If you haven't had a chance to watch Ben Leybovich's presentation at our last meetup, then you definitely want to check it out. It's about an hour long. About halfway through, he shares his spreadsheet with our members to show how CapEx and R&M affect the performance of your property.
But there's only one problem: What the heck are CapEx and R&M?
Listed below are some terms that you should know in order to help you better analyze real estate investments.
CapEx (Capital Expenditure)
A purchase of a fixed assets (such as a roof or HVAC - heating, ventilation, and air conditioning). These are large purchases that you can use over several years. When calculating your 'cap ex', you need to calculate the useful life (how long you can use something) of all the major fixed assets in your property. Then divide that by the cost. You now have the annual 'cost' for that asset.
Example: New Roof
Useful life: 15 years (Varies by type and location. An area with extreme weather will wear out a roof faster than an area with moderate temperatures.)
$5,000 / 15 years = $333 / year
$333 / 12 months = $28
So each month, you should be setting aside $28 of your rent collected to eventually replace the roof.
Ben Leybovich and Serge Shukat wrote a long piece on CapEx and how much you should expect to set aside for CapEx each month. Their conclusion - about $260 / month.
Link to their article: Cap Ex calculations
R&M (Repairs and Maintenance)
From time to time, your tenant might call you to fix a leaky faucet or loose cabinet door (or hopefully will call your property manager!) The property manager will then call a handyman to go in make the repairs. These are considered repair and maintenance costs and a general rule of thumb is to set aside 5-10% of the rent for R&M. (Note: When possible, try to find out from other property managers / investors what the approximate costs for R&M are instead of using a %. But a % is fine for making estimates.)
Vacancy (or Occupancy)
Your vacancy or 'vacancy rate' simply means what % of the year you expect your property to be empty and therefore not collecting rent. Standard vacancy is usually set at 5-10%. You can also figure out vacancy rates by Googling your area. But remember that vacancy can vary wildly within even a few blocks as desirability of your apartment and other factors come into play.
Occupancy is the opposite number. It's how much of the time there is someone 'living' in your property. So if you subtract the vacancy from 100%, then you get the occupancy.
Management or Property Management (PM)
Your property manager is the person who will look after your property, make sure rent is collected, help find a tenant when necessary, take care of maintenance requests by calling an approved handyman or plumber, and make sure the property is generally being well cared for. A property manager can be a company you hire, an individual, or even you, as the owner can be the PM. A PM will typically charge 10% of your rent and some PMs will not deal with properties that earn less than $1,000 / month in rent.
Although typically in a single family house, a tenant will pay all the utilities, there may be situations when the owner has to pay these costs. For example, when there is no tenant in the house but you need to keep the hot water on to keep the pipes from bursting. Or you want to keep the lights on so the house shows better. Also, if you own an apartment, you may have to pay the utilities in order to be competitive in your marketplace. Or you may have to pay the utilities for common area usage - for example, the lights in a laundry facility. Utility cost will vary from area to area.
Turns or Turnover
A turn is when you must 'turnover' a property for a new tenant. This typically involves cleaning it out, painting the walls, steaming the carpets, etc., depending on the condition of the apartment and the demand in the area. PMs may also 'charge you' half a month's rent to place a new tenant to offset their costs of coordinating the clean up and showing your property to others. In this video, Ben also mentions 'legal' costs as part of turnover, in case you need to evict a tenant. You could also set aside all legal fees under a separate expense category labeled, "Legal."
While there is a technical definition for economic loss (paperbased losses), in the video Ben is talking about losses due to not collecting rent from a delinquent tenant, offering concessions and discounts to help you move in a new tenant, etc. He's basically referring to the times when you're not collecting your full rent but separate from vacancy.
Each local government will charge you a % of the what your home is valued at annually in property taxes. The 'assessed' value is not the same as what you could sell it for. Usually what you can sell it for is higher than the 'tax basis' assessment for your property. In some areas, property taxes are really high as they include other special taxes such as a 'school' tax. Be sure to check online at the appraiser or assessor's office to find out how much the property you are thinking about purchasing paid in taxes the previous year (and whether the owner paid or not!)
NOI (Net Operating Income)
Your Income minus your Expenses. When calculating your NOI, you don't account for debt services (also known as "mortgage payments" - money you pay monthly to a bank because you borrowed money to buy the house). Debt service is calculated separately from your expenses.
Cashflow is how much earn from a property. If there's no debt on a property, you could consider your NOI and your cashflow as the same. But if there is debt on the property (you borrowed money from a bank and have to pay them a monthly mortgage), then you would subtract that 'debt service' from the NOI to get your cashflow.
NOI - Debt Service = Cashflow
Gross Rent Multiplier (GRM)
People want to know - how much is my house worth? One way to estimate the value of a house is to take the price of houses that have sold recently and divide that by their monthly rent income. You will get a 'multiplier.' Find the average of the multiplier to find the Gross Rent Multiplier in your area. It's only used to get a very basic sense of how much a property should cost.
Example: Houses on average sold for $100,000 in an area and the rents were on average $1,000.
$100,000 / $1,000 = 100
The GRM is 100. So if another house was getting $1,200 in rent, then you could work backwards:
$1,200 x 100 = $120,000
You would expect this house to be sold for about $120,000.
Cap Rate (Capitalization Rate)
The cap rate tells you how much of a return are you getting on the money you spend. To calculate it:
Divide the NOI by the purchase price.
So if you're earning $6,000 NOI on an SFR, and you paid $100,000 for it, then:
$6,000 / $100,000 = 6%
The Cap Rate is 6%.
Or you can say, the house is a 6 Cap.
So you are getting a 6% return (ROI - Return on Investment) on your $100,000.
If you wanted to see how much you should spend to buy a property, you can also work this formula backwards. Let's say you knew the NOI was $6,000 but you were wondering - what's the limit of how much I should pay for this property. Then you would take the NOI and divide it by the % return you wanted.
$6,000 / .06
You would get $100,000. You know that you should not spend more than $100,000 for this property if you want to get a 6% return. If you spend less, then you're return will go up.
CRC (Cash on Cash Return)
The CRC comes in to play when you finance properties (borrow money to buy them). In that case, what you're actually spending out-of-pocket (your money) vs what the bank is loaning you (loan) makes a big difference in your return.
Let's say that you wanted to buy a $100,000 house that was earning $8,000 / year.
You knew that the bank would lend you $80,000 to buy this house.
So now, you only have to pay $20,000 (down payment) in order to purchase the cashflow of $8,000.
But now you also have to pay debt service (mortgage) each month. That means your cashflow goes down.
Let's say your monthly payment to the bank is: about $400 / month or $4,800 / yearly.
Now subtract your debt service of $4,800 from your NOI of $8,000.
$8,000 - $4,000 = $3,200
You are left with $3,200. This is known as your cashflow.
You might be thinking - I'd rather have the $8,000 in cashflow without the financing.
But if you look at your return on investment, it's much higher under this scenario.
Instead of paying $100,000 to earn $8,000 (8% Return on Investment)
You are paying $20,000 to earn $3,200.
$3,200 / $20,000 (16% Return on Investment)
Double your return on the same exact property.
Your CRC in this case would be 16%.
(This is why so many real estate investors love low % bank financing on their properties!)
IRR (Internal Rate of Return)
To understand IRR, you have to understand the time / value of money. Over time, because of inflation, your money is worth less in the future than now.
If you have $10 now.. how much will that be worth in 50 years?
Probably a lot less because of inflation.
The problem with Cap Rates and CRC is that they only look at a single moment in time when calculating your returns.
The IRR takes into consideration a whole set of cashflows that take place over the life of your investment.
It then calculates your compounded annual rate of return.
Why compounded annual rate? Because that's how most investments are measured.
If you go to a bank to open a savings account, the bank will tell you how much your compounded annual rate of return will be.
So if you're getting a 10% annual compounded rate of return, that means in:
End of Year 1: $100 x 1.10 = $110
End of Year 2: $110 x 1.10 = $121
So instead of simply earning $10 / year (simple rate of return) on your $100, each year your interest grows because the principal is being compounded.
The IRR works backwards and says:
Based on all the money you've earned over time, this is how much you were earning on an annual compounded basis.
Purchase price: $100,000 (all cash)
Year 1: -$90,000 (Purchase price is $100,000 but you earn $10,000 in rent, so in total you spent $90,000 in Year 1. This is expressed as a negative number and the IRR always starts with a negative number).
Year 2: $10,000
Year 3: $10,000
Year 4: $10,000
Year 5, $10,000 + $100,000 (you sell for $100,000) = $110,000
So, if you measure that out, over the course of this investment, you spent:
and you earned:
So calculating the IRR, you get:
13.4% annual compounding rate of return
(In order to calculate the IRR, you can use the free spreadsheet we've created for our members - see below for details.)
If some of the math behind these calculations confuse you, here's the best resource I've found on the subject:
After I read this book, I felt like I was ready to analyze any type of real estate deal (or other type of investments.) I highly recommend it! This is an affiliate link by the way.
If you'd like a few free resources on the subject of IRR and Net Present Value, check out the following websites:
And if you'd like a free copy of the spreadsheet the Ben used in his video, we've recreated it for our members.
Join our Closed Facebook Group and you'll find an Excel Version of the file as well as a Google Docs version.