Financial Metrics & The Time-Wealthy Investor
When I set out to write The Time-Wealthy Investor, I intended from the beginning to make it unlike every other book I’d ever read on real estate investing. Some books I read were fantastic, others less so. All of the books I read, however, had one underlying theme: how to make a living in real estate. The Time-Wealthy Investor shows you not just how to make a living, but how to make a life.
I have a degree in accounting, and I worked in the field of banking as both a credit analyst and loan review consultant.
So, I know a thing or two about financial metrics. Some metrics are important, and others aren’t as much. Like the pilot of an airplane, you must look at all of your instruments. If you’re only looking at one thing, like the altimeter, you might think you’re doing well. Unfortunately, the altimeter only tells you how high you are above the ground at a specific moment in time; it won’t tell you that you might be 30 seconds away from flying into a hill. That’s why you have to look at all of the metrics in context.
For example, getting a 20% ROI (return on investment) might sound fantastic at first, but you quickly come to realize that it’s meaningless if your level of investment is small. If you only invested $1,000 in cash to get you into your highly-leveraged real estate deal, a $200 annual return amortized over 12 months nets you a whopping $16.67 per month. Not anything I’d stay awake at night getting excited about. If anything, if I’m that highly leveraged, I might find myself staying awake at night for an entirely different reason, making sure I can make the mortgage payment!
Where Cash Flow Comes From
For those of you in the business already, I know this might sound obvious, but equity is what generates cash flow. For those of you still learning about this concept, this should make it easier. If you had a mortgage and purchased a property for $200,000 that was valued at $300,000 (by market standards), you have $100,000 in equity.
That $100,000 is really what generates the cash flow. Renters will be willing to pay rent based on the $300,000 value of the property. I’m not saying it’s impossible to cash flow properties with little equity, but you’ll have to be much more involved every day, and you’re leaving yourself much less room for error or the occasional bad tenant.
Net Dollar
The concept of the “net dollar” is basically what will keep you from going broke. This is what I failed to understand early on and cost me a LOT of money. You might have the best-looking investment on paper, with a 30% ROA (return on asset) or a 25% ROE (return on equity), but if your net dollar is a small number, you’re going to get eaten alive the first time a maintenance issue comes along.
Here’s an example of what I’m talking about:
Let’s say you buy a property for $50,000 and get a mortgage for $40,000, and it cost you $12,000 in cash to consummate the deal when you add in closing costs. The property is “worth” roughly $55,000. (I put “worth” in quotes because I’m not talking about appraised value; I’m talking about what the property is worth to someone who would rent a similar property.) In this case, the rent is $550 per month. So far, so good.
For a 15-year mortgage, your monthly payment is going to be about $295 based on a roughly 4% rate. Add in $60 for insurance and taxes, and you’re looking at a total mortgage payment of $355 per month. Factor in the rent of $550, and you’re looking at a per-month profit of $195.
If you’re not impressed by these numbers, good — you shouldn’t be. Consider that from a metric perspective, this investment looks decent in some areas, but not so good in others:
What’s worse is that this is based on a tenant being in place, not paying late, with NO maintenance expenses. This is where the wheels come off the wagon.
If you’re not considering your net dollar return, this is where you will struggle. Consider how much it costs for ONE service call for a furnace or air conditioning service. In my market, $350 is not unreasonable. So basically, my profit for this property is eaten up for nearly two months, because I didn’t consider my net dollar or what things cost.
The moral of the story:
You don’t pay bills with percentages; you pay bills with dollars. Don’t get hung up on metrics alone.