Residential Real Estate Investing. It’s about the cash flow, stupid.
Real estate investing, even on a very small scale, remains a tried and true means of building an individual’s cash flow and wealth. – Robert Kiyosaki
I often hear real estate investors bragging about their residential rental property’s return on investment (ROI). A quick search on www.biggerpockets.com found 6,784 results for “ROI”. Here is actual quote I found while reviewing my search results:
Q: “What does anyone think about 6% to 8% ROI for single family homes for buy and hold property?”
A: “That’s really low especially if you are leveraged. I am looking at 15% minimum.”
Upon close analysis, it became clear to me that some people are totally missing the mark when it comes to real estate investing. To be sure, ROI is a fun ratio to use and has its place -especially at cocktail parties, the golf course, the local Meetup Investor Group, and college text books.
According to the www.Investopedia.com definition, ROI is a performance measure used to evaluate the efficiency of an investment or to compare the efficiency of a number of different investments. The basic formula is below.
ROI = (earnings – cost of investment) / cost of investment * 100%
Let’s look at an example using the Out-of-Pocket Method. This method results in a higher ROI than the Cost Method. Definitely the method you’ll want to use while talking to your investor friends at the Meetup meeting.
You buy a single family home as an investment property for $150,000. You put down $30,000 cash or 20% and finance the difference of $120,000. (I know, in the Denver residential real estate market these numbers are nuts. It’s just an example to make a point.)
Then you spend $50,000 cash for repairs and rehab. So, the out of pocket costs are $80,000. The new appraisal comes in at $250,000 and BAM, you’re rich! After all, that’s what they do on those HGTV shows. According to the Out-of-Pocket Method, your ROI is 212%.
$170,000/$80,000*100=212% ROI.
Other people’s money, baby! You can’t wait to tell your boss to shove it on Monday morning. “This is awesome!” you scream with your best Tony Robbins voice.
But wait, there’s more.
ROI can totally mislead you. There are different methods to ROI calculation. There are too many factors left out of the equation. ROI is mostly for comparing similar investments at a similar point in time with similar variables – ceteris paribus. It’s almost impossible to compare similar investments in residential real estate because they are not similar. Relying on your ROI calculation, you may buy the wrong property, in the wrong part of town, at the wrong time, and at the wrong price.
If you are using ROI for your decision-making process when buying residential investment properties, you may find yourself six months down the road sucking your thumb while lying in the fetal position under your bed.
Call your old boss and apologize for telling him to “Stow it, Dingy”. You need your job back.
Think differently than the so-called “financial sophisticated” crowd. Stay in the real world. Keep real estate investing simple. It really comes down to this basic question – Is more money coming in or is more money going out of my pocket? It’s basic addition and subtraction. Residential real estate investing is about cash flow. Good residential real estate investors buy properties that make good cash flow sense from day one. Leave the ROI calculations to the college textbooks and cocktail parties.