Accumulation of Wealth Formula
Over the years the methods of measuring the value of an investment has evolved to something we can all understand. That measurement is the called "Accumulation of Wealth" formula. It is a formula because it takes into account variations in income and expenses, income taxes and capital gains. The income is tracked or estimated over a period of years, so that at the end of the holding period the amount of after tax proceeds plus the yearly cash flows are measured and a rate of return is established. This can be after the fact which is real, or projected, which is our best educated guess based on experience and knowledge of the market and the property.
The accumulation of wealth is a true measurement of the worth of the investment to you. Its like selling widgets, if you sold a 100 widgets that cost $1.00 wholesale, then you have to pay taxes and expenses, what did you really make. So the key is to buy widgets for less or cut expenses or sell widgets for more than the competition. The idea is, that it does not matter how many widgets you sold but how much money you put in your pocket that is yours to keep. That bottom line is influenced by those factors mentioned, either pay less wholesale, reduce expenses, raise the price or do a combination of all in an effort to retain more of the earnings.
So the "Accumulation of Wealth" measurement is more accurate than a "Cap Rate" or the "Internal Rate of Return", because it measures the true or actual "Rate of Return". So, "Net Operating Income" divided by the "Sale Price" will give you a "Capitalization Rate" and hopefully that is not as far as you take it in the quest to determine a good investment. I can almost with accuracy state that the percieved return of say, 9% upfront is not 9% on the end.
That old saying that "Garbage In", Garbage Out" is certainly true in commercial or multi-family investments. What does impact all investments, just to name a few, that are obvious. Estimation of Income, usually estimated slightly on the high side, expenses can surely be understated. This is so critical. If income or expenses are skewed then the whole outcome is off. If you use projected income, then Vacancy "Must" be true to give you a reliable "Gross Operating Income". If "Gross Operating Income" is off then NOI is Off and every projection there after is suspect.
I use actual income and actual expenses. If you cannot get that out a a seller or agent then its time to walk away. When you do get expenses be sure to look at those things that will surely increase. In analyzing income look at the market and see if the rents or actually in the market and if "Vacancy" is true. These three things if not accounted for will make or kill your deal and they are lack of income, rising expenses and high vacancy.
What we do not want to do, ever, is come out of pocket each month to make expenses or debt service as that will certainly not accumulate any wealth. I have seen expenses and income change at different rates and an investment become upside down in a few short months. Now that is what is called a "Sinking Feeling", (Not a sinking fund) :} Upside down is when we start to look to others for answers and blame the broker or counselor and banker for getting us into this mess. It is kinda hard to blame the banker as they use ratios for lending and risk assesement and if the deal does not fit in their guidelines then they ask you to put more money into the deal or they just do not loan.
If the broker or counselor is relying only on the going in "Cap Rate" or "IRR" or "MIRR" then I would want to know how much money will I put in my pocket each month after all expenses and income tax. If I cannot put a $1,000 a month into my pocket then I will not do the deal as structured. A $1,000 a month will give very little cushion in multi-family projects. If you clear $200 per month in a rent house your probably okey if the market holds. When we re-model a house to flip, the minimum return is $20,000 after all fees to banks and selling fees. I will say that 20 grand can be eaten up in a hurry, especially if you have to hold a property 6 or 8 months.
My advice, ask the broker or banker for a cash flow analysis and net sale proceeds at the end of the investment. then measure the return. Also, always be concerned about the monthly amount of money in your pocket, after tax. Money in the pocket is always good and that is what its all about.