Master Real Estate Financials for Your Objectives
If you are a wholesaler, buy & hold investor, flipping to retail customers or flipping to investors, it is imperative that you understand the underlying financial concepts that savvy investors use to evaluate houses.
I have REIAs that focus only on purchase price and rehabs not exceeding 65 or 70% of the After Repaired Value (ARV). These are great guidelines for flipping properties to ‘retail’ buyers. Most savvy investors find that evaluating Cash-on-Cash return and Cap Rate is important when they are looking at holding properties for rental, when they leverage their investments, and when they look at lease/purchase or subject-to opportunities.
Wholesalers – You should first understand what the criteria that your buyers utilize to evaluate their investments. Are they looking for homes for rentals (also known as buy and holds), flipping to other investors after rehab and placing tenants, or are they flipping these homes to residents? Perhaps some of your buyers are looking for owner financing or homes that will easily qualify for financing. I have some buyers that buy first based on their investment strategies, and others that also add other criteria (only upper middle-class neighborhoods, homes built after 1980, low crime areas, etc). Determine these criteria and keep a database of these buyers. They will appreciate not getting buy and hold/rentals if they are focused on flipping homes to prospective residential owners.
Wholesalers should also ensure that their calculations consider their profit…
Buy and Hold Properties for Rentals
Most investors buy these homes based on Cap Rate. Capitalization rate (or “Cap Rate”) is a real estate valuation measure used to compare different real estate investments. Cap rate is usually calculated as the ratio between the annual net operating income (NOI) produced by an asset (home) and the original capital cost (the price paid to buy the asset/home plus rehab/repairs).
Net Operating Income is the Income less expenses (Utilities, Taxes, Insurance, Maintenance). For example, let’s say this is your scenario:
Monthly Rent $1000
Utilities $ 0 (tenant pays all utilities)
Taxes $ 100 (property tax plus other taxes – include HOA fees if necessary)
Insurance $ 50
Maintenance $ 100 (I use $100/unit up to $100K home value, $200/unit up to $200K, etc)
Monthly exp total $ 250
Monthly Net Operating Income $750
For Annual Net Operating Income, you can multiply by 12 – but you haven’t considered vacancy or other issues you may face. For a benchmark, you can multiply:
Monthly Net Operating Income x 10 = Annual Net Operating Income (NOI)
Note: my calculations multiply by ten instead of twelve for Annual NOI, which is a great guideline to buy properties. When you are selling properties you would of course figure in your market vacancy rate and multiply monthly NOI times 12.
For our example of $750/month, that results in $7,500 Annual Net Operating Income.
If we purchased this home for $65,000 and spent $10,000 in rehab costs, then our Cap Rate is:
Annual Net Operating Income $7,500
______________________________ = 10% Cap Rate
Purchase Price + Rehab $75,000
A Cap Rate of 10% is standard for most single family homes in metro areas of the Southeast US. For major metro areas in the West or Northeast, the CAP rate might be significantly lower.
In addition, I look for a $200 monthly income.
Here is a great online calculator for CAP Rate:
NOTE: CAP rate is based on a Cash purchase, and doesn’t consider financing costs such as monthly mortgage payments.
You might purchase a property in the following situations:
- You got a bank or private loan
- You got the owner to hold the financing
- You purchased the property for 30% of its value (tax lien)
- You got a lease purchase or a subject-to purchase with a low option fee
In these situations you can consider your Cash-on-Cash return. In many situations (such as a lease purchase or subject-to) the CAP rate might be lower than the normal rate in your area. However, you aren’t putting down cash for this investment.
Consider a home you purchase for a rental. Rent will be $1200/month
Purchase price $100,000
Down Payment $ 20,000
Closing costs & fees $ 5,000
Cash Invested $ 25,000 (your cash investment)
Financed Amount $ 80,000
Monthly payment $ 630 (includes $100/month for taxes and $100/month for insurance)
Maintenance/month $ 100
Monthly cashflow $ 470 ($1200 rent minus $630 payment minus $100 maintenance)
Annual cashflow $ 4,700 (only 10 months to accommodate vacancy plus other issues)
Cash-on-Cash Return is Annual cashflow divided by Cash Invested
$ 4,700 / $25,000 = 18.8% Cash-on-Cash Return
Here is a great calculator for Cash-on-Cash Return:
Flipping for Sale to a Residential Homeowner
These investments usually use a factor that is calculated as a percentage of the After Repaired Value. To start this evaluation you must properly consider the correct After Repaired Value (also known as ARV). It is routine for an appraiser to provide a ‘subject to’ appraisal. A “Subject To” appraisal is one in which the value is based on a what a home will be worth after an improvement has been made.
Many investors will guess at this amount without an appraisal. I had a home that I was rehabbing with 2 main level bedrooms and a bedroom in the walkout basement. The appraiser I hired (for $400) informed me that since the master bedroom (on the main level) was very wide, I should consider making this master smaller and incorporating a third bedroom on the main level. Based on comparable sales in the area, this change (cost of about $1200) was worth $15,000 in the appraised value!
I recommend that you understand the home area, use an appraiser, or get a knowledgeable real estate agent to provide a CMA (Comparable Market Analysis) to provide a reasonable After Repaired Value.
You should also understand true costs to rehab a property. I have seen wholesalers lose local credibility by drastically underestimating the rehab costs. There are some good real estate software tools that can help. In my local REIAs there are contractors who will provide a rehab estimate for $50 – $100.
The standard most flippers use ranges between a maximum of 65% to 70% of the After Repaired Value.
For example, let’s say you find a home for $120,000 that needs $15,000 of rehab. The After Repaired Value (ARV) is $200,000
Purchase price plus rehab $120,000 plus $15,000 = $135,000 ( 67.5% of ARV)
This 70% ARV calculation provides some flexibility to consider PROFIT, holding & closing costs, and unforeseen issues (or opportunities) during rehab. Many new investors focus on ARV, but this isn’t the appropriate benchmark in buy and hold, subject to, lease purchase, or financing situations. If you can find homes that meet multiple benchmarks (such as a Cap rate suitable for your market and 70% of ARV) then you probably have a great find!
Here is an ARV calculator:
As you can see, your investment objective is critical to determining the correct calculations. Don’t stick with one calculation or benchmark, as your objective will dictate the calculation used. If you can get more than one benchmark to work for your prospective properties – Great! You will have two exit strategies for your property. Many investors find that they plan for a Fix & Flip to a homeowner, but for some reason the property doesn’t sell. Having the ability to rent this property to provide cashflow (using the CAP rate) may be a great alternative.
Curtis Waters is a broker with Real Estate Realty LLC, and is licensed in both North and South Carolina. In addition to being an active investor of multifamily and single family properties, Curtis has an extensive background in sales and an MBA from Florida Tech.
Real Estate Realty LLC, 6000 Fairview Rd Suite 129, Charlotte NC 28277