Spirepoint | Tracking Your Stats
Thanks for Spirepoint providing another valuable posting on real estate investing.
Tracking Your Stats
Have you ever found yourself struggling to answer the following questions?
* How much profit does each of your rental properties make?
* How much cash flow does each property generate?
* Am I properly leveraging the equity in my properties?
* Am I over-leveraging my properties?
* What is my return on investment?
If you can't answer these questions by running a report in your accounting system, then you're not alone. Many investors get so caught up in managing the day-to-day operations of rental real estate, that they don't have time to ensure the bookkeeping is done correctly, let alone determing performance statistics for their properties.
As we've said in the past, good bookkeeping can make you money. However, good bookkeeping alone is not enough. You need to be able to run reports and 'track your stats' to determine how well your investments are performing.
Profit vs. Cash Flow
Many people confuse making a profit and generating cash flow, but in accounting, they are very different things. One way to understand the difference is to think of profit as theoretical and cash flow as reality.
What does that mean? Let's use an example
You own a rental property with a mortgage payment of $1500 per month. It's a new mortgage, so most of the payment is going towards paying the interest owed (e.g. $1400), and a very small amount goes towards paying back the mortgage (e.g. $100).
In accounting, the $1400 interest paid shows up as an expense on your Profit & Loss statement, but the $100 mortgage repayment shows up on the Balance Sheet. So to most people, while it may appear as though you have a mortgage expense of $1500, in accounting software, it shows up quite differently.
Now let's look at how that same mortgage payment affects cash flow. When that mortgage payment comes out of your bank account, it doesn't matter that $1400 was allocated to interest and $100 to repaying the mortgage. The fact remains that your bank account is now $1500 lower than it was beforehand. If you look at a Cash Flow Statement, you'll see that the cash comes right out of your pocket.
So why should all of this accounting stuff make a difference?
Well, a Profit & Loss statement tells you how much money you earned in theory and as a result, how much income tax you will need to pay the government. And more importantly, a Cash Flow Statement shows you where your cash is going (and if you don't know that, your cash will eventually disappear and you won't know why).
Out of all the accounting reports available, a Cash Flow Statement is the most important yet most underutilized report available. Professional investors learn to track their profits AND their cash flow on a regular basis. This allows them to know if they are making money (in theory) and if they have enough cash to pay the bills (both critical items to know for any investment).
Leveraging Your Properties
How many times have you heard a new investor wanting to do a 'nothing down' deal? It seems that many investors have limited cash (or none at all), yet they still want to buy property.
The problem with nothing down deals is the amount of leverage used. Now there's nothing wrong with leverage, but people always seem to forget that leverage is a double-edged sword - it can magnify your gains, but it can equally magnify your losses. Also, in real estate, increased leverage increases the size of your mortgage payments, which as a result, reduces your cash flow.
Normally this is not a problem for professional investors who know how to balance between the appropriate amounts of equity and debt. But many new investors tend to overleverage their properties, reducing or eliminating cash flow, and then a year later, they are forced to sell the property because they can't afford it.
Here is an example of how leverage can cause real losses to new real estate investors:
* A new investor buys a duplex at market value with a 10% down payment. That means there is 10% equity, and a 90% mortgage.
* Since the mortgage amount is so high, cash flow is almost break-even.
* The investor is new to real estate, and doesn't understand that there can be unforeseen expenses on a regular basis (e.g. roof repairs, tenant damage, etc.). One major expense can easily force the property to be negative cash flow. Already this 'investment' can cost the investor money every month.
* If the market slows down and property values are reduced by for awhile, the value of the duplex could easily be worth less than the mortgage owed. If the investor is forced to sell the property due to negative cash flow, they could easily lose their 10% investment.
Professional investors know leverage is a tool and track the loan-to-value (LTV or % of the mortgage) for each property they own, as well as their entire portfolio.
Return On Investment (ROI)
Many investors get excited when they see the potential returns offered through real estate investing. They run the numbers a few times, and then jump in both feet to buy a duplex, triplex, etc.
That seems to be the last time they even think about return on investment, or if they do think about it again, they use their original numbers.
* Joe buys a triplex and calculates his 'return' to be 29% based on cash flow
* Three years later, the value of the triplex has increased, and so he calculates his new ROI based on the new values
* He tells everyone he knows he's making a huge return on his property
There are a few problems with this scenario:
* In real estate, ROI often fluctuates because original calculations are done 'pro-forma' (estimated)
* Actual cash flow is usually quite different from projected cash flow (e.g. a tenant skips 1 month of rent, utility costs increase, the roof suddenly needs replacing, cash flow is negative and you have to personally contribute cash to pay the bill, etc.)
* Many investors include mortgage pay down and appreciation as part of the ROI calculations. The problem is you never truly know your return until the property is sold and all closing costs are paid.
Professional investors know that, at best, mortgage pay down and appreciation are 'estimates' and should be calculated separately from cash flow. Cash flow returns should be calculated annually and compared to the original estimated ROI. This allows the investor to determine if the investment is performing adequately.
As you can see, accurately calculating real estate statistics can be a bit more involved than what most investors do. It is not difficult or complicated, but it does take some work and should be done on an ongoing basis to assess investment performance.
If you don't understand some of the basic accounting concepts described above, you should start learning today. Accounting is the language of money, business and investing, and if you don't understand the language, how can you expect to understand what's going on? Take the time to learn this important skill and track your stats - you won't regret it.