Cap Rate, Cash on Cash Return, Net Operating Income, Vacancy Rates, Gross Rents, Operating Expenses, and Debt Service all have one thing in common.  They are fancy terms that you MUST UNDERSTAND if you want to get in the game of Real Estate Investing.

And you should want to get in this game, because you can change your families financial future and create wealth beyond your wildest dreams through the vehicle of real estate.

Every deal you analyze will look like this:

Gross Annual Rents minus Operating Expenses = Net Operating Income

Net Operating Income minus Debt Service = Cashflow

I am going to break these terms down starting from the back.

Cashflow is THE MOST IMPORTANT number you need to understand.  If your cashflow is tight, you will not be able to absorb a bad year, or a recession.  You must have a large enough cashflow to pay you the monthly checks that you desire.

That is where cash on cash return comes in.  The cash on cash return is simply the annual cashflow divided by the initial cash investment.

For example, if you buy a property for $1,000,000 and you put $200,000 into it, and it provides a cashflow of $20,000/yr, what is your cash on cash return?

The Math: $20,000/$200,000 = 10%.  For what its worth, I do not do any deals that are less than 10% cash on cash return.  I do that because I want to make AT LEAST 20% on all of my deals, each and every year, so when you factor in appreciation, depreciation, and debt reduction, a 10% cash on cash return will get you about 20% year over year, in a good market.  If theres a market correction, which always does happen, then you have a couple years of less healthy returns, but you should be able to withstand it due to the cashflow buffer.  I cannot share the exact cash on cash return that I target for all of Towner Companies deals at this time, as that is the secrete sauce, but I will be sharing that when we launch the Million Dollar Portfolio virtual training program in the coming months.  Stay tuned for that.

Next, lets talk debt service. This is easy… its simply your mortgage payment.

Now lets talk Net Operating Income, which I will refer to as NOI.  NOI is your cash remains after you pay all of your operating expenses.  NOI is extremely important because it eliminates debt from the equation when you are analyzing deals, and allows you to come up with a cap rate.  You might ask, “why is it important to eliminate debt from the equation?”  And the answer to that is simple.  Once you start doing commercial deals, you quickly realize that mortgages aren’t always structured the same way.  Big players who know the game can often times attain better loan structures than newbies with a poor balance sheet.  But that should not negatively affect how the property is valued, so we utilize the NOI to determine the cap rate, which effectively is a number that tells people the value of the property.

Cap Rate: NOI / Purchase Price

Lets go back to the example we discussed earlier.  Lets say that $1,000,000 property had a NOI of $70,000.  The cap rate on that property would be $70,000 divided by $1,000,000 which equals 7%.  In strong markets, when the property values are driven up, the cap rates go down.  In recessions, when values decline, cap rates go up.  Hence why its always best to buy during recessions, but you still want to be in the game every day because opportunities are ALWAYS out their for the sophisticated investor.

Understanding Cap Rates is CRITICAL.  This term comes up in almost every single conversation I have with a Commercial Broker.  And your banker is going to want to know the cap rate as well, so get to know cap rates so well that you can calculate them on a napkin.

Gross Rents are simply the total rents that the property will bring in for a year.  Its important to apply a vacancy factor, which is a percentage of those rents that get discounted due to vacancies.  We typically project 10%, but it depends on the type of the property.  You are then left with Net Rental Income which is your gross rents minus your vacancy factor.

Operating Expenses are pretty self explanatory.  These are all of your expenses except your mortgage payment.  As easy as this is, new people to the real estate game may talk about operating expenses with a more seasoned broker, and you can find yourself on a different page very quickly if you are including the debt service.  Typical expenses include insurance, property taxes, utilities, garbage, lawn care, snow care, repairs and maintenance, cleaning, property management, etc.

In conclusion, if you can master and understand these key terms in real estate investing, you will be well on your way to mastering the basics.  Real Estate is such a simple game, but you need to understand the language and be able to “talk the talk” with folks in the industry.  Something I did that can help you, is I looked at hundred of properties online and requested financials if they weren’t publicly available.  I then would analyze the deals, come up with the NOI, the Cap Rate, and then the Cash on Cash Return.  I did this over, and over, and over again until I could analyze a deal in under 30 seconds.  I obsessed over this, literally working on improving my ability to analyze numbers any free second I had.  I stayed up late, I got up early, and did what it took to master the numbers,

And that is when the entire game changed for me. I joined an exclusive club of real estate investors who actually understands the numbers.  I don’t need to rely on brokers or bankers to tell me how a property performs.  In fact, I pride myself on being the best at analyzing deals and understanding the numbers.  You don’t want to scale up and build a multi-million-dollar portfolio if you do not understand the numbers.  You could get a year or two down the road, realize things aren’t working out how you had hoped, and BOOM, your toast!

So do yourself a favor, and commit to learning this game.  Commit to being a life long learner in general.  Practice in your spare time, get out your calculator, and master the numbers.

Best Regards,

Greg

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