For the last few weeks we’ve been talking about calculating ROI for real estate investing. The first week we talked about the cost approach versus the out of pocket approach. Ultimately as real estate investors, we look at the out of pocket approach to determine our personal return on investment.
On day two we talked about the different types of returns on investment. You can have a return on the equity position of the property, its cash flow, or on any of the other four ways to make money in real estate. Today we’re going to take it a step further.
Making a Profit
-Never be all in for more than 70-75% of the ARV
-Equity Position subtracted by Transaction Costs = Net Profit
-Net Profit/All In = ROI based on Equity
-Yearly Cash Flow/All In = ROI based on Cash Flow
-If you can borrow at a lower rate than your ROI, you make money
-If your out of pocket is low, you can make even more
-The Spread between what you borrow and what you put your money to work to create = profit
With the cost approach, there’s typically about 30-40% profit available in a real estate deal. So if we buy a property that has a $100,000 after repair value, we’ll never be all in to that property for more than $70,000 (or 70-75% of the ARV). All in includes purchase, repairs, and anything it costs to buy and rehab that property.
So if we’re all in for $70,000 that gives us an equity position of $30,000 on that property. But if we turned around and sold it the next day or after a year we’d have to pay transaction costs like a title policy and a 6% realtor commission which ends up being about 10% of the deal. This allows us to walk away with $20,000 dollars net profit.
So if we’re using the cost approach, take the net profit ($20,000) divided by your all in and that would give you a 28.5% return on investment based on equity.
As we learned last week you can also make money on cash flow- so lets say you’re holding this property for a year and it cash flows $700 a month (For this example let’s assume you have $1,000 a month’s rent and since you paid in cash you only have taxes, insurance, and maintenance allowing you to walk away with $700 a month). If you multiply this by 12 it’s $8,400 a month cash flow. This divided by your all in gives you a 12% return on investment for cash flow.
So if you add these two together you get about 40% return on investment. On most of our real estate deals we make a 30-40% return based on a cash and cost approach to real estate investing. So if you can borrow at a lower rate than this you can make money in real estate investing. If you borrow at 15% and then make 30% on that money, you get to keep the difference.
What makes it even better is when your out of pocket is low- by using leverage you can get an even higher return than 15%. The whole theory is that if there’s a spread between what you borrow and what you put that money to work to create, then you can make a profit in real estate investing.
As always, if you have more questions make sure to put them below in the comments section and I’ll get back to you.