At a local real estate investor meeting I was discussing some deals with new wholesalers. I am seeing trends among wholesalers and other real estate investors:
- No understanding of return on investment/CAP rate
- No understanding of cash-on-cash returns
- No understanding of general rehab costs
Wholesalers – many new wholesalers speak with homeowners and take whatever they are told regarding price, condition, and rehab costs. Some wholesalers take the price offered with no negotiation and hope it is a deal. Others will guess the rehab costs (usually too low) to make the deal look more attractive.
Trying to sell your wholesale deal to your buyers list without an understanding of the underlying financials will hurt your reputation with your potential buyers.
It is also important to ask the seller questions regarding problems you see while inspecting a property. You can get free rehab evaluator software here. Don’t be afraid to ask the seller questions – success in real estate involves understanding the underlying financials – plus above all, real estate investing requires that you know how to interact with people.
Return/CAP rate – I wrote an article discussing the return on investment/CAP rate. You can view the article here. If you have issues with the calculations, the article page includes a calculator.
Investor math – some investors use a 1% rule – if the property sells for $80,000 then I must rent the property for $800/month. You will see from the article referenced above that this will not provide for profit. If your area doesn’t allow for a 10% return, then you might consider purchasing in another community or state.
Cash-on-Cash return – many investors face situations in which they must get a third-party or seller mortgage to purchase the property (this includes a subject-to or lease purchase transaction). I recommend a minimum return of 20% on the cash used as downpayment. This is called your cash-on-cash return. I have seen situations where the CAP rate was under 10% but the Cash-0n-Cash return was over 20%. This is especially true in cases where the seller had little equity, but the annual return is good.
For example, a seller has a home worth $100,000 but owes $90,000 and a mortgage payment (principal, interest, taxes, insurance) of $700. Add $100 per month for a maintenance allowance. The market rent is $1000/month.
Rent – $1000/month
Mortgage payment – $700/month
Maintenance allowance – $100/month
Cash flow – $200/month – $2000/year (with 2 months/yr for ‘oops’ to include vacancy & other unforeseen items)
Let’s say the home needs $10,000 in repairs & closing costs and you simply took over payments or leased/purchased the home (watch for due-on-sale clauses and prepare accordingly)…
Initial cash investment – $10,000
Annual return – $ 2,000
Cash-on-cash return – 20%
So this home might not meet a 10% CAP rate – but it does provide a 20% Cash-on-Cash return. With a low investment you can focus on your return.
This is an excellent time to remind wholesalers that monthly cash flow is important! Imagine if you took some of the income from wholesaling homes and invested in cash flowing properties. You will see your equity increase as you pay down these loans and get monthly cash flow from properties you now own.