How to Be Sure if a Property is Worth Investing and Worth Financing?

GoFinance

What is missing in Rich Dad Poor Dad series of books?

The author of New York Times Bestsellers: Rich Dad Poor Dad, Robert T. Kiyosaki, has challenged and changed the way millions of people around the world think about money. In his series of personal finance books and the CASHFLOW® board game, he has been emphasising the importance of cash flow in all types of investment, particularly real estate investments and businesses.

However, none of his books or the CASHFLOW® board game explicitly teaches people how to calculate cash flow of an investment, especially when options of finance or loans are involved. He probably skipped the part of calculation in order to keep the contents of his books and the board game easy to understand. Simplicity normally sells better.

In real investments, the missing part of Robert’s work is as imperative as knowing the importance of cash flow in investment itself.

What is the most important calculation in an investment evaluation?

Many individual investors let good opportunities slip through their fingers without knowing it mainly because they fail to identify if an investment is generating enough cash flow or not. This happens commonly in real estate investments as most of them involve finance. Moreover, calculation of cash flow becomes more sophisticated when there is a loan involved in an investment.

How is the real return if you borrow a lot of money to finance your property purchase? Is the return rate going up if you fork out more money out of your own pocket? How about paying 100% cash? How is the actual return affected? These are some of the questions novice investors just cannot answer.

Many individual investors are also not aware that their existing investments are not properly leveraged for the maximum return. Unlike institutional investors who have a professional team to perform the computation, most individual investors do not know how to calculate return on their financed investments. You want to know exactly how much return you will get according to different financing scenario. But how do you do that?

The answer is that if you want to evaluate a property investment and maximize the return, you need to calculate based on at least two different scenarios:

  • Scenario 1 – Use the highest leverage or in other words, maximum financing possible (70%-100% financing).
  • Scenario 2 – Use low leverage or no financing  (pay 100% cash or up to 20% financing)

Then you calculate the cash-on-cash yield. These different scenarios produce different yield. That difference in yield show you a graph shape.

You can use an Excel spreadsheet to deal with this. Put in the formula, input the variables and voila! You can plot a graph showing you the yield trend instantly.

Methodology Explained with Sample Calculations

Let’s put this method of evaluation in numbers so you can understand it better. Here is the scenario:

  • Property Name: One Damansara Condominium
  • Asking Price: RM405,000
  • Legal & Brokerage fee estimated: RM18,225
  • Monthly Maintenance Cost: RM180/month
  • Furnishing Cost: RM10,000
  • Mortgage interest: 4.3% per annum
  • Loan tenure: 30 years

Let’s do some calculations to see if this property is worth investing, with the objective to rent out the place for a steady monthly income.

Scenario 1: 90% LTV, installment – RM1803.81/month, rental – RM1200/month

The cash you need to fork out for this investment includes:

  • 10% down payment = RM40,500
  • Legal and brokerage fee = RM18,225
  • Furnishing cost = RM10,000

Total cash capital = RM68,725

Monthly cash flow   = rental income – (installment and maintenance)

= RM1200 – (RM1803.81 + RM180)

= (RM783.81)

So it is producing negative cash flow. Since it is sucking money out of your pocket every month, it is not worth investing.

Scenario 2: 90% LTV, installment – RM1803.81/month, rental – RM2200/month

In this scenario, let’s assume that you manage to find a tenant who are willing to pay RM2200/month. Your total cash capital is still the same as Scenario 1, RM68,725. But you will generate a positive cash flow now.

Monthly cash flow = RM2200 – (RM1803.81 + RM180) = RM216.19

Cash-on-cash yield or return on cash investment is the annual cash return in percentage of total cash capital invested. It is computed by dividing total monthly cash flow of a year by the total cash capital.

Let’s calculate the Cash-on-cash yield:

Cash-on-cash yield = RM216.19 x 12 / RM68,725 = 3.8%

Now this property will be worth investing because it is generating income every month. The return is even higher than putting the money in Fixed Deposit.

What’s Considered Worth Investing?

A real estate investment that generates monthly cash flow effectively put money into our pocket every month, while equity in the real estate investment increases and the value of the real estate appreciates over time. This is the real estate investment that we are looking for – an investment worth investing.

For a real estate investment, the actual return should be better than indicated by cash-on-cash yield. Each month the mortgage loan repayment comprises two portions: principal and interest. The loan is being paid down by principal payment. Although the paid principal is not spendable, it is like money in the bank when investor sells the property.

Scenario 3: 30% LTV, installment – RM601.27/month, rental – RM2200/month

Similar to Scenario 2 above, but this time you just borrow 30% loan, not the maximum of 90%.

So the total cash capital increases because you need to pay 70% of the property value with your own money.

Total cash capital = RM311,725.

Total monthly cash flow = RM1418.73

Cash-on-cash yield = 5.5%

Compared the yield to Scenario 2, it is higher here. That means that the less you borrow, the higher yield you get.

This also means that although this property providing RM2200 monthly rental income is worth investing, it is not worth financing. The more you finance, the lower the return you get.

Now, let’s look at Scenario 4 which is the most exciting part. Everything stay the same, but the rental income increase to RM2400/month.

Scenario 4: Rental – RM2400/month

Using the same calculation method as above, we found that when you finance 30%, the COC Yield is 6.23%. But when you finance 90%, the COC Yield is 7.27%. If you manage to finance 100%, the COC Yield is even higher at 9.17%

Here is the table showing the result of all the relevant calculation:

LTV Cash-on-cash Yield
Pay cash 6.15%
10% 6.17%
20% 6.20%
30% 6.23%
40% 6.28%
50% 6.33%
60% 6.42%
70% 6.55%
80% 6.77%
90% 7.27%
100% 9.17%

 

What’s Considered Worth Financing?

In Scenario 4, you can see that the more you borrow to buy this property, the higher yield you are getting from the deal!

This example shows that the property is not only worth investing, it is also worth to finance the investment. The more money you borrow for this investment, the better return you get! If you can spot this kind of property, it is better to keep the cash to yourself and borrow as much as you can.

Most knowledgeable investors, large or small, experienced or beginners, rely on this type of system for determining if a property meets their investment requirements. It also serves as a convenient way to analyse various ways of purchasing the same property and choosing the best one. It gives investors an easy way to compare several properties, using the same formula on each.

“GoFinance” or Not?

By using this GoFinance™ method, an investor can evaluate accurately whether his investment is a “Go” or “No-go” to invest as well as to finance for maximum return.

The problem is that you really need to do a lot of calculation and many people just don’t really know how to make the best use of Excel spreadsheet. Therefore, there is a great need for a tool that helps individual investors to make these computations easy. That’s why we created this methodology and called it GoFinance™ to serve this purpose.

Now we have shown you the methodology behind how these calculation work and the logic behind the calculations. You can take out your computer and build this tool for yourself too. Or you can easily try out the web-hosted version we build on our website at www.PropertyMethod.com.

Remember this – numbers don’t lie!

GoFinance

This article was co-written with KCLau of KCLau.com and published in September 2014 issue of Property Insight magazine.

About The Author

ongkl

Coming from a humble little town named Tangkak in north Johor state of Malaysia, I am so lucky to have chances to learn and work both in Johor Bahru and Singapore - a conurbation with 6.49 million still fast growing population - since year 1996. Hope now I can have a chance to contribute back to the community by sharing what I see, what I know and what I learn in this wonderful place.

5 Comments

  • Zairi

    Reply Reply October 19, 2014

    interesting subject to discuss, on another point of view, if LTV increase it will reduce our Debt Coverage Ratio (DCR). If LTV 70%, DCR is 1.59 and LTV 90%, DCR is 1.24% (Still in good number). Do you hv any recommended property in Johor if we get LTV 90%, their DCR is still more then 1.24%?

    • ongkl

      Reply Reply October 19, 2014

      Hi Zairi,

      Thanks for sharing the insight of using DCR as another check of performance.

      DCR is a ratio of net operating income (before debt services) to total debt services. It can be used as a measurement of property’s ability to produce enough cash to cover its debt payments.

      For example, in scenario 2 the monthly net operating income is RM2020 (monthly rent RM2200 less maintenance RM180), and total monthly debt service is RM1803.81. So the DCR is 2020/1803.81 = 1.12.

      A DCR greater than 1 means that the property is generating enough cash flow to pay its debt obligations. A DCR below 1 means that there is not enough cash flow to cover loan payments.

      This ratio is normally used by bankers to assess debt servicing ability.

      Though DCR decreases with higher LTV, the saving in cash capital required with higher LTV can serve as an additional “buffer” of debt servicing.

      DCR of an investment property depends on 3 key factors: rental income, maintenance costs and loan repayment, which vary among different properties and individuals. We just have to evaluate each property individually and make sure it is generating cash flow to us, at least, then its DCR will be above 1 for sure.

  • KCLau

    Reply Reply October 20, 2014

    Great explanation about DCR and thanks Zairi for bringing this up.

    It shows that Zairi is also very knowledgeable in property investment analysis.

  • Zairi

    Reply Reply October 22, 2014

    Hi Ongkl & KCLau,

    It would be great if you can share your knowledge on IRR & MIRR to estimate the best time/year to sell the properties. Thanks in advance

    • ongkl

      Reply Reply October 25, 2014

      Hi Zairi,

      My understanding about Internal Return Rate (IRR) & Modified Internal Return Rate (MIRR) in property investment is limited to the effective return with consideration of the present value of profit (cash flow & capital gain) over a period of time, while the latter has additional consideration of financing cost on capital and reinvestment of interim cash flow.

      The returns calculated reflect a more accurate annual return on investment that is achieved over the entire investment period. Therefore they are normally used to assess the actual performance of an investment in comparison to others.

      There is a good example here showing how IRR can reflect the difference in actual return of a new condo and an old rental apartment.

      We can use IRR/MIRR to monitor if the actual return of our property is increasing, maintaining or decreasing from time to time. If the return has been decreasing continuously over 2 to 3 years time, it may be time to consider selling.

      FYI, I normally use return on equity instead of IRR/MIRR as an ongoing measure to monitor if it is time to sell a property because it is easier to calculate. Though return on equity does not factor in the time value of money, it is good enough to reflect the actual return based on past and current information of our property.

Leave A Response To ongkl Cancel reply

* Denotes Required Field