On the surface it looks like good cash flow.

Am I missing something?

There are also new guidelines on converting existing residences to an investment property.

Also, FHA is still available (quite a hot deal, actually) if–BIG IF–the borrower is going to occupy on eof the units (must be 2-4 plex).

I would add that underwriter are acting much more stringently on ALL fronts, so expect no leeway on the 2nd home (owner occupied) vs the investment property distinction.

I have had to break the news to several potential investors, who were still operating under the old assumptions.

One more thing, FMA recently increased it’s “hit” to price on investment property, which has increased the gap between owner occupied and investment rate/costs.

Real estate is just another investment asset class with stocks, bonds, companies, etc. the same accounting and finance theory applies. The same financial statements are used. The same financial analysis techniques are used for a duplex, 200 unit apartment building, retail, office, industrial, etc.

The biggest mistake investors make include failing to create realistic financial statements estimating the real property assets future cash flows. Worse, many investors fail to calculate the assets yield or Return on Investment (ROI) using proper discounted cash flow techniques such as IRR or NPV. A failure to calculate the yield results in the inability to compare the assets effective yield to the yield of alternative investments such as another multi family property, Boeing stock, mom and pop min mart, tax free bonds, franchise XYZ, etc. Relying solely on capitalization rates is a mistake. Capitalization Rates describe the assets ability to generate operating income before financing and depreciation as a component of the sales price. That isnt a ROI calculation as it does not address all cash flows.

When creating financial statements under budgeting real operating costs and capital improvement reserves is a very common mistake of inexperienced (and sadly with a few experienced) investors. Operating costs include much more than property taxes, insurance and utilities. If the investor decides to manage the property, then pay yourself for being the property manager. If it doesnt cash flow with property management today, then it likely wont cash flow with property management five years from now. A few investors may argue that the capital asset growth or appreciation is their payment for managing the property. No, this is incorrect. Net cash flows received from operations (rent less all expenses) and cash flows received from capital asset growth or appreciation upon disposition of the asset (sale price less all selling costs, retiring all debt, excise taxes, etc.) are investor returns for investing capital. This is the investors return of capital and return on capital. If the capital asset growth is paying the investor to be a property manager, then it isnt paying to be an investor. Property management costs need to be accounted for as operations costs.

Because prices are very high compared to the rent received a higher down payment or more cash at risk will lower the investors yield with a larger denominator in the yield equation. An investor can acquire property with a lower down payment and accept the negative cash flows. Negative cash flow adds risk that must be accounted for. The negative cash flows effectively become more cash at risk in the future. The timing of contributing more cash to fund the operations is delayed and effectively becomes more cash at risk or an increase to the “down payment”. In the past many investors accepted advice that negative cash flow is OK because of appreciation. Maybe and maybe not. The additional risk should include additional reward. Each decision has an opportunity cost and risk. Relying on capital asset growth every year of five years is far riskier than relying on receiving rent next month that provides cash flow after all expenses. This is easily explained with the financial concept of the Time Value of Money. A dollar today is worth $.98 a year from now because of inflation. The longer the investor waits to receive the cash flow the more risk is associated with the cash flow.

Suppose an investment costs $1000. The investor will receive net cash flows for $250 a year for five years for a total of $1250.
CF 0 = -$1000
CF 1-5 = $250
IRR = 7.93%. The yield or ROI is 7.93%

What if the return of capital and return on capital was a lump sum of $1250 in year five?
CF 0 = -$1000
CF 1-4 = $0
CF 5 = $1250
IRR = 4.56%. The yield is 4.56%. significantly less than the first example.

How much does the year five lump sum payment in the second investment need to be to equal the first investments yield of 7.93%?
PV = -$1000
PMT = 0
PMT/Yr = 1
Yrs =5
I = 7.93%
FV = $1464.57

Because the risk of receiving all the cash in the last year is higher, the investor must receive $1465 to achieve a yield of 7.93%.

Why is this so important? “Is this duplex pretty?” is NOT financial due diligence. When investing in real property the investor must have a real estate professional who has the skill set to prepare accurate financial statements and the necessary financial analysis to determine the appropriate down payment (from an investment point of view), risk, and yield options.