Periodically I get calls from some hyper, would-be real estate tycoon asking about buying a condo or a building as a real estate investment. By the time they call me they have pretty much decided what they want to buy and all they are interested in doing is figuring out how to buy that one property that fits their predetermined notion of what a good real estate investment is. Typically their notion is largely influenced by what some friend got in the same building or maybe they like the way a certain place looks or it looks really cheap for that building…and the list goes on.
But what happens next never ceases to amaze me. I ask a couple of basic questions starting with “What return are you looking to earn on your investment?” The response is often silence or irritation. Clearly they haven’t given this much thought and they want to be the next Donald Trump (minus the comb-over) by the weekend and I’m standing in their way.
Therein lies the problem. I’ve heard that Americans’ math skills are embarrassingly low but you can’t purchase even a $100,000 asset without giving it a lot of thought and doing some serious number crunching. A long time ago I posted on calculating the return on a real estate investment and it was a damn good post so there’s no point in repeating that material here. But the other half of the problem is that first question I always ask which is “What return do you want?”
Now it turns out that that’s not a very easy question to answer, though it doesn’t exactly require a knowledge of partial differential equations. Coming up with an answer really comes down to a lot of qualitative considerations, much of which is highly personalized. However, there are some general concepts to consider.
What return can you earn from a comparable investment?
Well people often inform me that they can only earn maybe 1 -1.5% on CDs right now. True. But that’s not a comparable investment. It’s virtually risk free, hassle free, and highly liquid. Real estate is just the opposite of all those so you need to earn a premium above the 1-2 year CD rate. Just to give you an idea of other investments out there that are much more comparable you can earn 8.7% on a Bank of American preferred series that is highly liquid and hassle free. Citigroup preferred is yielding almost 8.5%. You can earn 11.6% on the Advent Claymore Global Convertible closed end fund, which is trading at a 7.2% discount to net asset value. Or, if you want something with a real estate angle, there is the Helios Strategic Mortgage Income Fund paying 10.3%. All of these are highly liquid and hassle free, though the Advent Claymore and Helios funds are leveraged and have a lower average credit quality than the two preferred series I mentioned so they are much riskier. I’m not recommending these investments necessarily but you need to understand what the real alternatives are.
Return on assets vs. return on equity
Return on assets is basically the return you get in the absence of a mortgage on the total value of the asset. In real estate this is often referred to as the cap rate – short for capitalization rate. Return on equity is the return you get after mortgage interest expense on the equity you have invested in the property. Your target for the two numbers are nowhere near the same for the simple fact that when you are leveraged 4:1 you have a lot more risk then when you pay all cash. If the value of your property goes down 5% on an all cash deal you lose 5% of your investment. On a 25% down deal you are going to lose 20% of your investment. Therefore, you need a much higher return on your investment when it’s levered 4:1 vs. no leverage at all. So if you get excited at the prospect of goosing your return by levering up you are supposed to get a higher return but there is no free lunch.
It’s hard to say what your return on equity should be for any given level of leverage but what I can tell you is that the closer the return on assets is to your borrowing cost the less sense leverage makes. In fact, the less sense the entire investment makes.
The bottom line
Do yourself a favor. Before you go off and try to buy an investment property slow down, lay all the emotion aside, get out a calculator, and consider your alternatives. Real estate investing can be very profitable but only if you approach it with a cold, hard, analytical sensibility. And if you’re looking for me to give you a number (I’d rather not) all I can tell you is that a lot of people feel like they need an 8% cap rate, though I can show you plenty of examples of people investing in real estate well below that number.