By JODI SUMMERS
Passive real estate investors sit back and feel confident that with time, property investments get easier and more lucrative. Proactive real estate investors want to know how much their property is yielding on its equity. Proactive investors are always looking for ways to increase their return.
“The whole point of building a larger net worth is to provide the wherewithal for living expenses while you do what you most want to do,” notes George Kinder, author of “The Seven Stages of Money Maturity.”
Those looking for maximum bang for their buck are big on yields. Yields work this way — say you have $100,000 to invest in a Certificate of Deposit. You would see which bank offers the best rate on the money — a.k.a. the best yield on their equity. If First World Bank is offering 3.28 percent and World First Bank is offering 3.4 percent; obviously you are going to buy the CD with the 3.4 percent yield — $3,400 annually. Say you liked the return and bought a million dollar CD, the cash flow would be $34,000 and the yield would still be 3.4 percent.Yield is a constant, but the cash flow changes as the equity changes.
“In the recent marketplace, you can exchange a property every couple of years for a considerably higher yield,” confirms investor Bruce Norris.
If you’ve held an investment property in SoCal for three years or more, it’s most likely bumped up in value. Maybe it’s time to exchange that property for something that will make more money for you.
“If it is your intention to be the master of your financial destiny, you must begin paying more attention to your money,”confirms Orman in “The Courage to be Rich.”
Take the concept of yield and apply it to real estate. Let’s say you paid $500,000 for a well-located eight -unit in the property lull following the Northridge earthquake. Because of your reputation with the lender and your promise to fix the damage and bring the building up to code, you were able to squeeze by with $150,000 down and took at $350,000 loan. When you bought the property, your cash flow (total income less expenses and debt service) was $10,000. Your yield on equity, or cash-on-cash return was 8 percent. The math is your cash flow — $10,000 — divided by the hard cash invested — the $125,000 down payment.
Thanks to the growth of the real estate market in the past decade, that property has gone up in value four times, and it now worth a cool $2,000,000. The amount of the loan has dropped to $250,000, making your current equity in the property $1,750,000. Cash flow has grown to $50,000 annually. As a passive investor, you are delighted, you are making a 20 percent yield on your original investment. An active investor you divide the $50,000 net income by the $1,750,000 in equity and realize that your current cash-on-cash return is 3 percent. Appreciation has shrunk the yield on your investment.
"Some people are content to acquire and hold property,” states Norris. “More aggressive investors are constantly turning over properties to maximize the yield on their investments.
What is the financial difference between active and passive investing? By reinvesting the $1,750,000 to earn an 8 percent yield, as the investor was receiving on their original equity, their current cash flow would be $140,000 — $90,000 more than the $50,000 annual cash flow the investment property is currently earning.
“Financial freedom requires not just insights but also actions, and to carry out these actions you must learn about money and how it needs to be treated” — As financial guru Suze Orman asserts, SUZE ORMAN ‘THE 9 STEPS TO FINANCIAL FREEDOM’
“You have to have a relationship with your money.”
“Investing in real estate is all about math,” notes Gerald Friedkin,founder of the Friedkin Investment Group, owners of some very nice commercial properties in Santa Monica.
Sure, part of investing in real estate is obvious — is the location good, are the structures sound — but the profits come from doing the math. To be a good property investor you’ve got to embrace a few essential commercial calculations. Knowing how to calculate these real estate revenue formulas is the first step in investing in commercial real estate.
“Aggressive investors will continue to buy and sell properties to create higher yields,” notes Norris.
If you are interested in active real estate investing, here are some terms that will be of use to you: Holding Period: The length of time the typical investor expects to hold the property.
LTV (Loan to Value Ratio): This represents the loan or debt portion of the property investment in terms of a percentage.
Mortgage Constant: Mortgage constant is a rate that reflects the periodic annual payment of principle and interest on a mortgage with a level amortization schedule that will extinguish the debt.
Mortgage Rate: Mortgage Rate is the annual interest rate lenders charge when making real estate loans.
Mortgage Term: Mortgage term is the number of years for which the mortgage was given.
Equity Dividend: The “cash on cash” return (usually reflecting the first year) that measures the portion of income remaining after satisfying all expenses including mortgage debt to the initial down payment.
Equity Yield: The annualized total return an investor would desire from the property (required rate of return on and of equity capital).
Jodi Summers is Director of the Investment Division at Boardwalk Realty Santa Monica. Contact her at or call (310) 309-4219. Visit her web site at www.SocalInvestmentRealEstate.com and www.san-tamonicalandmarks.com.
Originally published in the Santa Monica Daily Press print edition on November 8, 2006. Read the original PDF.