money-2696229_1920

Basic Finance: Internal Rate of Return

This is the second in a series about finance. Because saving for a down payment can have such an enormously positive impact on which property you can buy, I thought I’d explain a few things about how to invest your savings as wisely as possible.

The idea of investing can feel quite intimidating, but once you know how to compare various investment opportunities, you’ll be able to figure out which ones will earn you the most money. Last week, I reviewed the concept of compound interest (earning interest on your interest). Now, let’s talk about how to measure your return—what you earn.

When you consider the best way to invest, you need to know how much you will earn over what period of time. Be cautious if any investment advisor who gives you gross return (overall earnings) numbers without including a specific time frame or someone who simply uses payback time to measure your return. These are methods used to conceal some aspect of the investment—to dupe unsuspecting investors.

With gross return, if an investment advisor says you’ll earn $1,000,000 over the life of the investment, but fails to mention what the term is, you may have to live to be 125 years old to enjoy those earnings. If an investment advisor tells you the payback time on an investment is three years, that sounds great—you’ve recouped your investment in three years. But what it doesn’t tell you is how much you could have earned on a different investment with a slightly longer payback time.

Because the idea of payback time is simple, I often hear people use this measurement when deciding whether to make a particular investment. Let’s say we invest in $10,000 worth of widgets. We get back $3,333 per year for three years the total investment is “paid back.” On the other hand, if you invested that $10,000 in something that paid you $3,000 per year for five years, your internal rate of return would go from zero to about 15 percent, a far higher return. This is why I avoid payback time as a measure of return. Using the payback method, you would choose the first investment instead of the one with higher return.

I mentioned “called internal rate of return” just now. This is the very best way to measure investments because it allows you to compare investments with different interest rates and payment schedules over time.

The internal rate of return is the rate at which net present value (today’s value) of a set of cash flows equals zero. The cash flows include two things: the initial investment (as a negative number) and the returns (as positive numbers). Confused? Let’s use an example to clear things up.

Let’s say you have $10,000 in your bank account and you want to buy a house ten years from now. You don’t know whether you should invest your money at 1 percent for ten years or 2 percent for five years. If you only cared about gross return, these two investments would be indistinguishable: they both earn $1,051. However, the internal rate of return looks at the time it takes to earn the money. If you can earn $1,051 in half the time and then reinvest your earnings, clearly the second investment (the one with the higher rate) is a better choice.

If you want to play with numbers (one of my favorite pastimes), there’s a great website that allows you to calculate all manner of things: calculator.net. You can calculate payments and returns related to mortgages, taxes, all manner of loans, investments, and more.

If you have questions about real estate or property management, please contact me at rselzer@selzerrealty.com or call (707) 462-4000. If you’d like to read previous articles, visit my blog at www.richardselzer.com. Dick Selzer is a real estate broker who has been in the business for more than 40 years.

 

money-2724245_1920

Basic Finance 101: Compounding Interest

When it comes to buying real estate, many people tend to get a little overwhelmed by the financial side of things as they try to understand the short-term and long-term effects of the down payment, interest rate, points, and other financial factors. So, I thought I’d write a little series to explain some important financial concepts.

When you try to qualify for a home loan, lenders want to know your debt-to-income ratio. They calculate this by adding up all your monthly debt payments (car loans, student loans, revolving credit card debt, etc.) and dividing them by your gross monthly income (the money you earn before taxes and other deductions). Lenders’ primary goal is to make sure you can repay the loan. So, while it’s okay to have some debt, it’s best to have as little as possible.

To pay down your debt, the best approach is to consistently pay at least the minimum required to stay in good standing on all your loans. Hopefully, you have money left over, and if you do apply it to the debt with the highest interest rate. Also, try not to be tempted by credit card teaser rates, because when those zero percent offers jump to 24.5 percent a few months later, your bill will skyrocket.

Once you’ve paid off your debt, it’s time to start saving and this is where the power of compound interest puts you on an accelerated path to purchasing your own home. Albert Einstein called compound interest “the eighth wonder of the world.” He said compound interest is the most powerful force in the universe and the greatest mathematical discovery of all time. That’s pretty strong language for a guy who took his numbers seriously.

So what is this amazing force? Compound interest is the addition of interest to the principal sum of a loan or deposit. Said another way, it allows you to earn interest on your interest. Compound interest is the result of reinvesting interest rather than paying it out, so that interest in the next period is earned on the principal plus previously accumulated interest. The longer you allow the investment to grow by reinvesting the interest, the greater the magnification of this effect as compared to simple (non-compounding) interest.

Here’s an example. If a 25-year-old invested $1,000 on January 1, 2018 at 5 percent per year, then on December 31, 2018, the new balance on the investment would be $1050. A year later, the new balance would be $1102.50 (the 5 percent interest was earned on $1050), and so on. After 40 years, the original $1,000 would have grown to $7,040. Without compound interest, the original $1,000 would have only grown to $3,000 ($1000 original investment + $50 per year x 40 years).

Here’s a fun fact. In 1626, Europeans bought Manhattan Island from the local Indians for about $29 worth of beads and other goods. If those Indians had the opportunity to invest their $29 at an annual compounding rate of 5 percent, they would now have $5,262,336,110. Some investments have monthly compounding. If that were the case for the Indians, they’d now have $8,118,216,133. Whether it’s $5 billion or $8 billion, it’s a lot of dough.

Now, I recognize that most of us can’t wait 392 years for an investment to grow; however, even over a shorter period, money can grow at an impressive rate, especially if it compounds monthly, daily, or even continuously, and there are investments that do this.

Recognize that compound interest can also work against you. If you are in debt, especially revolving credit card debt, your debt will grow just as quickly as your investment would, which brings to mind another Einstein quote about compound interest, “He who understands it earns it. He who doesn’t pays it.”

If you have questions about real estate or property management, please contact me at rselzer@selzerrealty.com or call (707) 462-4000. If you’d like to read previous articles, visit my blog at www.richardselzer.comDick Selzer is a real estate broker who has been in the business for more than 40 years.

Real Estate Investing – Part IV: Commercial Property

This summer I’ve written three “Real Estate Investing” columns covering single family residential properties; duplexes, four-plexes and apartment complexes with fewer than five units; and larger apartment complexes (with up to sixteen units). I recently received a request to write a column on investing in commercial real estate, so here you go.

Commercial property is not for the faint of heart. It’s not too different from the other types of real estate investing, but because of the longer depreciable life there are lower tax benefits and the bigger investment makes it a bigger risk (if you’ve heard of the risk/return trade off, that’s what I’m talking about: bigger risks can lead to bigger returns or profit. Of course, bigger risks can also lead to bigger losses, so it’s best to do your homework to minimize risk where possible.)

When investing in commercial real estate, you’ll want to run a thorough background check of any potential tenant(s), including a credit check and rental history. Don’t give the keys to anyone until the history and credit check come back clean. I’d also screen potential tenant(s) for business experience for the type of lease you’re offering. For example, if the whole reason a potential tenant is opening a restaurant is because his sister-in-law says he’s a great cook, the business plan may not be sound.

Although you may feel uncomfortable asking specific questions about the person’s business plan (especially if you haven’t done this type of lease agreement before), you’d be negligent not to inquire. When turning over an asset worth hundreds of thousands, or even millions of dollars, you want to be certain that the prospective tenant can and will perform the full agreement.

In commercial real estate, you’ll deal primarily with two types of leases: gross leases and triple-net leases. With a gross lease, the landlord is responsible for most expenses, including taxes, insurance, and routine maintenance (the tenant fixes things he breaks). With a triple-net lease, the tenant takes care of virtually all expenses, including taxes, insurance, and all maintenance.

There are pros and cons with both. As a landlord, a primary benefit of the triple-net lease is not having to deal with much property management. You’ll get no calls about a broken window or clogged sewer on a Saturday afternoon. However, if your tenant doesn’t keep up with routine maintenance over the course of several years, the long-term damage can be substantial. And, if the tenant’s business struggles, routine building maintenance is likely to be one of the first expenses to go. Sometimes the ill effects of poor maintenance are not immediately obvious, so trying to recoup expenses years after a lease begins is difficult (bordering on impossible).

As a rule, finding a tenant for a commercial building can take more time than for a residential property, so vacancies can last longer, but because commercial leases are typically multi-year contracts, vacancies are less frequent. As you consider negotiating a commercial lease, it will likely be quite different from the experience you may have had with a residential lease. Commercial tenants may be more along the lines of, “Have attorney; will travel.” If you’re lucky enough to have a major credit tenant (e.g., major grocery store, federal agency, national chain store), you’ll benefit from additional foot traffic and more stable rent. If your building allows for multiple tenants, a major credit tenant will attract other tenants. Because they know they bring these benefits, major credit tenants often play hardball when it comes to lease negotiations. They expect their rents to be lower  than other tenants, and even than operating costs for that space. Depending on how much lower, you’d be smart to play ball.

If you have questions about real estate or property management, feel free to contact me at rselzer@selzerrealty.com or visit our website at www.realtyworldselzer.com. If I use your suggestion in a column, I’ll send you’re a $5.00 gift card to Schat’s Bakery. If you’d like to read previous articles, visit my blog at www.richardselzer.com. Dick Selzer is a real estate broker who has been in the business for more than 35 years.

How to Buy a House

I’ve talked about why renters should consider becoming homeowners. The market is still a buyer’s market, for the most part, so this week I’ll share some information on how to buy a house.

The most important way to prepare is to get your finances in order. This means getting a credit report, collecting financial documents like your tax returns and W2 forms to demonstrate your reportable income, printing bank statements to show your cash reserves, and making an itemized list of your monthly obligations (rent, car payment, insurance payment, utilities, etc.). Gathering this data will allow you to figure out how much house you can afford.

The next step is to figure out how much house you want to afford. Do you want to have a little money left over at the end of each month, or are you investing all you can in your new home? Is there growth potential in your job? Does your spouse plan to go to work and increase your household income next year? Or, are you a young couple planning to start a family and have one of you quit your job to stay home with the baby? Be honest with yourself about what kind of payment will allow you to live the way you want to.

Remember, owning your own home means a mortgage payment, tax and insurance payments, and maintenance expenses. On the bright side, it also means building equity in your own property instead of paying rent to someone else so they can build equity in theirs.

So, you’ve got your finances together and have decided on your price range. Now, you need a real estate agent—one you like and trust. Tell your agent how much you want to spend, what your new home must have and what you’d like it to have. Share your preferences about location, property size, home size, number of bedroom and bathrooms, and any special considerations (e.g., Americans with Disabilities Act-compliant, one-story, specific school district). Be as picky as you can up front so your agent doesn’t waste your time showing you homes you’re not interested in.

Be prepared to look at lots of homes, and do yourself and your agent a favor: be completely honest. Tell your agent what you like and don’t about each. You won’t hurt your agent’s feelings if you share negative impressions. It’ll just speed up the process of finding homes that fit your needs. You should also be open with your agent about any contingencies. For example, you can only afford a home at this price after you receive the court settlement you’re expecting or as soon as you sign the contract for your new job that you’ve been promised verbally.

Once you’ve found the home you want, it’s important to be a savvy buyer. First, make sure all of the folks involved in buying the home are involved up front. If grandma is helping with the down payment and wants to approve the purchase, be sure to plan ahead. Sometimes buyers have to compete, and if you cannot make a timely decision, you could lose your dream home to a more organized buyer.

Then, work closely with your agent to make an offer that spells out exactly who is paying for what, and exactly what is included in the sale. Who’s paying for inspections? Repairs? Loan fees? Closing costs? What stays with the house? Hot tub? Window treatments? Pool equipment? Being a good negotiator means paying attention to the details. Your agent can help with this. They are familiar with real estate contracts and connected with local inspectors and service people (e.g., plumbers, contractors, electricians, pest and fungus companies) who can provide quality work.

I was recently asked, “When does an agent’s relationship with a buyer or seller end?” I said, “When one of you dies.” Smart real estate agents know that people typically stay in their homes for about seven years. After that, they’ll need a good agent to help them buy and/or sell their next home, and if that agent has been helpful during those years, they’ll be the first person that the buyer or seller calls. So don’t hesitate to ask for help from you agent even after the sale, they will be happy to be of service, it means you will remember them.

If you’re short on cash, see whether the seller is willing to work with you by paying for some of the closing costs or loan fees. This allows you to use the cash you have towards the down payment or for repairs. If you are pre-approved for a loan, sellers are more likely to help you out because they know you are a serious buyer able to complete the purchase.

Enhanced by Zemanta