When I set out to write The Time-Wealthy Investor, I was intentional 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. I feel the 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 worked in the field of banking as both a Credit Analyst and Loan Review Consultant. 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, the altimeter for example, 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 a pilot, and you, have to look at all of the metrics in context.
It’s going to be difficult to summarize all the financial metrics into a neat little article, but I will give you some thoughts about what I feel are the most important in relation to everything else. If you haven’t read that far into The Time-Wealthy Investor, what I’m about to say might sound a little strange. Financial metrics, without context, are pretty much worthless.
The reason I say this is because without context, getting a 20% ROI (Return on Investment) might sound fantastic at first, but you quickly come to realize that it’s meaningless if you’re level of investment is very small. For instance, if you only invested $1,000 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
Cash flow comes from equity. To those of you in the business already I know it might sound overly obvious, but equity is what generates cash flow. For those of you not quite up to speed on this concept, this should make it easier. If you got a mortgage and were able to purchase a property for $200,000 that would, by market standards, be valued at $300,000, 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’re going to have to be much more involved on a daily basis and you’re leaving yourself much less room for error or the occasional bad tenant.
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. The reason why I’m making such a big deal about this is because 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 you’re “Net Dollar” is a very 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 you 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 that would rent a similar property. In this case, the rent is $550 per month. So far so good.
For a 15 year mortgage, your 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. Factor in the rent of $550 and you’re looking at a per month profit of $195 per month.
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:
ROI = $2,340 (annual return) / $12,000 (cash investment) = 19.5%
ROE = $2,340 (annual return) / $15,000 (value of equity) = 15.6%
ROA = $2,340 (annual return) / $55,000 (value of asset) = 4.25%
What’s worse is that this is based on a tenant being in place, not paying late, and there being NO maintenance expense. 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 what things actually cost. I didn’t consider my “Net Dollar”.
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.