Cash on Cash Returns for Rental Properties

Financial Place Online test fired their “Complete Landlord Calculator” today.  The first test involved what is referred to as “Cash on Cash” return.  The “Cash on Cash” return is the percentage of annual cash received vs your initial investment.  This is an important return as it defines how your investment cash flow looks.  A negative return indicates that the house is sucking up money.  Higher positive returns can be had with better management of the underlying financials such as interest rate, purchase price, and rent received.  A higher rate can also be had by increasing the amount of leverage of your investment capital.

Leverage of Capital:  The ratio between your invested capital and the purchase price of the asset.  In the case of a $50,000 investment and a $50,000 purchase price, the leverage is 1:1, or more simply expressed as 1.  However, if the investment was $5,000 for the same $50,000 asset as would be done through using the bank’s money to cover the other $45,000, the leverage would be 10.  A higher leverage will return a higher rate of return for investments who return a rate greater than the weighted averaged cost of borrowing.

The problem with using leverage is that negative returns get exaggerated in the same way.  This deals with both cash flows and a decrease in value of the underlying asset.  Using the $50,000 asset with a leverage of 10, a $5,000 drop in value wipes out all of your investment, since the bank still needs to be paid.  In most all cases, the bank has secured the loan by your asset, so they will be the first to be paid in case you have to sell.

The below chart shows an example case of “Cash on Cash” returns plotted against the amount invested.  The investment being examined has the following characteristics:

  1. This is a house priced at $150,000
  2. Your out of pocket closing costs are $1,500
  3. The mortgage is for a 30 year term
  4. The interest rate is 4%
  5. The rents collected is $1200
  6. Property management takes 10% of rents collected
  7. Occupancy rate is 95%.  Many rental markets are on fire right now
  8. Property taxes at $1500 per year
  9. Hazard insurance is $300 per year

Cash on Cash>>> The chart shows a very high rate of return in the case of 0% down (just the $1,500 closing costs).  From here the rate of return decays exponentially until it flattens near 6.5%.  This amount is the unleveraged rate of return.  Again, remember that too much leverage can be dangerous.  In the case of residential real estate, a healthy amount of leverage can be had between 10% and 30%, and will vary from opportunity to opportunity.  There was entirely too much dealing done during the sub prime era of real estate lending where 0% down deals were permitted on rental properties.  The highly leveraged cash flows swung to the negative after the crash and many investors did not have the cash on hand (which is why they did 0% down) to cover the losses, and thus lost their businesses.

 

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Time to take some gains off of the table

Bull MarketWith the S&P 500 now at 1472 investor confidence appears to be at a high.  The recent closing reinforces FPO’s forecast of being above 1400 come February 1st, but does that mean that its wise to stay in stocks?

As the investor, you are not your customer.  Your goal is to make money.  As such, if something is being made out to be an attractive buy, as stocks have been this last month, your job should be focusing on fulfilling that demand.  It is time to sell.  It doesn’t have to be a 100% move away from stocks, but taking some gains off of the table and going for what others are dumping is what the smart money is doing; by either selling into this rally or by moving all of their money elsewhere.  Attractive options include bonds, real estate, and commodities other than gold (which is still relatively high).

This principle of serving as a facilitator to the markets is close to being a “market maker”.  In the strictest definition, a market maker simultaneously buys and sells all asset classes that they participate in at their predefined spread.  They operate at a large scale of economy which is why they can command this spread, however they must participate on both ends which means bearing risks of buying assets when there may be no one to sell to.  The average investor does not operate with the economy of scale of a true market maker, but their position is better in that they can choose what they buy and sell.

Seems simple, right?  Investing techniques can be heavily determined by charts and valuation data.  In fact doing so, is an essential part to being successful.  At it’s roots, investments are made by individuals, which are subject to behavioral patterns.  Part of the basic programming here is to buy what looks attractive.  This runs contrary to money making principles, which dictate to sell what looks attractive and use the proceeds to buy something of value.

How to earn an extra $500 a month: Part 4

OLYMPUS DIGITAL CAMERAPart 4 wraps up the series on earning an extra $500 per month.  The focus this time is not increasing income, but instead decreasing expenses.  After exhausting all of the previous options, there always remains the option of cutting expenses.  Below are three examples designed to save an average of $500 per month.  It is unlikely that a specific example may fit you perfectly, so the best option is to pick from each example those options that do work for you.

Example #1  ($150+$80+$270)

  1. A newly created cost is the smartphone data plan.  With many 2 phone plans pushing past $200, perhaps a simpler approach is needed.  Here’s the action… drop the phone plans and get a prepaid plan and free internet at your local library.  The savings here can be as high as $150, which still leaves an allowance for going prepaid.
  2. Cut out the $20 per week for office lunches, coffee, etc.  Home cooked food gets better with time and experience.
  3. Downsize your car payment.  If you have a car payment, try trading it in for something older that will reduce of your payment.  A New $24000 car will have a payment of $450 per month with good credit.  Cutting down to a $10000 car will save $270 per month.

Example #2 ($300+$100+$25+$75)

  1. Refinance that car.  Extend the term if needed.  It will be good to free up the cash flow, and car debt for those with good credit it is not that expensive.  If you had three years left and a balance of $24000 at 5%, refinancing to five years at 2%, would save $300 per month.
  2. Cut the cable TV.  With good quality programming on Netflix and Amazon Prime, cutting the high end cable and movie packages will save upwards of $100 per month.
  3. Ask for a reduction in rent.  This applies to good tenants who pay on time.  A vacancy costs a landlord a good amount of money.  On top of that, they are paying 10% management fees and taxes on top of every gain.  Asking for a modest $25 per month (or hopefully more) off of your month should be reasonable to many landlords who wish to keep a good tenant.
  4. Make sure not to buy more insurance than needed.  Insurance is mainly designed to protect personal assets.  If you don’t have much in the assets category, cutting insurance and raising deductibles can free up some cash.  $75 per month alone on health insurance is achievable.

Example #3 ($260+$40+$200)

  1. Carpool, walk, or take public transportation.  This really applies to your second car.  Get rid of that $15000 new car you just bought on a 5 year loan and save $260 per month.
  2. Ditch the home phone.  The home phone and long distance is now becoming more expensive than a prepaid cell phone with unlimited talk.  Since most have the cell phone, this will save about $40 per month.
  3. Refinance the house.  There are many options for no-cost refinancing.  Refinancing a house that you bought three years ago for $165,000 at 5% can now be refinanced at 3.25% for 30 years, freeing up $200 per month.

The FPO series on earning an extra $500 per month has provided multiple methods for achieving that goal of bringing in some extra income.  Combine that with some of the savings methods above, and the result should be a complete transformation of your personal finances.

How to earn an extra $500 a month: Part 3

Office chair and notebookPart 2 of this series explored methods of creating $500 a month additional income by investment opportunities requiring less upfront funds than would be otherwise possible, since the bank’s money is being used as leverage to raise the effective rate of return.  For part 3, FPO will provide guidance on increasing your income by $500 per month through your current job or expanding into various side jobs.

For your current job, there are several options.  Volunteering for overtime is the surest option, however many companies are cutting this back or eliminating it outright.  If its an option, and it fits your schedule…take it.  However, overtime is not right for everybody.  Asking for a raise is another common option, though frequently approached incorrectly.  Instead of asking, think of negotiating for that raise.  By asking, your thought process is centered around entitlement.  How many times has the phrase “I deserve this raise”, or “I’m overdue for a raise” come up?  By negotiating, you can have more power over the conversation.  Just like a supplier to your company would, convince your boss that your value to the company has gone up, and as such so have your rates.  There is no harm in coming up with a number first, as long as its high enough to meet your needs, in this case $500 per month.

Sometimes the raise may not work.  It may be their way, or the highway.  That’s where the side job comes in.  Everyone should have a “Plan B”, something that not only creates some additional income, but also something that can be expanded if your main source of income dries up.

Here’s a list of ideas and what it would take to get that $500 per month goal:

  • Ebay: sellers get 50 free listings per month and fees total around 11% of sales.  If you have an eye for value locally, there is a ready market on Ebay ready to bid up the price.  50 items at $11.11 profit per item before fees gets the $500 needed.
  • Etsy:  Etsy defines the online market for handmade goods.  If you have arts and craft skills, this is the place to do business.
  • Amazon:  Excellent for opening your online store.  Amazon provides all of the code to set up your own store
  • Virtual assistant:  Make money by providing products and services over the Internet.  Fiverr and Odesk are networks through which virtual services can be supplied.  The nominal price on Fiverr for a service is $5.  Do 100 of these and your month is covered.
  • Yard Work: Keeping a dozen medium sized lawns mowed a month should net $500.
  • Logging:  There are places with too many trees and places where firewood permits are allowed.  $10-$15 per cord buys a permit.  Keep costs low and expect to get over $100 per cord depending on locale.
  • Instructor:  Skilled at Kung Fu, MMA, Skiing, Skydiving, Scuba diving, Art, or Dancing?  Leasing space can be split based on time and many community colleges allow for such classes to be taught.
  • A Second Job:  This one may not be agreeable with your current employer, and there’s likely to be schedule conflicts.  Proceed with caution.
  • Trade Shows and Conventions:  These events run the range from antique shows to car shows, sporting events, vending opportunities, and of course holiday bazaars.

There’s no shortage of opportunities.  Find something you enjoy, and good luck!

-The FPO Team

P.S. –> Part 4 is centered around getting that extra $500 per month by reducing your bills.

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