Other traditional asset investing

1. Other traditional asset investing

Now you will learn about investing in real estate. Real estate investing is expensive and it's not as simple as location, location, location. In fact there are data-driven ways to invest.

2. Investing in a vacation condo

In this example, you're investing in real estate to rent it out for vacationers. When buying a vacation rental property, you can ask for rental history from the seller. Using Airbnb, nights are booked similar to a hotel thus historical information is similar to this table.

3. Money coming in

Prices fluctuate day to day and by month. The average price charged per night is shown in the column Avg Per Night. The incoming money is your reward for being a landlord.

4. Total money coming in

Let's calculate the monthly gross income in a new column. Income is occupied nights multiplied by Avg Per Night. So here 6 times 53 equals 318 and so on.

5. Money going out

Next, we'll calculate the monthly expenses. Firstly, there are fixed costs, like condo association fees. Additionally, there are variable costs, these fluctuate based on occupancy. The more nights your condo is rented the more electricity, water and supplies, like paper towels get used. As the landlord you need to account for both expense types. Sometimes this is provided by the seller but often you need to estimate variable expenses yourself.

6. How should variable costs behave?

Obviously, variable costs change. For example, if you have one renter staying 6 nights, you need to hire a professional cleaning service once for $110. If you have two renters per month you get the service twice but can negotiate a discount, $95 each time. The variable cost went down from $110 to $95 as the occupied nights increased to 12. However, the overall cost went up from $110 to $190. Usually variable costs go down with quantity but they can increase. For example, with higher usage, a fridge may break requiring a costly repair.

7. Calculating the operating expense ratio (OER)

Now, we can get to investment ratios. Let's calculate the Operating Expense Ratio (OER). The OER measures the cost to operate a rental property, compared to rental income. Setting aside depreciation, OER is calculated by dividing the total costs by the gross income. In February, the income minus costs was negative -$100. The property lost money. As a result, the OER is greater than 1. The most profitable month was March at $782. Now OER is lower at 0.675. Thus lower OER means your property is a better investment. Below 1 you make money and above 1 you lose.

8. Summarizing OER

You can summarize OER using a weighted mean to compare properties. Using a non-weighted OER average is misleading because not all months have the same number of occupied nights. Especially in seasonal vacation rentals the income differs by season so the month to month OER does too. Here, the non-weighted average counts January the same as March even though income is dramatically different. Thus, use a weighted mean. Each months' weight is the number of nights divided by the total nights in the data. Then, simply multiply each OER by its weight and sum the results to get 0.859.

9. Another investing ratio: cap rate

In contrast to OER, that focuses on expenses, capitalization rates help you compare properties based on their income without considering financing. A cap rate divides the net operating income by the property’s total cost. Let's look at a toy example. Keep in mind you need to more accurately estimate expenses in a real scenario. Let's assume net sums to $20,000. If the condo price is $100,000 the cap rate is 0.20. The fluctuating income represents variability in investment reward. Using a cap rate helps summarize your investment reward.

10. Comparing properties

Here are multiple OER and Cap Rate values for five properties. From an investment standpoint, no matter the location or quality,

11. Comparing properties

throw out Property 2 and Property 4 because the OER>1, which represents the property expenses. Next, shift focus to the property income by examining cap rate. You want to maximize the income for the money invested, and the maximum cap_rate here is 0.33. Unlike OER, the higher Cap Rate is better.

12. Comparing properties

Thus, holding everything equal it looks like property 3 is the best investment choice.

13. Let's practice!

Keep in mind, there are many investment property ratios, be sure to learn more than these two. Still, even these examples will help you make a data-driven investment property decision!

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