real estate investors in the 1990s lost prestige to stock investors even though real estate returns for the decade were great. Their spouses and friends criticized them as out of touch. Cab drivers had stock tips for them. The investment magazines and newspapers dropped coverage of real estate and added tech stock sections.

Sometimes pressure comes from employers or family members to own certain investments or investment classes despite your own preference. Company stock is pushed on employees regardless of the prospects. Family real estate is to be held for generations even if poorly located and badly managed. Resentment is inevitable. Some products are sold with great sales pressure. Annuities are foisted on unsuspecting buyers as safe, high return, and tax smart. In fact, they are low return, unstable, tax dumb, and very costly. The annuity buyer will eventually figure all this out and have regrets and resentments.

Many investors avoid resentments and regrets by never checking their results or by refusing to sell losers. Hoping to get even, they instead experience free-floating fears and anxieties.

If you can move from having just a budget to having a spending plan, your success at getting rid of debt is almost guaranteed. A spending plan will ultimately help you enforce what I’ve said from the start is the true secret of getting out of debt: spend less and pay more toward your debts.

At its simplest, a spending plan is some type of system that forces money to go where you’ve already predetermined it should go. In other words, it ensures that the amounts you filled in on your compromise budget get to where they need to, and don’t get exceeded. Unlike a budget, which mostly operates in a rearview mirror role, the spending plan acts like the front windshield.

A good spending plan does this by rescuing you from the two primary sources of budgetary failure: having too many things to remember and being an impulsive spender.

It overcomes your short-term memory challenges by setting aside certain amounts in advance for each category. When those set-aside amounts are used up, you know you’re done. There’s nothing to remember but zero. When you hit it, you’re done.

It also overcomes your impulsive spending by setting apart amounts you need to protect—namely, your discretionary income. If you decide what your discretionary income should be before you ever spend, there’s a lot better chance it’ll be there when the smoke clears at the end of the month.