Finance Matrix Investment and Real Estate

If  you’ve ever been puzzled by how real estate and finance are related, keep watching because I’m going to simplify the whole thing for you, make it easy to understand. And stay to the end because I’m gonna give you some resources that you can use going forward. A lot of people are terrified of the finance part of investing in real estate.

It’s because it seems like some unsolvable puzzle, but it’s not that complicated. Real estate finance is just a matrix, and it’s actually a pretty simple matrix. So let me show you how it works. Imagine a real estate investor looking at a piece of property, let’s say, an apartment building that they wanna buy. The investor isn’t really looking to just own the property.

Why do we invest in real estate? To build wealth. So what we’re really looking for is the income. And that income can come from the cash flow. It can come from appreciation, come from the tax benefits.

But imagine investing, say, like, $1,000,000 and then only making, say, $100 a year. That’s not really what we’re looking for. Right? It’s about building an acceptable level of wealth. And the way to determine whether or not an investment is acceptable is by measuring the return on investment.

Real estate investors need to be able to measure how much wealth they are generating relative to the amount that they invested. Let’s say we have a $1,000,000 investment. The owner collects the rents and other income. They pay all the expenses like taxes and insurance and utilities, and whatever’s left over is the net operating income or the NOI. If we paid all cash for the building, the NOI that’s left over after all the bills are paid, that is our cash to keep.

So if we take the NOI that we get to take home divided by how much we paid for the building, that’s our return on investment, also known as the cap rate. But that’s only our return on investment if we paid all cash for the building. Most of us don’t pay all cash because one of the benefits of real estate is the ability to use leverage. And leverage means using part of our own money as equity, part of the bank’s money as debt so that we can buy a bigger property and scale. And we do that by taking out a mortgage.

We bring our own money for the down payment. We borrow the rest from the bank and we use that as our total investment. And this is the financing. This is where real estate finance comes into play. Now going back to the net operating income, the income from the property, it is what it is regardless of how we finance the building, whether we paid all cash or we got part loan or multiple loans, the property still generates a certain amount of net operating income.

But whenever we take out a mortgage, a portion of the net operating income is going to go to the lender in the form of loan payments or annual debt service. And then whatever’s left over, the investor keeps as net cash flow. And the total cash each year going back to the lender, whether it’s interest or principal or both, when it’s divided by the loan amount, is called the loan constant. And that’s effectively the lender’s cash return back to them for the money that they laid out. The more we borrow, the more cash flow we have to give back to the bank.

But that’s not the only thing that can affect our loan payments. When interest rates go up, we have to borrow less money to keep the payment the same. And when interest rates go up a lot, it really starts to impact the cash flow. The more expensive a loan is, the less cash flows left over for the investor. But as the investor, it’s the net cash flow that we want.

And the way we measure our return is by taking our net cash flow and dividing it by how much we put in the property. That gives us our cash on cash return, our annual return on equity. But that’s only the first part of the story because we typically invest over time. And in order to understand return on investment over time, you need to be able to understand the time value of money. Understanding the concept of time value of money is key to knowing your numbers because it’s not just what we make in 1 year, but what we invest in the beginning to acquire the investment, the cash flow, positive or negative, that we earn along the way, which can vary, and then whatever gain or loss we had when we sold the property.

And all of this is very easy to calculate if you know how to work a financial calculator. Same thing with calculating loan payments for debt service. This is the road map that you need to take in order to really understand real estate investments. And the first thing, of course, is you have to know your numbers. And that’s what we’re talking about here, understanding the time value of money, how to calculate loan payments and debt service, and how to calculate your returns.

My know your numbers crash course is a quick little boot camp on financial analysis, and it only takes a few minutes to learn all of this. Once you understand how to run your numbers, then you just need to learn how to analyze investment properties. Then you can apply your knowledge of mortgage loans and leverage to calculate returns. Because you can’t calculate mortgage loans unless you understand things like net operating income and debt service coverage. So they all work together.