Math 201 - A Deeper Dive on the Real Estate Numbers

Hey YouTube, Cody here, and today we're doing Math 201 where we get a little bit more complex but are here to keep it simple. And we had a lot of people that watched our last math video that really enjoyed it, got a lot out of it. Today we want to go a little bit deeper. We're going to talk about how we really underwrite for cash flow, lender risk, and just to make sure that we don't lose this stuff. Because when you have margin in real estate, your odds of success are higher. So getting that started, we're going to go straight to Excel, share my screen here. We're looking at a couple things. We're looking at what's called a factor rate when we're looking at mortgages, and then we're going to look at debt yield. Now, if I told you there's a situation, you have the opportunity to borrow money at 4% and you're going to earn 5% on your money, I'd ask you, would you cash flow in that situation? Well, it depends, because in real estate, typically we've got what's called an amortization schedule, which means you're not just paying interest, but you've also got debt paydown. And the way that we underwrite what an amortization schedule looks like is with what's called a mortgage factor rate or rate factor. And this equation, the sole purpose is to find out, okay, what's that extra little bit of debt paydown? You can multiply this, what's called a factor rate, times any loan amount, and you'll know exactly what the payment's going to be based on the loan amount and the loan term, whether it's interest only or whether it is amortized. And you can do this over any amortization period. Now, in this case, the equation— we have annual debt payments divided by the original loan amount. That's it. It is a very simple equation. And so in this case, we've got a $1 million mortgage at 4% interest on a 30-year amortization schedule. If we just go on to our, our best friend Google here, and we look up let's just do mortgage calculator, see if the Google one pops up. And we do $1 million on a loan at 4%. Our monthly payment is $4,774. Well, if we want to multiply that out, because we got to remember this is always, always, always on an annual basis. We're going to take $4,774. We're going to multiply that by 12, and boom, we have $57,288. If we go back here, that was slightly rounded down, but we've got $57,289. That is our total annual payment. We're going to take our total annual debt payment, we're going to divide that into our original loan amount. And we've got what's called a factor rate, meaning that we can multiply out 0.0573 times any loan amount and you know exactly what your debt costs. Well, why does this matter when you're comparing the interest you're borrowing on a loan compared to the— in this case, what we're talking about is a cap rate, the return you would make if you paid cash. The reason this matters is you are paying cash for every single deal that you ever buy. It's just not your cash, unless you've actually saved up the whole payment. You're borrowing from the bank typically, so you're borrowing with their money, and their money has a cost. And so while most people look at interest rate, you should be looking at what's called a factor rate, because this tells you what the actual payment is going to be. And so in order to break even at 4%, You need to buy on a 5.73% cap rate or better, not a 4%. You don't get to borrow 4% to make 4%. You will lose money in the form of negative cash flow. And it's not like you're just throwing that money away. It's going towards debt paydown. But if you buy a whole bunch of real estate like this and your cap rate is less than your factor rate, you will lose everything. You'll lose all of your money because it's all going into debt paydown. And if you can't cash flow your assets, it doesn't matter how much real estate you own because a negative cash flowing business will not last forever. People have tried, it doesn't work. Then we've got debt yield. Well, above we're looking at, okay, we know now that our cap rate must be higher than our factor rate on a mortgage, otherwise we lose money. Debt yield is looking at risk to a lender. We're looking at what's the NOI. If you remember back to our other video, net operating income, the money you have to pay yourself and pay your debt. This is after utilities, maintenance, management, taxes, and insurance and repairs. If you have a $60,000 NOI, that's the amount of money you have to pay your debt. What happens if your lender has to come after you and take the property back? What return would they get? And the higher return that they get, the more likely they are to lend to you. And if you know this, it makes it easier and easier to pitch on acquiring new debt. In this example, the NOI, meaning the money that a property made after all of its operating expenses before debt, was $60,000 in a year. If a lender fronts $900,000 as a loan to buy that, If we just take our NOI, we divide it into their loan amount, that means that their debt yield is 6.67%. So they may be lending you money at 4%, 5%, that may be their interest rate. But if they have to take the property from you, they're going to earn 6.67%. Because now that new net operating income is going to them instead of you. So the higher that your debt yield is, the more likely you are to get a loan because it's a bigger incentive for them if you mess up. It's less risky for the lender. So the point today, shorter video for math because sometimes people don't want to watch an hour long, just keeping it simple. The way that you make money in real estate is on margin. You borrow money cheaper than your return, aka your cap rate, your cash-on-cash return if you paid cash. But you can't just compare it to your interest rate. You have to look at what's called the factor rate. You can do this for any interest rate, any amortization schedule. You can utilize Google to look at what the actual payment is and to do this equation. And once you know what it is, if you are borrowing at 4% on a 30-year AMM, you have to buy it higher than a 5.73% cap rate or you won't make money. It is that simple. And as far as debt yield goes, if you're trying to convince a seller to finance, you're trying to convince a bank, you're trying to convince a private party to lend you money, the higher your debt yield is, meaning the net income, the net dividends from an investment if it was paid for in cash, divided into the loan amount, the higher you can get that return, the more likely you are to get a loan. So that's it for today's short math video for Math 201. If you guys have more questions on this, want to see some specific examples, drop it in the comments below. And as always, feel free to reach out with any questions, thoughts, concerns, and like and subscribe if you haven't already. I'll see you guys next time.