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Cash on Cash Return

12/27/2011

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In investing, the cash-on-cash return is the ratio of annual before-tax cash flow to the total amount of cash invested, expressed as a percentage. The formula to compute cash-on-cash return is:

PurposeThe cash-on-cash return is often used to evaluate the cash flow from income-producing assets.

ExampleSuppose an investor purchases a $1,200,000 apartment complex with a $300,000 down payment. Each month, the cash flow from rentals, less expenses, is $5,000. Over the course of a year, the before-tax income would be $5,000 × 12 = $60,000, so the cash-on-cash return would be

LimitationsBecause the calculation is based solely on before-tax cash flow relative to the amount of cash invested, it cannot take into account an individual investor's tax situation, the particulars of which may influence the desirability of the investment. Furthermore, the formula does not take into account any appreciation, depreciation, or other risks associated with the underlying property.

Cash-on-cash return is essentially a simple interest calculation, and therefore is not subject to the compounding of interest. The implication for investors is that an investment with a lower nominal rate of compound interest may be superior, in the long run, to an investment with a higher cash-on-cash return.

Retrieved from "http://en.wikipedia.org/wiki/Cash_on_cash_return"
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Internal Rate of Return (IRR)

12/27/2011

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Occasionally someone will want to calculate the Internal Rate of Return on an investment property. This article explains how that formula works. (IRR)  The internal rate of return (IRR) is a capital budgeting method used by firms to decide whether they should make long term investments. The IRR is defined as any discount rate that results in a net present value of zero, and is usually interpreted as the expected return generated by the investment. In general, if the IRR is greater than the project's cost of capital or hurdle rate, the project will add value for the company.

To find the internal rate of return, find the IRR that satisfies the following equation

Example:
Year Cash flow
0 -100
1 +120

Calculation of NPV:
i = interest rate in percent
NPV = -100 +120/[(1+i/100)^1]
(This calculation is condensed.)

Calculation of IRR:
NPV = 0
-100 +120/[(1+IRR/100)^1] = 0
IRR = 20%

Problems with using IRRAs an investment decision tool, the calculated IRR should not be used to rate mutually exclusive projects, but only to decide whether a single project is worth investing in. In cases where one project has a higher initial investment than a second mutually exclusive project, the first project may have a lower IRR (expected return), but a higher NPV (increase in shareholders' wealth) and should thus be accepted over the second project. A method called marginal IRR can be used to adapt the IRR methodology to this case.

The IRR method should not be used in the usual manner for projects that start with an initial positive cash inflow, for example where a customer makes a deposit before a specific machine is built, resulting in a single positive cash flow followed by a series of negative cash flows (+ - - - -). In this case the usual IRR decision rule needs to be reversed.

If there are multiple sign changes in the series of cash flows, e.g. (- + - + -), there may be multiple IRRs for a single project, so that the IRR decision rule may be impossible to implement. Examples of this type of project are strip mines and nuclear power plants, where there is usually a large cash outflow at the end of the project.

In general, the IRR can be calculated by solving a polynomial. Sturm's Theorem can be used to determine if that polynomial has a unique real solution. Importantly, the IRR equation cannot be solved analytically (i.e. in its general form) but only via iterations.

A critical shortcoming of the IRR method is that it is commonly misunderstood to convey the actual annual profitability of an investment. However, this is not the case because intermediate cash flows are almost never reinvested at the project's IRR; and, therefore, the actual rate of return (akin to the one that would have been yielded by stocks or bank deposits) is almost certainly going to be lower. Accordingly, a measure called Modified Internal Rate of Return (MIRR) is used, which has an assumed reinvestment rate, usually equal to the project's cost of capital.

Despite a strong academic preference for NPV, surveys indicate that executives prefer IRR over NPV. Apparently, managers find it intuitively more appealing to evaluate investments in terms of percentage rates of return than dollars of NPV.

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What is a Cap Rate

12/27/2011

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Just what is a CAP Rate and how do I figure it?  
According to the Appraisal Institute, a cap rate is the method used to convert an estimate of a single year's income expectancy into an indication of value, by dividing the income estimate by an appropriate rate. Expressed as a formula, it looks like this:

Cap Rate = NOI / Value 

Where NOI = Net Operating Income. This also leads to the derivative formulae:

Value = NOI / Cap Rate, and
NOI = Value x Cap Rate

An investor is looking at a property listed at $100,000 She knows that the annual expenses will be $10,000 annually. and the income will be $20,000. The NOI is then $10,000 annually. Thus the cap rate is 10%.

A positive cash flow is hard to recognize if the cap rate falls below 10-15%. And lets face it, this is all about cash flow. 

Appreciation is a great plan but most people don't have the pockets to purchase a property that will not cash flow, waiting and hoping that it will appreciate. You need income. I need income without it you call me and yell at me. Not good!

You must have the prior operating expenses for the property. More importantly they must be correct. Let us go over the numbers with you and evaluate them.

You must understand the actual operating expenses of an income producing property. Those expenses have a direct effect on the NOI, which has a direct effect on the Cap Rate. Before proceeding, let's review some terms:
  • Monthly Income: The total of all revenue, such as rents, laundry, or other fees and charges (but NOT including deposits collected)
  • Annual Income: Monthly Income x 12
  • Monthly Operating Expenses: The total of all expenses directly related to operating the property, such as maintenance, management, repairs, utilities, taxes, pest control, advertising, etc. 
    but not including debt service.
  • Annual Operating Expense: Monthly Operating Expense x 12
  • Net Operating Income: Annual Income minus Annual Operating Expense
  • Net Profit: NOI minus Debt Service
  • Value: Asking price or market value of a property
Cap rate serves as an acid test of the profitability of a property. As mentioned above, cap rates are very sensitive to changes in income and operating expenses.

For illustration, let's choose a duplex that has two 2-bedroom apartments. Let's also say that you know the current fair market rent for a 2-BR apartment in your area to be $650/month. If this property is listed at $98,000, what would be the cap rate?

You cannot answer this question unless you know the operating expenses for this property. You can figure out that the annual Income should be $15,600, but that's as far as you can go. Let's say that you are told that the owner listed operating expenses as $4,300 last year on their tax return. Now, you have something to work with (even though owners tend to inflate the actual operating expenses on tax returns, in order to reduce taxes owed.)

Using these numbers, the NOI would be $11,300, and the cap rate would be 11.53%. But, let's say that the same tax return only shows $13,700 in rental income. How does this change things? Using that figure, the cap rate would only be 9.59%.

Your investment guidelines might require a 10% or better cap rate for rental properties. How could you get the cap rate up, knowing that the owner's tax return last year shows a NOI of only $9400? If you remember the cap rate formula, you can increase the cap rate by:

- Increasing the rent (it's $1,900 a year under fair market)
- Decreasing the operating expenses ($4,300 might be too high)
- Negotiating a lower purchase price ($94,000 would be a 10% cap rate)

Don't forget to factor in your closing costs and of course my management fees.

Now, did the previous owner do all of his own maintenance? Will this make your costs higher? What about taxes and insurace? They never decrease! Did he have a high vacancy rate prior to listing the property for sale. Very common to fill a property with warm bodies that may not pay rent, just to say it's full. If so will this make your utility and trash collection higher? Don't forget eviction costs. If he filled it up with deadbeats I will have to evict them. In this area that may take 90 days.

Don't go into these things alone. Please call me. I may save you a fortune.


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What does Turn-key mean?

12/27/2011

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_ What does Turnkey mean? What is a turnkey investment or what is a turnkey property?

Turn-Key is defined by Wiki as

"Turnkey refers to something that is ready for immediate use, generally used in the sale or supply of goods or services. The term is common in the construction industry, for instance, in which it refers to the bundling of materials and labor by sub-contractors. A "turnkey" job by a plumber would include the parts (toilets, tub, faucets, pipes, etc.) as well as the plumber's labor, without any contribution by the general contractors.
This is commonly used in motorsports to describe a car being sold with drivetrain (engine, transmission, etc.). A vehicle for sale without these pieces is sold "rolling". A racer may prefer to keep the drivetrain pieces to use in another vehicle to preserve a combination. Similarly, this term may be used to advertise the sale of an established business, including all the equipment necessary to run it, or by a B2B supplier providing complete packages for business start-up.
Specific usageThe term turnkey is also often used in the technology industry, most commonly to describe pre-built computer "packages" in which everything needed to perform a certain type of task (e.g. audio editing) is put together by the supplier and sold as a bundle. This often includes a computer with pre-installed software, various types of hardware, and accessories.

In The Wizard of Id, Spook's jailer is named Turnkey."

In real estate the term has two meanings; for rental property the term means to be ready to rent-ready or move-in ready. In investment real estate the term means a property that is already tenanted and fully functional as an investment property.

A turn-key property is one that is fully occupied with little or no maintenance required, generally with management in place. Often, local investors do not require the services of a property management company.

There is no dollar figure attached to the term turnkey only the fact that the property is leased, occupied and cash-flowing.

Cap Rates are often used to decide the income potential or value of a property. Please visit our Cap Rate description page understand the value of a cap rate.

We offer Turn-Key Property, Many of our current investors are interested in selling their investment portfolio. We can offer sales, leasing and property management for your turnkey investment.

Another use of the term turnkey is to say that a company offers turnkey services. Many contractors offer total turnkey services for rental property. Taking a vacant unit from vacant to cleaned, painted, and ready for occupancy.

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What does ARV Mean?

12/27/2011

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_ What does ARV mean?     Often in seeing advertisements or marketing materials for investment real estate you will see the term "ARV".

Simply put; ARV is After Repair Value, (sometimes called After Rehab Value) the value of a particular property or portfolio of properties after they have been remodeled.  It is calculation used to determine the market value of a property after it has been repaired. Allowing the investor to determine their potential return on investment (ROI).

Purchase Price$56,000
Repair Cost
$24,000
ARV
$100,000
ROI
$20,000



   
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