Guaranteed Cash Flow Formula

So what in the world is... the Holy Trinity?

Investors want a sure thing, a virtually guaranteed way to assure profit or cash flow. Well, for income property the HOLY TRINITY is:

Cap Rate = 8% minimum
Debt Coverage Ratio (DCR) = 1.6 minimum
ROI = 12% minimum

Millionaire Dave Lindahl buys his income properties according to the above guidelines and you should too.


HERE'S WHAT IT MEANS

Cap rate is the ratio of the Net Operating Income to the purchase price:

Cap = NOI / Price

Clearly, a larger number is better because that means you're making more (NOI) or paying less (Price) and many investors search for properties based ONLY on cap rate. But cap rate is only PART of the big picture. And you want to avoid chasing a moving target, that is, seeking 9-caps when the market dictates 7-8% cap rates or seeking 10-12% cap rates when the market dictates 9-caps. If you fall into that trap, you'll likely end up never buying anything.

CAP RATE is also a measure of risk: low risk = low cap rate, and higher risk = higher cap rate. That's why Class A apartments always have low cap rates (6-7%) and distressed or run-down or broken properties have higher cap rates (10-14%). Class A properties have the best facilities, best tenants, highest rents, and lowest vacancy rates even in recessions, and big-money ($300M+) INSTITUTIONAL investors are willing to pay lower cap rates (higher prices) for that long-term stability.

But cap rate is based on NOI which is calculated BEFORE debt service. So cap rate tells you if you're getting a good price, but it tells you NOTHING about cash flow (which is what is left over after you pay the mortgage!

For that you need the Debt Coverage Ratio (DCR) or the ratio of NOI to debt payments:

DCR = NOI / Debt Payments

So a DCR of 1.0 means you're making just enough Net Operating Income to pay the mortgage. That's why banks require 1.20-1.25 for a stabilized (adequately rented) property. That way, you have a little cushion to pay for unexpected expenses or a random hike in the vacancy rate without defaulting on the loan.

But Lindahl recommends a DCR of 1.6 or more because you don't just want a little cushion - you want a LOT. Why? Well, because you have to pay yourself and your investors if you have them.

Okay, so with a DCR of 1.6 or more you have a LOT leftover after debt is paid, but do you have enough?

To determine that you need to calculate your Return On Investment (ROI):

ROI = $-out / $-in
also known as ROI = (cash flow) / (initial investment)

Your ROI is how much you're getting paid - bottom line. Again, like cap rate, for safe stable-cash-flowing properties (Class A) you can expect a ROI lower than with higher-risk properties (rehabs or Class C/D).

Lindahl suggests ROI of 12% or more. Why? Because if you're a serious investor you likely have investors putting in cash, but YOU (the asset manager or general partner) must also get paid. Your investors get 9% on their cash and you get 3% on your time and effort to manage the asset's performance.

SUMMARY

So you use cap rate as a FIRST rule to determine your purchase price of a property. Then you use DCR to ensure you have sufficient cash flow after covering debt service. Finally, you calculate your ROI to make sure you have ENOUGH cash flow to pay yourself and your investors.

Cap Rate = 8% minimum
DCR = 1.6 minimum
ROI = 12% minimum

And THAT, folks, is the income property investor's HOLY TRINITY. It's as close as we're going to get to a guaranteed money maker!
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