Investors love their formulas – cap rates, gross rent multipliers, cash-on-cash return – but don’t let a bunch of fancy terms intimidate you. The basics you need to know when getting started in real estate investing are really appreciation and cash flow, or what I call a Pajama Money Rate. At the end of the day, you need to know how your asset is growing in value and you need to know how much cash it produces every month.
The reason I like really drilling it down and keeping it simple is I see investors dismiss an entire investment because of a cap rate that has been presented (cap rate simply is the net operating income divided by the purchase price). But perhaps that number warrants additional investigation. What about how the investor is going to be paying for it? What if the investor can improve the property and get a little more rent? What if those expenses can be brought down? For me, relying on a formula to label an investment doesn’t provide me the real information I need to analyze whether the investment will fit my own needs.
Instead, I apply my own Pajama Money Rate formula which analyzes appreciation and cash flow. Pajama Money is money that accumulates within your investments without you having to physically go out and earn it. I like to say that Pajama Money is generated while I am in my pajamas or lounging and I can instead send all my little dollar bills out with their suits and briefcases to make money for me.
Here is how it works:
Appreciation is the amount my investment has or is predicted to grow in value. What is great about appreciation is that I can use leverage to gain even more value. For example, let’s say I have $100,000 to invest. I can invest in the stock market, I can buy an investment property for $200,000, or I can buy an investment property for $400,000. What is strategically the best option if I want the highest gain? Assuming that all assets appreciate at 5% per year, here is what I can expect:
Of course, we haven’t accounted for expenses yet, as both of the property examples would include a monthly mortgage payment, but do you see how much more potential appreciation there is on the higher-valued property? In the stock market, after 10 years, that initial $100,000 investment has only yielded $64,701, but the $400,000 property has yielded $258,804 (plus additional equity from paying down the mortgage). Let’s take a closer look at how the relationship between equity and appreciation work on that $400,000 example property from above:
From a Pajama Money Rate standpoint, this investment is earning $30,447.50 per year. How? Here is the formula:
(Equity Year 10 – Equity Year 1) / 10 years = Pajama Money Rate
Cash Flow is the amount of money you will spend each month for holding onto that investment or will receive in exchange for using your investment. If you are just holding it for appreciation (like a vacation home that isn’t being used as a rental), then your cash flow would be a negative and would include all the monthly costs incurred from owning it – from the mortgage, property taxes, insurance, utilities, maintenance and repairs, and HOA fees (if applicable). In most cases, the goal would be to offset those monthly expenses with income (such as rent) and exceed the outgoing funds.
It is important to not only look at current cash flow, but future cash flow. Rents and expenses will increase over time, but if the investment is financed with a fixed-rate mortgage, the principal and interest payments will stay constant.
Using the same $400,000 property example we used earlier, let’s take a look at how cash flow might look over time:
Assumes rental income increases 5% per year, expenses increase 3% per year. Assuming the property is managed by owner.
This particular investment doesn’t start out with very much cash flow, but look at what happens after just a few years! That is also Pajama Money!
Depending on an investor’s individual goals, this property may or may not be a good fit. For example, what if the investor really wants monthly cash flow now and doesn’t care so much about appreciation? That would warrant a different kind of property. There are plenty of places around the country that receive high rents in proportion to property values. However, this might require the services of a property manager which will increase expenses. Let’s see how that strategy pencils, purchasing a $175,000 property which receives $2,000 in rent upon purchase:
In this example, the monthly cash flow starts out stronger, but because the property value starts at a lower amount than the previous example, it doesn’t increase as much – all very important to know for Pajama Money Analysis.
Don’t be intimidated by a bunch of investor talk. Take a look at how appreciation and cash flow work together on an investment property now and in the future to determine if it meets your Pajama Money needs.
Want to determine your Pajama Money Rate or plan for future Pajama Money? Start by downloading our Future Value Calculator available for Club Zebra members and fill out completely including the Pajama Money information in rows 40-47. Then fill out the Retirement in View section at the bottom to see what your Pajama Money needs are. Then you just need to make a plan to get there!
Prosperity Strategy, coming up this November, is going to be all about this topic – determining your retirement and Pajama Money needs and building you a Pajama Money funnel fueled by your current real estate business, making a plan for investments to supplement your Pajama Money, and finally focusing on how Vacation Rentals can be a very lucrative way to ramp up your Pajama Money rate. I hope you will join us!
By Denise Lones CSP, M.I.R.M., CDEI - The founding partner of The Lones Group, Denise Lones, brings nearly three decades of experience in the real estate industry. With agent/broker coaching, expertise in branding, lead generation, strategic marketing, business analysis, new home project planning, product development, Denise is nationally recognized as the source for all things real estate. With a passion for improvement, Denise has helped thousands of real estate agents, brokers, and managers build their business to unprecedented levels of success, while helping them maintain balance and quality of life.