As I update all of our investments for year end (it takes me until April, because many of our accounts don’t send year end statements until then), I like to compare our investment returns.

The stocks and index funds are easy, as Quicken computes the IRR. But I like to be able to compare our other investments too, like our real estate.

Unfortunately, it seems as if there are so many formulas to evaluate real estate returns, (ROI, ROE, Cash on cash, etc) pinpointing just one to use as a comparison is difficult. And everywhere I look, I find differing opinions on which formula to use. So, I’m going to work through multiple formulas:

Return on Equity

First up is return on equity. The return on equity formula I’m using is the ROE for properties beyond the first year of ownership:

ROE = Cash Flow After Taxes (CFAT) / (Property Value – Mortgage Balance)

For the first real estate investment we purchased (the house), I get this for 2011:

ROE = $1705 / ($248162 – $200926)

For the property value, I use the estimated fair market value on our tax bill, less the cost to sell the property.

The cash flow before taxes for this property was -$56 this year, but the -$5680 tax bill at 31% brought the CFAT up to $1705.

If the property was in the first year, you can divide by the initial investment in the property.

ROE = 3.61%

Another Return on Equity

However, it seems like the first ROE calculation is ignoring the change in equity from the prior year in the denominator, which I think actually should be part of the return. The principal is reducing, and the value is increasing (hopefully), without any additional contributions from us.

So, I calculated ROE method 2 for last year:

ROE(2) = CFAT + Principal Reduction + Appreciation / (Property Value Last Year – Mortgage Balance Last Year)

ROE(2) = $1705 + $2866 – $658 / ($248820 – $203792)

ROE(2) = 8.69%

Internal Rate of Return

So that brings me to internal rate of return (IRR). If I calculate the IRR for 2011 in isolation, using the following calculation in excel:

• -$45028 on 12/31/2010 (equity at beginning of year)
• $1705 on 12/31/2011 (CFAT)
• $47236 on 12/31/2011 (equity at end of year)

In excel, my formula looks like =XIRR(A1:A3,B1:B3). The amounts are in the first three cells in column A and the dates are in the first three cells in column B.

XIRR = 8.69%

The IRR matches the ROE(2), but only because I lumped the cash flow into one payment at the end of the year.

More Formulas

If you are working through the same exercise for your real estate, the other calculations I used to begin are:

• Cash Flow Before Tax (CFBT) = Net Operating Income (NOI) – Debt Service – Capital Improvements + New Loan Amounts + Bank Interest Earned
• Cash Flow After Tax (CFAT) = CFBT – Income Tax
• NOI = Income – Operating Expenses
• Debt Service = Principal and Interest Payments

Here are my numbers I used in the formulas if you are following along at home:

CFBT = $14716 – $14772 – $0 + $0 + $0
CFBT = -$56

Income Tax = -$5680 X 31%
Income Tax = -$1761

NOI = $32356 – $17640
NOI = $14716

When you calculate the returns for each of your properties using the formulas above, what did you get?

Note: I ran all of these calculations at our partnership level, and didn’t factor in my use of credit card balance transfers which covered some of my personal equity in the properties, and provided additional leverage. I wanted to start with the basic calculations first before I make them over complicated!

Our Other Real Estate

I ran the same calculations for our other real estate, the condo and the vacation rental.

The condo has a better ROE(1) at 4.01%, but a negative ROE(2) and IRR at -16.02% last year, largely because the fair market value of the property went down. I also calculated the IRR since we bought it: 37.7%. Because it was bought at an auction, most of the equity that we have is from appreciation in the first year, which makes the total IRR much higher. The IRR since we purchased the house is 1.3%

The vacation rental on the other hand breaks the calculation, with the negative cash flow, and the impact of the vacation home tax rules. I’m still trying to find a way that we’ll be able to compare that one in the same way after removing the impact of our personal use.

What is My Return?

I’m still trying to figure out if I can really use either the ROE(2) or the IRR to compare to our other investments. Is there a better way to compare on an apples to apples basis?

I know that some of you are heavily involved in real estate investments, so I’d like to hear from you! What do you think of my approach? Feel free to offer another way to evaluate the return. I tried to include all of my numbers for you to play with!

How do you calculate the return on your real estate investments? And how do you compare it to your stocks?

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Here’s what readers shared when I asked Have You Made A Low Ball Offer?

Strategies for Making LowBall Offers

JanniPi is closing on a new house this month. While buying a new house wasn’t originally in the plans until the current home one sold, JanniPi stumbled on an opportunity to live on the Delaware Bay with no yard work. JanniPi’s lowball offer technique:

I generally offer 10% less then asking, assuming the comps are solid and current. In this case, it was accepted by the seller, but they declined to make repairs or lower the price based on the home inspection… The house needs updating and a better heating source for year round use, which will be a big expense, but it’s so worth it!

Fowler starts his lowball offers at 10% below comps to test the sellers response and and see how much they will counter. The next step in Fowler’s lowball strategy:

I will add in immediate costs/issues which may bring that up to 40% below asking. As long as your numbers are backed by reasonable data you will not appear delusional or insulting.

Stanley has had success with offering as much as 40% below comps. Stanley’s strategies for lowball offers on homes:

One thing that works is add on contingencies you don’t care about but allow the seller to negotiate them out giving the feeling of accomplishment. Seller financing is a good one as well as seller paying closing cost/mortgage points, repairs etc.

Big-D shared a successful low ball bid. After telling the owner the list and research (and skipping a real estate agent which saved the owner 3%), the owner agreed. The result? A purchase price for 35% below the asking price. Here’s how Big-D puts together a lowball offers on homes:

I second Stanley. I get the land value from the local property tax authority, and start with that as a base. I take detailed notes in the walk through – looking at age of stuff, windows, floors, any mechanicals, any thing that might need to be replaced. I put that into a pot and start at 10% below comps if everything is perfect. If the house is 30 years old and the kitchen cabinets are 30 years old with drawer paper on them, take money off. If there are windows that have busted seals, and you have single/double pane glass windows, etc. If your furnace/hot water heater are 15 years old, etc. These are all things I take value off of and then I make my offer.

The offer should not be offensive, and the way I measure that is simple. How much would it cost for me to replace this house from scratch. If this house were burned to the ground, how much would it cost for me to have this house build exactly the same, new, at builders cost (plus cost of land). That should be the lowest you go (regardless of neighborhood, because you made an insulting offer).

What is the worst they can say, “No”? When they come back with a higher offer, come back with one that is okay. I will come up a few grand, but then I will get this capitulation in the closing (2 grand for a new furnace).

John has made a few low ball offers, usually when he’s purchasing a car. John’s lowball strategy:

I am only willing to pay what I think the product is worth or a bit less what I think it is worth. I’ve upset a few people, but who cares, I think they were trying to rip me off. In my opinion it is better to give them the opportunity to accept an offer rather than never receive one. With that said, I’d be pissed off if I continuously got low balled. But such is life.

Shahid bought a new house in a NW Chicago suburb in 2008. One of the strategies in negotiation is to walk away… but have you ever walked? Shahid did and it turned the lowball offer into a purchase success story. Shahid’s lowball strategy:

My house was listed at $215,000. I started out at $165,000 with a max price limit of $180,000 in my mind. We negotiated and I went up to $178,000 and they were stalemating at $190,000. I decided to walk. About a week later they called up and said that they would accept the $178,000 if I was still interested.

In hindsight, I think if I had walked at $175,000 I probably would have gotten it. In the end, I closed at 83% of listed price.

I had the realtor do some research and see what the current owners had paid for it. ($165k 7 years earlier) I knew that I had to offer enough for them to repay their mortgage, pay realtor fees, etc. and break even.

Next Steps

Thank you for sharing your stories! They are very insightful for me and all of the readers at My Dollar Plan.

If we decide to make an offer, I feel much more confident about making a lowball offer!

If you have a lowball offer strategy or success story (or failure) to add, please tell us about it!

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It was amazing that we landed another property, just days after Closing on Our First Rental Property.

Auction Atmosphere

The auction took place in a conference room at a hotel. We grabbed seats in the third row, so we’d be right in the middle of the action. As the room filled up, they took down the divider to the next room and added more chairs.

They did a “mock” auction so everyone would feel comfortable with the bidding process and the “chant” that the auctioneer uses. It was a little intimidating at first, but once we got used to it, we were fine. It actually became entertaining to watch the auctioneer try to get people to raise the bid, with little comments thrown in… all while keeping his chant going.

The auction moved very fast, just as we expected, so I’m glad we were prepared with our lists and maximum offers for each section.

If you’re worried about going to an auction and “accidentally” buying something, we saw it happen. Someone made a mistake on a property. However, there are bidding assistants walking around helping and they let the person retract their bid immediately.

Bidding Process

The properties were divided into sections based on developments. Each section had multiple properties listed and the highest bidder got to pick their property. Then anyone else that wanted one at that same price could do so. If there were still properties left, they would start the bidding again.

You had to keep track of which homes were already taken, so you’d know which one you wanted once you won. We prenumbered each set of homes and condos based on the leases already in place, from highest to lowest.

Calculating Our Maximum Bids

Our maximum bids were calculated based on being able to break even with the properties. We had ideal bids that would provide some cash flow, but had a maximum in mind just in case we got caught in a bidding war. Our maximum bids were all 40 – 60% of the assessed values, so I didn’t even know if we’d be in the game at first.

When we saw the first two properties go for 65% of assessed value, we knew instantly we were going to be able to bid at some point during the day.

Our Losing Bid

During the section that had the houses we wanted, we were outbid by $2500. The bidding came down to us and another person. We went back and forth starting at about $140,000. Our maximum bid was $149,000 and we gave our final bid of $150,000. The other bidder offered $152,500 and we passed.

The auctioneer actually teased me a little before he declared it sold, asking if we were really going to let a property go for a difference of $2500. It was all math to us since it was an investment property, so we passed, but I could easily see how you’d go above your maximum if it was a house you wanted to live in!

We did submit paperwork to be contacted if for some reason the winner backs out before closing, but we’re not expecting a phone call.

Our Winning Bid

By the time we got to another section with some condos we were interested in we had a bidding assistant that kept looking to us to jump in, as we’d been doing throughout the auction. It was helpful because we could communicate with him as we went what we wanted to do.

There were 20 condos and we were able to win the second bid and scoop up one of the condos for $60,000. We got our first choice, which was the condo with the highest rent already in place.

Our maximum bid was $65,000 so we were really pleased when we won. The condos went anywhere from $56,000 to $67,500. We considered buying some more at $56,000, but our maximum offer was only $50,000 for the lower rent condos, so we passed…. which was really hard!

We then proceeded to the contract room to fill out paperwork and meet with the bank. We’ll close in about 2 weeks once the title work is done. Closing costs will be about $900.

After we were done, we were treated to a free lunch for all the winning bidders!

The New Condo

The condos were brand new 1500 square foot, 2 bedroom townhouses. They’re in a small bedroom community nearby. About half the properties for sale were already leased.

The condo we won was $60,000 plus a 10% fee to the auction company, for a total sales price of $66,000.

There was automatic financing available for a 30 year fixed rate at 5.4% if you put 10% down. No brainer!

The condo is assessed at $134,900. Comparable properties are currently listed at $139,500. Recent sales were in the range of $130,000 to $150,000. So, we got it for less than 50% of assessed.

Here’s how the numbers look on a monthly basis:

• Rent: $895
• Mortgage payment: $334
• Taxes: $225
• Condo fees: $120
• Management, maintenance, reserves, etc: $135-$180

Since it’s brand new it will have very little maintenance cost and most of the other costs are covered in the condo fees. It should cash flow between $35-$80 to start off with.

The numbers aren’t ideal, but it was a quick way to build some equity with a tiny investment.

Quick Sale

Our friends who attended the auction too, also picked up one of the condos in the same complex we did. They received an offer to buy their condo while they were in line to sign contracts from an investor that bought the other three in the same building. Talk about a quick turnaround! They exchanged business cards, and will try to work something out soon.

What We Learned

Consider all properties. Prepare to buy or do research on all the properties at the auction. We planned to just bid on the houses, but found out the night before that the condos would allow leases. That opened up an opportunity we had not planned on.

Bring your supplies. We put together numbers in an hour before the auction for the condos, and had to place some phone calls to verify tax info. It was good we brought a laptop and cell phones.

Stay for the entire auction. About half way through the auction, they went back to one of the properties in the first section. Apparently the deal fell through, so they reopened the bidding on it, starting over. By then, I think many of the people had left that were in the market for those properties. So it paid off for whoever got the property the second time around, even cheaper.

Stick to your numbers. The auction was really exciting! When we got home, I actually had some buyer’s remorse… remorse that we didn’t buy more! But we stuck to our predetermined numbers, so I was happy.

Action Plan

Now that we landed a property that has instant equity, we are trying to decide if we will hold it, sell in a few months, or get a HELOC to fund another investment property.

We rarely have auctions in our area, but there’s another one planned next month. I’d love to go, but I think it will depend on when our new baby decides to make an appearance!

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It’s our first real estate investment and our first venture into being landlords. Getting Started in Real Estate Investing has some of the resources and evaluation tools we used for this deal. Here’s how it all came together.

Negotiation and Financing

Offer. We got a heads up from our Realtor about the house two days before it was listed. We set up an appointment immediately. The house was listed for $285,000. We offered $260,000 for the property with the seller to replace the siding. Another offer came in the following day and they countered without the siding at the same price, so we took it.

Inspection. After the inspection, we found the major problems to be the furnaces, air conditioners, and water heaters were at the end of their life expectancy. We asked the sellers to replace the furnaces and air conditioners, which they agreed to. It will cost them about $9,000.

Loan. We secured a 5.875% 3/1 commercial ARM with a .25 point. We needed a commercial loan because we’re buying it with our partner under an LLC. With 20% down and some money in reserves for maintenance, we’re throwing in $32,000.

Insurance. We’re getting our landlord liability policy through Allstate. They had a cheap rate with good coverage. We’re also considering moving our personal insurance policies there, because their umbrella covers the landlord policy, which is not common at other insurance companies.

Management and Maintenance

Contractors. Angie’s List has ratings of local contractors. The popular categories are: plumbing, electricians, remodeling, roofing, carpeting, landscaping, and painting. They’ll be helpful when it comes to getting some of the work done in the inspection that we’ll be responsible for.

Management. Our partner will be handling the property management. It’s part of the reason doing this partnership was appealing. Scott and I don’t have any interest in handling the phone calls and dealing with the tenants. In exchange for his services, he’ll get a cut of the rent.

Apartment Searches. I had a few people contact me asking if they could rent our new apartment. However, since it’s already filled, a good resource to search for apartments is at Apartments.com.

Cash Flow

Here’s how the numbers look on a monthly basis:

• Rent: $2310
• Mortgage payment: $1230
• Taxes: $450
• Insurance: $65
• Utilities: $65
• Management, maintenance, reserves, etc: $350-$450

Based on the amount of maintenance needed each month, it should cash flow between $50-$150 to start off with.

Leverage Strategy

As always, I like to use other people’s money when it makes sense. Last week, I got an offer for a 5.99% for the life of the balance transfer on a couple business credit cards.

Combine that with Penfed’s 2.99% balance transfer offer right now and we’re financing the whole thing. By using this money instead of our own savings for the down payment, it will triple our IRR! We’ll have a bit of negative cash flow on paper, but the tax savings for depreciation should cover it.

Next Steps

We’re busy planning our action steps for our next property. Now that we know a little more of what we are doing, we’re going to also include foreclosure listings and home auctions.

We’re actually going to an auction this weekend to see if we can’t score a deal, as one of the local builders is unloading more than 50 properties. If it’s exciting, I’ll post updates on Twitter while we are there!

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We had a very open and honest discussion about finances, and we have a lot of the same goals and expectations. And because we’re both finance people, we also have a common understanding of how we want to approach valuation and decisions on the properties.

In fact, we even went and saw a property nearby… although, we’ll just say that “needs some work” was an understatement! (We don’t plan to do fixer uppers, rather buy a property that’s ready to rent.)

Real Estate Investing

We’re always working on diversifying our income, and this will be a good complement to our current income sources, which have shifted significantly over the past year.

Readers had a lot great tips and suggestions to consider before taking on the landlord duties:

• You need to make sure you’re financially secure, and that you’re ready to deal with the hassles, even as a secondary owner. – Pete
• Be very careful and understand what you are getting in to. You will get phone calls from your renters to fix things in the evenings and on weekends. Also, you can have problems with how renters treat your property. – Stella
• I’m a landlord. If I had it to do over again, I still would have bought a rental property, but I would have made sure the math worked better. Make sure that the mortgage is no greater than 60% of the expected rent. – MITBeta
• Investing in real estate can be scary, particularly at first. But if you don’t over-extend yourself and take it slow, it’s actually a lot of fun and, over time, very profitable. – Rob
• I had people coming out of the woodwork to discourage me. “Do you really wanna fix toilets?” was the most often posed question. My response was…”No. I don’t want to fix toilets but if I fix one a month and get paid $650 to do it that would be fine by me.” I consider this a part time job/ small business that will naturally require some of my time. By doing this, I was able to create some expectations on the time and money I have to commit personally to this investment. Furthermore, I put in a best case scenario and worst case scenario of owning the property and even a time line with an exit plan in place if I hated it. – Eric

Real Estate Resources

In addition to the helpful suggestions from readers, I’ve found some sites and forums with lots of knowledgeable real estate investors sharing their experiences:

• Mr. Landlord: The site behind the free newsletter I mentioned before.
• Creative Real Estate Online: Very active forums focused on financing.
• Real Estate thread at Fatwallet.

Evaluating Properties

We’re on the MLS mailing list for the rental properties in our area. In addition, we’re keeping our eye on FSBO and Craigslist.

To determine if the property will provide a positive cash flow and decent rate of return, we’re using various spreadsheets, with number obtained from the MLS listing, our electric company, and the seller’s Schedule E. Here are some that I’ve found, in addition to the homegrown one my partner created:

• Property Analyzer Spreadsheet: Great for IRR calculations.
• Investment Property Calculator: Basic Cash Flow Calculator.

If it passes our initial review, has a positive cash flow, and a decent rate of return, we’ll set up an appointment to view the property. We have plans to see a handful more soon.

Financing

We found a bank (Bank of America) that’s willing to look at one year of self employment income (with at least 2 years in the industry), so we should be able to secure financing for the residential (1-4 unit) properties through them, with 25% down.

I’m also tentatively planning to apply for the loans in Scott’s name only to keep my credit card arbitrage running smoothly in my name. I usually try to avoid any joint financing when possible, to keep both of our credit reports looking better.

We’re also exploring the possibility of using seller financing, or land contracts, too.

Partnership

Everything I read, says don’t have a partner. However, I think that there are pros and cons to any situation. I’m not saying it’s going to work out perfectly, but in this situation, it’s worth a shot. We’ve had a professional business relationship for about 6 years, so we know each others strengths and weaknesses.

We’ll have our lawyer draft the partnership agreement with a predetermined exit strategy in the contract. That way, if it all goes downhill, there’s a way out.

Management

This is actually one of the reasons that we’re exploring the partnership. The other party plans to do all the management for a fixed percentage of income. This was the single reason that kept us out of real estate investing in the past… no interest in having to manage it. He’s putting together his outline of duties for us to check out.

Action Plan

We’ll be viewing some of the properties in the next few weeks that passed our analysis. I’ll keep you posted on how it goes…

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