High Tech Tools Redefine Cash Flow Analysis
- January 30, 2017
When analyzing investment properties, conventional thinkers knee deep in real estate dogma worry about property tax rates and property management fees and any number of other data points. However, a scientific approach to property data yields a far more accurate and simple buy / no-buy decision. Yes, science (specifically, sensitivity analysis) helped me identify the single most important piece of information that predicts the cash flow success of an investment.
When I retired from my thirty-year Silicon Valley high-tech career in 1999 and went from part-time to full-time real estate investor, my goal was to replace my corporate salary with cash flow from rentals. In order to identify the highest cash-flow properties available, I needed to understand what factors to look for. I'd heard the conventional wisdom used in judging the strength of a rental property, but no one I met had an actual, proven, dispassionate, methodology. No offence, but gut feeling doesn't guarantee a payday.
In the scientific / engineering world it is common to perform a sensitivity analysis. This is a process where one tests varying independent variables to see which ones affect and by how much, the desired outcome. For example, one can vary the cell phone receiver bandwidth to determine the optimum signal to noise reception. Pulling a page out of my former career's bag of tricks, I decided to apply sensitivity analysis to the problem of rental investment evaluation. The results yielded some surprises.
The Cash Flow Sensitivity graph illustrates the relative importance of seven common property cost variables to cash flow. Using one typical property as an example, its cost variables are adjusted to reflect a 20% improvement (i.e. taxes 20% lower; occupancy 20% higher, etc.). For each variable, the cost improvement also reflects an improvement cash flow; however (and this is the key point), by vastly different orders of magnitude. Clearly a 20% decrease in taxes improves cash flow, but not nearly as much as a 20% improvement in rent ratio!
This same methodology was used to analyze hundreds of properties of all types from numerous parts of the U.S. and the conclusion remained the same: Rent Ratio is king. Interest rate is the second most important predictor of performance, but it doesn't vary much from one property or region to another.
Rent ratio is the ratio of the monthly rent as compared to the property value [Total Monthly Rent / Total Property Investment or Value = Rent Ratio]. It was determined that this ratio typically needs to be greater than .01 or 1.0% with a 20% down payment in order to yield positive cash flow, regardless of the region or price range. For example, a rental property with an investment of $100,000, after all costs are included, should have a minimum rent of $1,000 or 1% / month of the total acquisition cost.
The second illustration shows how amazingly much the rent ratio varies from one MSA (metropolitan statistical area) to another and gives you a first order guide to where the best cash flow regions and properties are without doing a complete analysis on hundreds of properties. Now you no longer have to guess or wonder about where and what to look for: just follow the numbers.
In his book, Predictably Irrational, author Dan Ariely observes "We are all far less rational in our decision making than standard economic theory assumes.”" By using rent ratios as a key component of rental investment decision making, we can base our buy / no-buy decisions on rational data and enjoy a more profitable and stress-free buying experience.