Let’s jump right into two scenarios. We’re going to compare two different fourplexes, each located in a different market.
- Fourplex #1 is $250,000.
- Fourplex #2 is $750,000.
Which is the better deal? If you said #1, you’re wrong. If you said #2, you’re also wrong. Why is that? Well, we don’t have enough information to decide. Let’s look deeper into the psychology that price plays. As real estate investors, the purchase price of a property is often the first thing we look at. However, price is not the most important number when analyzing a real estate investment. Before you hit stop and think I’ve lost my mind, or have a rich uncle with deep pockets, let me explain!
You may have even heard the term “you make money when you buy the property”, or something along those lines. So wouldn’t purchase price be a critical factor? Let’s go back to our two fourplexes.
Fourplex #1 is in rural Kentucky. It’s a 1970’s construction, Class C property with more deferred maintenance you would prefer. The total rents per month are $2,000.
Fourplex #2 is in the heart of Austin, Texas. It’s a 2000’s construction, great location with proximity to high paying jobs, and has upgraded finishings throughout. This is a Class A property. The total rents are $8,000 per month.
Which is the better deal? While it’s still hard to say, we can start to see that the rent to value ratios for fourplex #2 are a good amount higher than they are for fourplex #1. If we continued our analysis comparing property taxes, insurance, operating expenses, etc. we would come down to the metric that really matters to us, as real estate investors – cash flow. Cash flow is important because it allows us to do several things:
- We can hold the property as long as we need, and not have to sell during a down market, compared to if we were buying for appreciation.
- The cash flow we make is profit in our pockets.
- By having a positive cash flow, we know the property sustains itself and won’t require additional capital investment.
- We can reinvest the cash flows and exponentially scale our real estate portfolio.
Real estate cash flow is the economic driver in our investment decisions. I don’t know about you, but I’m not sure what will happen in my market next year, the year after, or anytime into the future. I would rather buy a property that creates positive cash flow, so that I can hold on to it for as long as I want, and possibly even my entire life.
Another metric that we can use to compare properties is the Cash-on-Cash Return (CoC). This is the ratio of annual cash flows to the total amount of cash invested (down payment, closing costs, and repair costs). Let’s take our Fourplex #2 in Austin, Texas as an example. We purchased it for $750,000 and put the traditional 20% down ($150,000). With monthly rents of $8,000 let’s assume we’re cash flowing $1,500 per month, or $18,000 per year. That means our Cash-on-Cash Return is $18,000/$150,000 = 12%
An Infinite Return
Continuing down this path, let’s look further into the future. This property is in Austin, Texas where the population is growing, jobs are moving to, and the demand is increasing. Our rents and property values continue to rise over the next 5 years. Eventually, we’ve built up significant equity in our fourplex. But as we know, the rate of return on equity is….. 0! So we decide to refinance our fourplex and cash out our equity. For the sake of not getting too deep in the number here, let’s assume we’re able to refinance for a higher loan amount, and we can pull out $150,000 in equity, which just so happens to be the exact amount of money that we put into the property with our down payment initially. Our new cash flows are now only $1,000 per month. But let’s look at something really vital here. We want to calculate our CoC Return now. Our annual cash flows divided by our total amount of cash invested. Our annual cash flows are $12,000 per year divided by our total amount of cash invested, which is $0. $12,000/$0 = an infinite return on your investment.
This means that all that cash flow you receive is free money to you. You no longer have any of your money in the property, and every dollar you make is an infinite return! You have just unlocked the power of true wealth creation! So now that you have your $150,000 originally invested in your fourplex back in your pocket, you could go do this again and again, snowballing your portfolio, while generating passive income along the way and building wealth. This is The Real Estate Way to Wealth and Freedom.