Twice this month I was exposed to "gurus" touting ROI (Return on Investment) as the compass to evaluate the purchase of a single family residence. Nothing wrong with this approach, except BE SURE TO INCLUDE ALL EXPENSES. Often these gurus will leave out expenses; and therefore inflate the ROI.

Remember ROI is calculated by subtracting ALL yearly expenses from yearly income; then divide this figure by your cash investment.

I am going to paraphrase the concept both gurus were trying to portray. Say you find a house worth $65,000 for $50,000 cash. Assume further the house can rent for $650 monthly. Both gurus pointed out that there are expenses to take into account; then listed only the cost of management and insurance. The calculations looked like this: $650 monthly rent x 12 months equals $7,800. Subtract from this figure a 10% management fee and also $3,000 for taxes and insurance, and we are left with an income of $4,020. Divide this yearly income by the $50,000 cash investment, and according to the gurus, you will enjoy an 8% ROI. Not bad; right? We shall see.

The scenario continues where the real estate investor will refinance the property and receive $42,000, with payments of $200 monthly or $2,400 yearly. According to the gurus, subtracting the $2,400 mortgage payment from the yearly income of $4,020 and the investor will have a cash flow of $1,620. However, because the investor received $42,000 from a refi, he/she has only $8,000 invested. So if you divide $1,620 by $8,000, the investor will enjoy an ROI of 20.3%. WOW! Fantastic deal; right?

Maybe not. The above concept is valid IF AND ONLY IF, all the expenses have been listed. For those who have taken my apartment workshop or who currently own rent houses can attest there are more expenses to rental properties than management, taxes and insurance. In this article I am going to mention only two:
1. Vacancy
2. Repairs and maintenance.

Can we agree that vacancies are part of owning rental properties? Let's conservatively assume a two month vacancy. For example, the first month a tenant does not pay the rent; and then idealisticaly moves out without the cost and time of an eviction. Assume further that it takes a month to find a "qualified" tenant. Under this common scenario, the income will be reduced $1,300 ($650 x 2 months). I am not going to add in the costs of make ready or fix up to make the house marketable which would reduce the income even further.

Follow me here. Subtracting $1,300 from the original $4,020 we find the income has been reduced to $2,720.

For repairs and maintenance, let's assume there will be no major repairs, and allow only $50 monthly for maintenance. This equals $600 yearly. This expense will reduce the yearly income to $2,120. If you divide this total by the original $50,000 cash purchase, we have a more realistic ROI of 4.2%

Let's take this scenario to another level. Suppose the investor was able to refi for $42,000 with yearly payments of $2,400 yearly. (This in and of itself is not assured as any investor with rent houses can also attest) Subtracting the mortgage payments of $2,400 from the $2,120 income that includes vacancies and repairs, and lo and behold rather than having 20.3% ROI, the investor actually has negative income. Moreover, this does not even take in other costs, like closing costs in purchasing, accounting, gas to inspect property and make ready, just to name a few.

Not the best situation to be in, is it? How good is this deal looking now? How many of you would purchase a property with AT BEST a 4% ROI, and at worst negative income.

To add to this example, last month I had an investor in a similar situation try to sell her note. She sold her property to an investor, and she allowed only taxes, insurance and management as a gage for expenses. According to her calculations her buyer would enjoy an income of approximately $200 monthly income after debt service. However, when minimal vacancy and repair allowance were included, the property could not service the debt. We had to pass on buying the note.

In conclusion, calculating ROI or cash on cash is a useful tool to evaluate real estate investments. However, to be valid, the ROI assumptions MUST include ALL expenses. To add to this axiom, every investor should be thinking of not only return ON investment, but also return OF investment. This will be the topic for another discussion. Be careful to include ALL expenses when evaluating rental property. Otherwise your ROI will be inflated, which will result in loss of money.

If you have any questions or comments, be sure to contact me In the subject line, write ASK the PROFESSOR.

Remember, if you know of someone who has a note to sell, I will pay referral fees at the least, and will also split my profits if you would like to "co broker" a Note with me.

I have a Get a Note Quote web page that can be filled out and submitted for professional pricing. Check it out.

Tom Henderson /a.k.a. THE NOTE PROFESSOR .

Copyright © H&P Capital Investments LLC All rights reserved

FREE Real Estate
Note Newsletter and Archives
click here to subscribe and view the archives of past information packed issues through 2009. And be sure to forward this newsletter to a friend that would have an interest in Owner Financing and Real Estate NOTES.

Current ARCHIVES (end of 2009-2012)

How many of us have heard "We need to run the government like a business". As popular as this mantra might be, there is only one problem. It cannot be done. It is a myth; a fantasy.

Why is running the government like a business an impossibility? Simple; when evaluating the success or failure of a business, there is only one objective standard, PROFIT.

To be profitable, firms must satisfy their customers. In a nutshell, if business produces a good or service that is needed or desired and operates in an efficient manner, where income exceeds expenses, then this business is successful and will continue to exist.

To maximize profits, a business must continually evaluate markets, expenses, trends, prices and customer satisfaction in order to operate in the most efficient manner. The measure of the success of the business is the profit it generates.

Contrast this concept to a government program. A government bureaucracy has no need to price its service because its revenue is created by taxes, not voluntary exchange. The bureaucracy will continue to exist and even grow no matter if it is run efficiently or not. In short, without a profit model to gage success, it is impossible to evaluate the success of a government program. Even the most efficient entrepreneur would not be able to apply his/her skills to determine if a program or department is being run in the most effective manner. Why, because there is no objective standard, to evaluate a department, like profit

If profit is not the compass by which government programs are evaluated, what is? From a political standpoint, isn't the yardstick politicians use to measure success of a government program the number of votes or campaign donations it will generate for the politician? Vote for me, and I will "give" you (fill in the blank).

How do you evaluate the millions and millions redistributed by the Department of Agriculture? I know it is popular, especially to those receiving funds, but how do you evaluate its success? Or take the Department of Education. Since we know the American education system is a failure, by what logic is this department still in existence? If the Department of Education were a business, it would have been bankrupted a long time ago would it not. Yet it still exists and worse, there are cries for more funding.

Another example is the SEC which overlooked Enron, MF Global, and Madoff, while vigorously prosecuting that harden criminal Martha Stewart. How do you evalutate the effectiveness of the EPA which wants to shut down businesses because of controversial issues? Are the millions and millions of dollars spent on these departments cost effective?

No matter how you answer this question, since there is no absolute yardstick to measure success, your answer is merely an opinion. Is it becoming clear that the measurement of "success" of a government program depends more on a political agenda rather than on a logical evaluation? In one political atmosphere these departments are "good", while in another political atmosphere these departments are "bad". Not a good method to gauge effectiveness is it?

Notice I did not say the purpose of government agencies do not have value. This is a topic for future issue of the Note Professor Newsletter. I merely want to point out that running these departments like a business is impossible, since there is no objective way to evaluate the effectiveness of the hundreds of millions of dollars these programs cost the taxpayer. With the exception of politicians determining how many votes or campaign funds a program will generate, there is no logical way to evaluate a government program.

Without a profit motive, waste is inherent to any government program. Think of how your business model would change if you did not have to be concerned about revenue nor expenses. For example, there is an axiom in bureaucratic budgeting that says, "Do not cut your budget or staff, or you will lose it forever!" Is it any wonder with this type of mentality we see scandal after scandal, year after year no matter which party is in power?

Do businesses ever waste money by paying employees that are not needed or more than they are worth? Of course they do! To the extent these inefficient actions continue is the extent to which the firm will be unprofitable. When profits decline to a certain point, there is a "house cleaning" where marginal jobs and uneeded expenses are eliminated. Parenthetically, this is one reason why some corporations are now showing more profits after downsizing. It is not because sales or income increased, but rather because non essential employees and expenses were eliminated; and therefore profits increased. The point is firms that are run efficiently will enjoy profits and are therefore successful. Firms that are not run efficiently fail, and capital is diverted to more productive firms.

Not so with government programs. Year after year, administration after administration, we see scandals, fraud and waste. At the same time, in every election cycle, politicians will promise that if elected, they will eliminate waste and "run government like a business." But nothing ever changes. Why? Because when there is no profit motive, waste in inherent.

Moreover, when you operate under our current economic system which has decayed into collectivism/statism where wealth redistribution is now deemed moral and sustainable, compounds government waste and fraud. (For more on this subject see The Note Professor Newsletter Jan/09 issue)

Running the government like a business is an impossible task in and of itself. However, keeping the same collectivist/statist system of economics, while at the same time promising to cut spending is an outright fantasy. It cannot be done, even by the most astute entrepreneur.

Until we restore free market principles and abandon collectivist/statist concepts, waste an fraud will continue to grow.

If you have questions, CONTACT ME. I will address them in future issues.

Copyright © H&P Capital Investments LLC
All rights reserved

If you have not attended a Note Professor "How To Get Rich with Notes" class, be sure and purchase the Note Professor Note Book manual to enhance your knowledge of creative real estate financing and note buying and selling.

"I got your news letter. It was great, purchased your (Notebook) and it was awesome. I used your renter technique and it worked also. I am getting 41% return thanks to your expert advice. I have spent hundreds and not able to do any thing thru other gurus" Gary W. Garland, TX

"It blew me away what a powerful tool notes can be. Lots of great information, worth every penny! Highly recommended."
Jeff C. The Colony/Investor

"Your manual is short and straight to the point, it's rare to buy something today that gives you your money's worth. Thank you" Stephan B. Phoenix, AZ

You will learn at least one new usable concept to increase your profit in buying or selling notes and real estate.
Tom Henderson, author

By popular demand, THE NOTE PROFESSOR NOTEBOOK is now available in easy, downloadable E- book form for a the low, affordable price of $39.95. Other products are also available, including HOW TO MAKE OBSCENE PROFITS with SMALL MONEY, and GUIDE FOR SECOND LIENS. There is also a FREE download of CHECK LIST FOR OWNER FINANCING. Simply go to the NOTE BUYERS STORE. I can think of nowhere that you can find such information packed products at such incredibly low prices. We are still working out the bugs, so if you have any problems, be sure to contact me.