Interested in buying a rental property? Before you buy, you’ll want to determine the property’s investment value to make sure you’re paying the right price. The “cash on cash” valuation method is a pretty reliable way to do this. Many experienced investors have a “target” cash on cash rate. If the property produces cash on cash equal to or greater than their target rate, they buy. If not, they walk away. So if that’s true, shouldn’t you be able to start with the desired cash on cash return then work backward to figure the ideal price? The word you’re looking for is yes!
In this article, we’ll walk through a real estate valuation method that our course instructor, Tom Lundstedt, calls “float and desire.” This is a robust method that allows you to identify the desired rate of return and then work backward to calculate the optimal price of an investment property.
The float and desire method
Appraisers call it the “band of investment theory” and bankers call it the “debt capacity method.” Lundstedt calls it “float and desire.” Regardless of the name, this method combines three key factors—income, expenses, and financing—to arrive at the investment value of a property.
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Four-step recipe for buying a rental property at the right price
The formula for the float and desire method involves a “four-step recipe.” The recipe uses five ingredients to arrive at the optimal price for buying a rental property:
- Net operating income (NOI)
- Available financing
- Target cash on cash return
- Loan to value ratio (LTV)
- Loan factor
Remember: In order to work financially, a property has to provide enough income to satisfy the demands of both the lender and the buyer.
Step 1: Calculate the lender’s demands
Of the five ingredients, the ones that are most important to the lender are the LTV and the loan factor. The way to combine these ingredients to calculate the lender’s demands is to multiply the LTV by the annual loan factor. The resulting number represents what the lender demands from this property
Step 2: Calculate the buyer’s demands
The ingredients that are most important to the buyer are the down payment and the cash on cash return. The buyer will only acquire this property if it provides the target cash on cash. To calculate the buyer’s demands, multiply the down payment by the desired cash on cash return. This number represents what the buyer demands from this property
Step 3: Add them together
We know the property must satisfy the demands of both the lender and the buyer, so we must add them together. Add the lender’s return (the answer from step one) plus the buyer’s return (the answer from step 2). The total represents the cap rate the property has to produce to satisfy both parties
Step 4: Incorporate the net operating income
The final step in the recipe includes the last ingredient, the net operating income. This is critical because it’s from the NOI that the buyer’s and the lender’s returns must be met. Divide the net operating income by the answer from step 3 to arrive at the optimal price for buying a rental property.
Checking your work and mastering the method
How do you know you’ve arrived at the right price? Double check it. When you use the float and desire method to calculate investment value, always double check your answer by working backward. For an example of how to do this, as well as an easy-to-use “Float and Desire” Worksheet—and a ton of other info to help make you a more savvy investor!—enroll in McKissock’s online course: Real Estate Investing: Beyond the Basics. The course also includes case studies and examples of how to apply this method to properties.
Whether you’re buying a rental property yourself or working with an investment client, the float and desire method is a powerful tool to help you make the right decision—and pay the right price.
About the course instructor
Tom Lundstedt, CCIM, is known as the funniest investment and tax guy in America. His programs for REALTORS® have entertained and enlightened thousands of audiences from sea to shining sea. He’s a former Major League Baseball player whose striking combination of humor and real-world examples makes powerful subjects spring to life. He’s the author of a series of audio CDs and Study Guides on the subjects of investment real estate and taxation. Visit his website at www.tomlundstedt.com.