Most of my clients are recurring. Well, looks like they like me and the solutions I provide to them. And here’s another success case I would like to share with you.
Just for the sake of this story, I’m going to call my client Mr. C. He’s fairly young to be called "Mr" (he’s actually 35 years old), but it suits the purpose.
Mr. C is a real estate investor, with a total of 11 doors bringing him money every month, between single family homes and multifamily (which he started to purchase after he met me 😁 )
The Strategy Behind Everything
He’s strategy is simple, but not simplistic. He buys properties using leverage (a.k.a, money from other people, such as banks), increases the value of rent via cosmetic and basic renovation, build equity for a while and use this same property to cash out money to buy the next one. After that, he repeat the process.
Let me give you an exemple so you can understand better.
If you buy a property today for $300,000.00, giving 20% down, you have $60,000 of equity on that house and $240,000.00 in debt.
Considering an interest rate of 5%, in a 30 year mortgage, after 3 years you own the bank $228 thousand, increasing your equity in $12,000.00.
Let’s say that the property value went up 6% per year, as the average rate. After 3 years, the property market price is $360,000.00, giving you an extra equity of $60,000.00.
In total, you have $72,000.00 in equity that you can ask you bank to lend you that money so you can buy another property.
That’s what Mr. C does. As long as the cash flow (revenue from the property, discounted the mortgage payments) are positive, you are building equity and filling your pockets at the same time.
But You Can Make More Money
If you paid attention to what I wrote, I considered that the property value just went up by the average rate of 6%, without doing anything. But there are more things you can do to increase your property value.
The first thing you can do is minor renovations. Updating the kitchen and bathrooms, painting, cleaning, and other small details. One way to figure out how much money you can make is looking other properties in better conditions and see their market value. If the improvements that you have to make to achieve that value are less expensive than what you can make, go for it.
But when we talk about income producing properties, that’s not the only thing. Or that’s not the MAIN thing. You need to be able to increase the value of the rents, because a little thing called Cap Rate.
Cap Rate is King
Cap Rate is the measurement of how much your investment is being capitalized, meaning, the return you are getting for the investment you are making. Like this:
If you buy a property for $400,000.00 and it makes, after expenses, a Net Operating Income of $40,000.00, you have a 10% Cap rate. If you make $20,000.00, you have a 5% Cap Rate.
With that exemple I already told you that the lower the return, the lower the Cap Rate. Keep this in mind.
In the Miami market, a residential property in good conditions will be trade around 5-6% cap rate. The better the conditions, the lower the Cap Rate (because it reduces your risk).
What I mean by that is that the Cap Rate is a given, meaning, you need to focus in increasing the Net Operating Income, because the investors will look at your cap rate and won’t pay more than 5-6%.
That’s how you calculate the CAP Rate:
CAP RATE = VALUE OF THE PROPERTY / NET OPERATING INCOME
Which also means that
VALUE OF THE PROPERTY = NET OPERATING INCOME / CAP RATE
So, considering that the Cap Rate is a given, or it won’t change, the only variable you can mess around with is the NOI. The higher, the better.
The Hidden Gain
After analyzing 25 properties, Mr. C decided to buy one that was we got under contract and closed for $410,000.00.
The gross income of that property was $28,800.00. We always consider as a proxy for its expense around 20% of the Gross Income, or, in this case, $5,760.00. With those numbers, his Net Operating Income was $23,040.00, and his Cap Rate 5.62%.
Mr. C purchased this property financed, putting down 25%. With all the closing costs, his Cash to Close was about $120,000.00, with a 6.5% interest rate mortgage (yes, we got the rate on its peak).
Looking at the numbers from TODAY, the property, even though it had a NOI of $23k, was losing $283.31 every year, after paying the mortgage. But why was this a good deal?
Well, the current owner was charging a very low rent from the tenants. At the moment of the purchase, the rents were $1,200.00 per month, and we saw that the current market price for that kind of property would be, at a minimum, $1,800.00 per month.
Considering that it was a duplex, the correction of the rent would increase the Gross Income of the property from $29k to $43k per year, and a NOI of $34,560.00, making its cap rate going from 5.49% to 8.43% per year!
To increase the rent, we calculated around $15,000.00 in renovations to the property, to make it a little better.
The Final Countdown
Remember that I said that the Cap Rate is a given? Well, Mr. C is not here to play charity. Why would he sell a property with 8.43% cap rate for the next investor, not making any money out of it?
I said before that the VALUE OF THE PROPERTY = NET OPERATING INCOME / CAP RATE.
The new Net Operating Income of Mr.C Property is $34,560.00, and I also said that in Miami the properties are sold with a Cap Rate between 5-6%. In this case, I’m going to leave the same Cap Rate as the one Mr. C had when he bought his property: 5.49% per year.
With those numbers in mind, we can find that Mr.C property, with the new rent, is
VALUE OF THE PROPERTY = $34,560/5.49%
VALUE OF THE PROPERTY = $629,508.20.
If Mr. C potentially sells his property for this new value, he will make $219,000.00 in net profits, considering the price he paid plus the $15k renovations.
Now, Mr. C bought a $410,000.00 property but he only put down $120k, financing the rest, and added another $15k in renovations, making his total investment $135,000.00
With $219,000.00 return in a $135,000.00 investment, that’s a potential 162% return on his money, not considering the net cash flow he will receive for the the rents in the meantime.
If you want to check out those numbers, download the spreadsheet I use to analyze a deal quickly in button bellow.