Blog Archives

5 Actions to Manage Your Personal Finance If You Are Generation X

5/31/2013

Q. I am 42 years old, know nothing about finance. Can you tell me any simple ways to better manage my personal finance?

A. If you belong to Generation X (roughly between age 35 and 55), please consider taking the following 5 actions to manage your personal finance, it's still not too late.

1. Prepare 3-6 months' emergency fund.
The rainy day fund is not just for the occasion you lose your job, it could also be used towards some unexpected big expenditures. For dual-income earners families, 3-month fund maybe enough, for single person, you better have 6-month fund ready.

Where to put the emergency fund? A previous blog has discussed this topic.

2. Pay off high interest rate debt.
By now hopefully you have paid off your student loans, now it's time to deal with those credit card or car loan debts, if you have any.

A typical question is: should I save money for emergency fund first or pay off high interest rate debt first?

The answer is, save emergency fund first, because if you lose your job, no one, except your own family, will help you go through this tough period of your life, you really need the fund.

3. Maximize your retirement saving accounts.
This of course starts with your company-matching 401(k) or 403(b) account, because you should get the free company matching money first.

If you still have money left each month, and if you qualify (AGI lower than $180K in 2013 for joint-filing families), contribute to your Roth IRA account (maximum annual contribution $5,500 in 2013) or traditional IRA. Should you open traditional IRA or Roth IRA account? It depends on your future tax rate, if you expect higher future tax rate, contribute to Roth which you pay tax now and don't have to pay any tax later.

4. Save for your kids' college funds.
Should you save for your kids' education fund first or save for your retirement fund first?

This is really a no-brainer. You need to take care of yourself first before taking care of your kids, because your child can apply for financial aid to go to college, there is nobody there to lend money to you for your retirement life!

5. Get a Term insurance.
If you don't have Term insurance yet, get one today!

But there is no need to buy those expensive permanent life insurance products, because your goal is to get insurance for your family if anything happens to you, this is not time to mix insurance with investment, because your action 3 above should have already addressed the investment part.

Term insurance is really a commodity nowadays, we can guarantee you for the lowest cost Term insurance. So if you need one, please contact us today.

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4 Health's You Need For A Happy Life

5/30/2013

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Physical Health. If you are sick, you won't be happy. So please start exercising regularly.
Emotional Health. You need to have the emotional health to develop positive relationships with people around you.
Mental Health. With an active mind, you will be able to continue to generate great ideas for your life. But you need to practice, mentally. Just like physical exercise doesn’t get you in shape overnight. Mental health takes long time and regular mental exercise.
Spiritual Health. In everyone's life, there are always some points of time that one feels helpless and wants to give up. It's OK to seek help from a higher power. “Please help me out!” Also, have gratitude. We're all grateful that we're alive today.

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Baby Boomers How to Maximize Cash Return?

5/30/2013

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Q. I am a retiree, what's the best way to maximize the return of my cash while preserving safety?

A. Quantitative Easing policy from the Fed brought incredibly low rates to ordinary consumers, but also hurt many of the baby boomers, with CD rates less than 0.25%, is there a safe way for baby boomers to generate enough returns from their hard earned cash? If yes, what to do?

Seniors who want to maximize their returns from their cash should consider the following ways:

Avoid those confusing financial products that "promise" high returns. In this period of historically low rate environment, it is unwise to lock any long term return at this time. Or at least you will pay dearly for such "high return".
Back to the basics of investment - diversify. If your life expectancy is more than 5 years, you should consider setting aside a portion of your portion in stock funds, such as low cost index ETF's, even you know they are riskier than bonds or CDs.
Remember, return comes with risk, you can't have both at the same time. So be ready for the risk you are taking, as long as you are diversified enough, you will be fine.

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Where Are the High Yield Opportunities

5/29/2013

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At PFwise, we don't encourage chasing hot stocks, because they could turn cold overnight. But for some investors who are looking for high yield opportunities, we want to show you some numbers below which clearly tell you where to find high yield opportunities.

The following data is as of May 7, 2013.

Telecom, Utilities, and Consumer Staples are where high yield opportunities are!

But high yield typically means slower growth (which translates to capital gains). So the next natural question is, which high yield stocks also offer great growth opportunities?

We can use PEG (Price to Earnings ratio divided by growth rate) to gauge growth opportunity, the lower the PEG, the higher the growth potential.

Using Fidelity's stock screener, as of May 21, 2013, three large-cap common stocks with the lowest PEG and highest dividend yield are:

CenturyLink Inc. (CTL) – 5.74% dividend yield
FirstEnergy Corp. (FEL) – 5.08% dividend yield
AT&T Inc. (T) – 4.84% dividend yield

Note the above stocks belong to the large cap category, if you are looking for such opportunities among mid-cap stocks, here is the result:

As of May 21, 2013, three mid-cap common stocks using filters of lowest PEG and highest dividend yield are:

Norbord Inc. (NBRXF) – 7.53% dividend yield
New York Community Bancorp Inc. (NYCB) – 7.19% dividend yield
Home Loan Servicing Solutions Ltd. (HLSS) – 7.11% dividend yield

But remember, large cap stocks tend to be less volatile (aka less risky) than mid-cap stocks.

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6 Ways to Save on Healthcare Costs

5/29/2013

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Annual premiums for employer-sponsored family health coverage increased to $15,745 in 2012, up 4% from 2011, according to the Kaiser Family Foundation/Health Research & Educational Trust 2012 Employer Health Benefits Survey. The survey also found that, on average, workers pay $4,316 and employers pay $11,429 toward those annual premiums.

With so many priorities competing for your hard-earned dollar, smart saving tips can matter in every facet of your financial life. Here are six ways to potentially get better value for your health care dollar and save on medical costs.

1. Seek value-oriented health care solutions.
There are four types of providers:

a PCP
a specialist(s) for any existing or expected conditions
an urgent care provider
a full-service hospital.

Your doctor and insurance company should be able to help you identify the best potential options for your situation.

For example, you may find that seeking care from a primary-care physician (PCP) or a high-quality urgent care center rather than an emergency room may be a better way to go. In some cases, an emergency room visit could cost $2,000, while an urgent care facility may cost $200 for essentially the same care, a big difference when it comes to paying the final bill.

2. Communicate with health care providers.
Communicating your objectives for cost control is important no matter what type of plan you are in, but particularly for anyone in a consumer-directed health plan (CDHP) with a high deductible. If you have this type of plan, you should let the provider know that you will be paying for the service yourself so he or she can understand the need for you to control costs.

IFor example, if your intention is to receive an annual physical that may not be subject to any co-pay or coinsurance costs, be sure to confirm before the appointment that the provider will bill the procedure as an annual physical and not as a different, higher-cost procedure.

Here is a list of questions you should ask for the care provider:

A clear description of the diagnosis and proposed care, free of confusing technical jargon
The benefits, risks, and cost alternatives to the proposed care
Cost comparisons for alternative treatments
The number of comparable cases the provider handles
Qualifications of the key personnel involved
The expected out-of-pocket charges and fees based on the proposed care, your condition, and your health plan

3. Save on drug costs.
Depending on the condition you have, some prescription drugs can cost up to thousands of dollars per year to fill. Consider the following strategies to help control drug costs:

Use a generic drug. Insurance plans often charge a higher price for name brand drugs than for generic drugs. You should review the list of available generic drug options with your doctor to see if there could be a safe, effective, and lower-cost alternative to any name brand drugs now being used. But also check with your insurance company which generics are covered before asking your doctor to renew a prescription, as the plan's list of approved generics can change over time without a doctor's knowledge.
Get a 90-day vs. 30-day supply of medications. Longer supplies often have a modest discount. Also, look into preventive vs. nonpreventive drugs. If a drug is classified as preventive, it is often much less expensive than a nonpreventive drug.
Double-check prices. Don't assume that a health plan's prescription drug distributor offers the best price. Other distributors may offer a better price for the exact same drug. You should also check the price of your prescriptions at local retail drug stores.

4. Be creative.
Think outside the U.S. box. It pays to shop around for prescription providers and medical care facilities, even out of the United States.

5. Maximize your health care benefits.
Many health care plans are increasingly rewarding particular behaviors (e.g., healthy eating) and discouraging others (e.g., smoking). The key is to clearly understand the products, services, and providers that are covered at the lowest cost to you, and then consistently choose these over alternative options. At a minimum, you should take some time each year to confirm that your preferred PCP, specialist(s), hospital, dental, and vision care providers are still in your plan's network and that you remain eligible for the highest level of reimbursement.

6. Know your rights.
All people should know their medical rights, including rights to privacy, to access medical records, to have loved ones make decisions for them when they cannot, and to have hospital visits. But there is another set of rights to be aware of:

The right to know what medical services cost before they are incurred
The right to select medical providers
The right to choose or refuse medical services. Although medical providers are trained to act in our best medical interest, they do not necessarily act in a patient's best financial interest; it is the patient's right to agree to or refuse services.

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Where to Put Your Cash?

5/29/2013

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Many people don't know how to appropriately manage their finances, an example - they put all their cash in a savings account.

Is it safe? Yes. But to increase your income potential, you have to confront certain risks.

Where to put your cash depends on what's the use of the cash. Below we will use four hypothetical examples to illustrate where to put your cash.

Example 1. Everyday Expenses

Daily liquidity need: High
Tolerance for losses: Low
Vehicles to consider: Money markets, checking and savings accounts

Example 2. Emergency Funds

Daily liquidity need: High for a portion of the fund, lower for the rest
Tolerance for losses: Low
Vehicles to consider: A mix of highly liquid accounts, such as money market funds, and less-liquid options, such as CDs or conservative bond funds

Example 3. Near Term Savings Target

Daily liquidity need: Low
Tolerance for losses: Low
Vehicles to consider: Treasury bonds and FDIC-insured CDs with maturities corresponding to the date you need your money

Example 4. Near Term Allocation in Long Term Funds

Daily liquidity need: Low
Tolerance for losses: Moderate
Vehicles to consider: A range of bonds and/or bond funds representing various credit qualities and short durations

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How Retirees Without Solid Income Could Secure a Low Rate Loan

5/28/2013

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As a retiree, are you asset rich but income poor?

You might sit on a big IRA or 401(k) account, but with little income from social security and pension plan, your chance of refinancing or getting a mortgage loan with a great rate is extremely limited, thanks to a "debt to income" ratio used by all lenders. You probably won't even qualify for a loan!

What can you do?

You should take advantage of a little known plan offered by Freddie Mac and Fannie Mae for seniors.

Here is a hypothetical example -

You have $500K in a retirement savings account, you haven't touched it but could without any IRS penalty because you are older than 59 and half. You like to refinance with a low interest rate, but your debt to income ratio is too high.

If you use the Feddie Mac's guideline, you can ask the loan officer to use your untapped $500K retirement asset, he or she may apply a 70% discount rate to that amount, which arrives at $350K.

Now, the underwriter divides the $350K by 360 (for a 30-year loan), that is amount $1K per month. The lender can add this to the senior's current monthly income - social security payment or pension income, for the purpose of recalculating debt-to-income ratio.

In this way, a retiree doesn't have to take money out of the retirement fund, but still qualifies for a low rate loan.

If your loan officer is not familiar with this guideline, ask him or her to call Freddie Mac or Fannie Mae, but don't let the high debt-to-income ratio be an obstacle for you to get a great loan!

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Book Review: The Smartest Investment Book You'll Ever Read

5/28/2013

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I tend to ignore books with titles such as "the smartest" or "you will ever", because I don't believe anything that is "absolute" - everything is relative. But, since several friends highly recommended it to me, I picked it up and read it.

Wow, I really wanted to shake hands with the author - Daniel Solin!

Mr. Solin is an arbitration lawyer and a Registered Investment Advisor, but he is really against the overall financial "advisor" group as he views, correctly, most of them are financial "salesmen or saleswomen" rather than "advisors".

The positives

This books is an easy read for people with little financial knowledge or just starting out in the investing world. It delivers the messages in simple language without tons of charts or numbers. Yet its messages are very powerful -

Be on the side of the smart money, don't be fooled by marketing gimmicks or media sensations.
Be consistent year after year, investing in low cost index ETF funds.
In this way, you will be rewards by the market as you will go with the market, in a very relaxed way.

In this book, Mr. Solin also includes some questionnaires to help the readers to develop the right asset allocation which makes ideas from this book very actionable.

I found it incredible as Mr. Solin's ideas are exactly what I advocate, no more, no less. I am happy I am not alone, as I am on the smart money side.

By the way, this book also shows who are the smart money investors and how large is the smart money, you will find many well known names, including Warren Buffet, you may wonder, isn't Mr. Buffet a great stock picker? How come he becomes an index investment advocate? You need to read the book to find out the answer.

The drawbacks

I want to mention a few things I am not happy with this book:

1. Lack of solid numbers and reference sources. As a number guy, naturally I want to see lots and lots of numbers, but I understand this book is not intended for people like me

2. The questionnaire leaves room to improve. I found its questionnaires too simple and lack of enough theoretical support. That's why at PFwise.com we will introduce a more systematic approach to help people determine the optimal asset allocation.

In summary

All in all, it's a great book to read, and I have to agree, if you read this book, you don't ever need to read any other books, because you will have a very solid financial future if you follow the ideas laid out by this book.

I believe you can borrow this book from most local public library. But it's good to keep it at hand as the only investment book you will ever need, it's worth the $12 investment.

If you click here and buy from Amazon, I might earn a small reference fee from Amazon, but you it won't cost you anything extra. Thank you!

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Why Low Interest Rate Is Hurting Your Chance of Getting a Pension?

5/28/2013

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Based on a recent report from The Pension Benefit Guarantee Corp, the federal agency that insurers private sector pension plans, the number of employers that offer pension has declined from 112,208 in 1995 to only 25,600 in 2011. That number is probably a lot less today in 2013.

One major culprit is the low rate that consumers are enjoying!

Why the low interest rate is hurting employees getting pension?

Here are the reasons:

Pension is reported as a liability on the employer's books, the lower the interest rate, the higher the pension liability and the more contribution the companies are required to set aside more money to meet future obligations, talking about the perfect storm, for employers!

No wonder GM paid Prudential $25 billion to assume its pension risks, and Verizon transferred $7.5 billion pension obligation to Prudential as well.

When employers found they cannot take such increasing expense anymore, the only thing they can do is to stop the pension plan!

When a pension plan is stopped, employers typically offer a match, say 3% to an employee's 401(k) contribution, but such contribution, which lasts through the years of an employee's career with the employer and stops when the employee stops working, has no way to measure up with the potential benefits offered by a pension plan which covers the entire retirement life or an employee.

For example, an employee with a $40K salary who receives 3% company match, and contribute 7% of her own money to the 401(k) plan each year will end up with roughly a third less in retirement fund after 25 years than she would have with the pension plan.

Of course, employees themselves should take some of the blame as well - when searching an employment opportunity, how many people ask if the employer offers pension? Everyone just cares about now - how much salary and vacation time I can get today instead of how much future pension income I can get 30 years later.

The unfortunate human nature!

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Why Star Stock Pickers Don't Exist - The Case That Mad Money's Cramer Made Impossible Thing Possible

5/27/2013

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Mad Money's Cramer has a huge following, but few people actually profited from his advice, in the long term, and consistently. In fact, after reading this blog post, you probably will have an idea to outperform him, easily.

Let's take a look at the case why Mr. Cramer delivered something truly impossible -

On Nov. 20, 2012, Jim Cramer urged everyone to exit two stocks - HPQ and BBY - immediately. Six months later towards the end of May, HPQ was up 115.62% and BBY was up 124.64%.

Maybe the overall market has been on a tear and these two are just the laggards?

Nope. Out of the 749 stocks in the Wilshire US large-cap index, BBY was the 3rd best performer while HPQ came in 4th.

Statistically, the probability of being wrong enough to get two of the four best performers was 1 in 35,062.

But wait, things could get worse.

On Oct 13, 2009, Cramer published a book "Getting Back to Even", in which he recommended buying HPQ (out of 12 highlighted buys), between then and his Nov. 20, 2012 selling recommendation time, HPQ lost 73.83%. By that time, he switched position!

If you are a loyal star stock picker fan, you will be whacked twice!

Yet that's not the worst!

Here is why Cramer delivered something truly impossible -

Below are the top 4 performers out of the 749 large cap stocks in the past six months:

NFLX: 174.49%
GMCR: 161.68%
BBY: 124.64%
HPQ: 115.62%

What were the recommendations from Cramer?

We already knew he recommended selling BBY and HPQ, how about the other two?

On Sept 20, 2012, he recommended getting out of GMCR and on Nov 2, 2012, he recommended getting out of NFLX!

Statistically, the odds of making four sell recommendations on what ends up being the four best performers out of 749 different stocks is 1 in 13.1 billion!

By comparison, the odds of winning the Powerball jackpot are much better at 1 in 175 million!

Instead of gambling in the stock market by following those star stock pickers, maybe you should try playing lottery!

Or playing against whatever those star stock pickers recommend?

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5 Cases Against Hedge Funds and Why You Should Care

5/27/2013

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A hedge fund, by definition, should hedge risks for its investors, right?

Wrong! In fact, hedge funds increase risks for investors, dramatically, here are some facts:

From 1995 to 2010, hedge fund managers earned $379 billion in fees, the investors in those funds earned only $70 billion in investment gains.
About 1/3 of the hedge funds are funded through feeder funds or fund of funds, which means another layer of fees that will further increases the hedge fund managers' fees.

Why such dramatic wealth transfer from investors to fund managers? Thanks to its hefty fees.

Case 1 against hedge funds - hefty fees

Hedge funds charge "2-20" fees: 2% of asset under management, 20% of investment profit
Mutual funds' average annual fee: 1.44%
Index ETF's annual fee is typically under 0.25%.

Such fees create huge wealth, for fund managers only, and are a big drag on performances, which brings us to the Case 2 against hedge funds.

Case 2 against hedge funds - poor performance
The following data are based on the HRFX Global Hedge Fund Index performance:

In 2012:

Hedge funds return: 3.5%
S&P 500's: 6% gain

Over the past fix years

Hedge fund index: negative 13.6%
S&P 500 index: added 8.6%.

So far in 2013

Hedge funds: 5.4%
Mutual funds: 14.8% in average
S&P 500's: 15.4%

Smart investment (investing in a low expense index ETF) clearly beats hedge funds easily!

But why investors still sent billions after billions of hard earned money to hedge funds?

For the very elusive benefits, and some non-financial benefits - a bragging right ("I am a limited partners in so and so hedge fund"), access to the client-only market commentaries (which you know how they fare), and a chance to invest in the next star fund manager's hedge funds, which will bring us the third case against hedge funds.

Case 3 against hedge funds - the unpredictable star performers
People have heard of John Paulson, whose bets against subprime mortgages earned him big fame and billions of dollars. Of course he capitalized that fame and started many more hedge funds, but his performance since then? One fund lost 52%, and another one lost 35%. Ouch!

You certainly wish your money is not in one of those funds, but if you are in, can you get out quickly?

Unfortunately the answer is NO, this brings us the case 4.

Case 4 against hedge funds - poor liquidity
For most hedge funds, there is typically two minimums: a minimum amount to invest (that's why it requires investors to be "accredited") and a minimum length of time to keep the money in the funds (usually minimum 1 year), and there is only a very small window when you can withdraw funds,

If you are truly a billionaire, you probably don't mind losing a few millions, but if you are an ordinary so called "accredited" investor, why do you want to lock money into a hedge fund with unpredictable performance and hefty fees? Especially when it comes to case 5.

Case 5 against hedge fund - secrecy, with little regulation
The fact is, regulation on hedge funds are beefing up, but when compared with the typical mutual fund industry, hedge funds' operation is still a black box for investors, this should be worrisome given most hedge funds have no limitation in terms of what they can do - they can own derivatives, trade currency futures, buy credit-default swaps, invest in structured products, liquid assets, etc., you name it.

In summary, hedge funds are really for hedge fund managers. But if you still want to gamble, and not as an "accredited" investor yet, you are welcome to try your luck at the new casino just opened in town - Goldman Sachs Asses management just announced that it would launch a new mutual fund that will allow mom and pop investors to put their life savings into the gambling table, with access to all the trading strategies employed by hedge funds - a Multi-Manager Alternatives Fund (GMAMX), with minimum $1,000 a bet.

Any takers?

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How To Do Due Diligence On Your Mortgage Lender

5/26/2013

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Nowadays, lenders are doing very illogical things when scrutinize loan applications - whether you are a first time applicant or a veteran. As a consumer, you should do the same due diligence on them! Here are a few tips a consumer loan applicant can and should do.

a. Select a local mortgage loan officer.
With the rates hovering around historical levels, many part-time amateur "lenders" showed up in local newspapers' ads sections, they might have passed the exam, or worse, they are not even licensed, just act as "marketers". Only work with a local loan officer that is experienced in the entire process - underwriting, processing, appraising, and closing your loan with local expertise.

How about online sourced loans? Well, maybe you can get a quote from an internet site, but just ask yourself one question - what if the loan couldn't be funded, what recourse do you have? If you can afford such a gamble, it's Okay to work with a rock bottom online lender.

How to check your local mortgage lender, broker, and loan originator's background?

You can Google your state government's relevant departments with key words such as security, banking, licensing, and regulation, etc. because each state the regulatory departments are called differently.

b. Check your mortgage lender's credentials.
This website is worth bookmarking - The National Mortgage Licensing System & Registry (NMLS), it maintains a FREE site that provides consumers with access to the administrative and license information for state regulated mortgage lenders in all 50 states and the District.

At the site, you can search your proposed mortgage lender's licensing information, how long your loan officer has been in the business and with what businesses, whether the lender has been the subject of any state disciplinary proceedings.

Not all mortgage lenders are regulated at the state level, for commercial banks that have the word "National" or use the initials "N.A." (National Association) in their names, savings banks and savings and loan associations having the word "Federal" in their names or use the initials FSB (Federal Savings Bank), FSA (Federal Savings Association), FA (Federal Association), or FSLA (Federal Savings and Loan Association), they are regulated under the federal law. You can check this website to verify their information - HelpWithMyBank.gov.

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How to Quantitatively Evaluate a Real Estate Investment Opportunity - b. Quasi-Quantitative Model

5/25/2013

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In our last blog post, we discussed how to appropriately use Cap Rate to evaluate real estate investment opportunities.

How do you calculate the actual rate of return you can expect from this opportunity, that is tailed to your specific financing method?

We will use a quasi-quantitative model that many investors can apply easily.

The essence of this model is to figure out the positives and negatives of a real estate opportunity.

Let's start with the following assumptions:

The property's price is $200K, you will purchase it with 20% down and rest with a loan at 5% interest rate. The rent is $1,500 per month, estimated expenses (excluding mortgage expense) combined are $200 per month.

The Positives of Owning This Property

a. Property value appreciation
Let's assume its annual appreciation rate is 2% (which is norm for most of the nation). Please note this 2% is based on the entire property's value.

b. Rental income and potential increase
Assume rental income has no projected increase, also, it's normal to expect average 1 month's vacancy each year, so the annual return from the rental income is $1300*11/$200K = 7.2%. Please note this rate is based on the entire property's value of $200K.

The Negatives of Owning This Property

a. Property Tax
Local government relies property taxes to support its operation, let's assume your property tax rate is 1.2% - please note this is based on property value.

b. Insurance/HOA
We will assume annual insurance and HOA cost is $1,200, it is 0.6% of the property value ($1200/200K).

c. Mortgage Expenses
You are paying 5% interest rate on a $160K loan, this is equivalent to 4% of the property value ($200K).

d. Opportunity Cost
Your down payment of $40K (=20%*$200K) has opportunity cost. If you don't use it for this property, you can very well be investing it in stock market which has average 6% annual rate of return. This is equivalent to 1.2% of the property value (=$40K*6%/200K).

In Summary
Positive rates of returns = 2% + 7.2% = 9.2%

Negative rates of returns = 1.2%+0.6%+4%+1.2% = 7.0%

Note the above comparison is based on apples to apples basis with both using the property value of $200K as the basis. Since the 9.2% is greater than the 7%, it appears to be an investment worth pursuing.

A warning, the above calculations fail to consider any labor costs incurred by you, as the property owner. Before committing yourself as a landlord, ask yourself - is this party time really for me?

This quasi-quantitative model is fairly easy to apply, but it fails to give you the actual rate of return you will get from this investment.

We will develop a truly quantitative model to evaluate your actual rate of return on any investment opportunity, and discuss in our next blog post.

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How to Quantitatively Evaluate a Real Estate Investment Opportunity - a. Cap Rate

5/23/2013

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This is the first of a series blogs discussing how to evaluate a real estate investment opportunity's return.

The Real Estate market is getting hot again in the U.S., however, this time, the market dynamics are distinctly different from that of the last peak. Why? This time, a key demand side factor is investors, yes, many investors are pushing the housing prices higher, in many locations.

However, of the many real estate investors, few know how to properly evaluate and calculate their real estate investment's returns. How about let's start with a simple and common measurement in RE investment - Cap rate.

What is Cap Rate?

In short, Cap Rate = annual net operating income / cost (or value) of the investment

Why Use Cap Rate?

Many real estate investors believe that when evaluating real estate investment opportunities, the first question they should ask is - what are the cash flows of the deals?

Wrong!

Why cash flow is the wrong question to ask? Because two different investors might approach the same opportunity with two different financing methods.

The cap rate, however, measures a RE investment opportunity's potential returns, independent of the buyer's financing method.

How to Calculate Cap Rate?

Let's use an example to illustrate:

Example 1.
You bought a house for $200K cash, rental is $1,500 per month, there are no other expenses. How much is your cap rate?

Your annual operating income = $1500*12 = $18000

Your cost = $200000

Cap rate = 18000/200000 = 9%

Now you think it's easy to calculate cap rate? Let's try example 2.

Example 2.
You bought a house for $200K with 20% down and borrowed the rest 80% at 5% annual interest rate. The rest conditions are the same as in Example 1. What's your cap rate now?

Cap rate will be the same in this case, because neither annual net operating income nor the cost of this investment changes.

What changes is your actual rate of return, thanks to the different financing methods you used.

Cap Rate Complications

The denominator of the Cap Rate formula is cost or value, you might ask what's the difference between the two. When you are contemplating buying the investment property, you use the cost figure. However, having bought the investment property for a few years, when you recalculate the cap rate, you should use the value of the property.

Example 3.
You bought an investment property 10 years ago for $100K. Your net annual operating income was $10K and remains so today, but your property's value has appreciated to $200K, what's your Cap rate now?

Is it still 10% ($10K/$100K) or 5% ($10K/$200K)? The answer is the latter: $10K/$200K=5%, you need to use current value of the property in the denominator.

To understand why use the latest value, rather than the original value in Cap Rate calculation easily, we can take a look at the following example -

Example 4.
Assume now you have a new investment opportunity - its cost is $200K, its net annual operating income is $20K,

If you compare this opportunity with the one you currently have, obviously the new opportunity is better - same value of the property ($200K), but better net annual operating income ($20K > $10K).

However, if you still use the cost to calculate the Cap Rate, you will be misled to the conclusion that your current property is as good as the new one, because both Cap Rates are the same at 10%.

What went wrong?

You need to use Value in the denominator of the Cap Rate calculation!

The current Cap Rate of the property you bought 10 years ago is only 5% ($10K/$200K), less than the new opportunity you are facing (10% = $20K/$200K).

In summary, from the examples discussed above, you can see how cap rate is calculated and how its calculation should change over time.

You can also see that your rate of return and cap rate are two different things.

How to evaluate your expected rate of return of a real estate investment opportunity? We will discuss in our next blog post.

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