Real Estate Investing: Buying a Rental Property using "float and desire method"
If you are interested in buying a rental property, you first need to determine the property’s value. This will help you in making sure that the price you are about to pay for it is justified. Each guru of the real estate has their own way to determining the price of any given property. One of these price determining methods is “cash on cash” valuation, which is a widely used method. They set their “target” for cash on cash rate to achieve, which they want out of their investments. If the property they are going to buy will give them money equal to or above this target (when sold), they immediately latch onto that deal. Many believe this system to be terrific and one can make the cash on cash rate work backward to figure the ideal price.
Let us now talk about “The float and desire method” which helps us evaluate the value of a property at any given time.
The float and desire method
This method is fairly known among appraisers and bankers who call it the “band of investment theory” and the “debt capacity method, respectively.” This theory was named by Tom Lundstedt. The method is uses a combination of income, expense and financing to arrive at the investment value of a property.
Four-steps in “float and desire” implementation:
The formula for this method involves four steps. These steps are futher linked up with five ingredients which are a must add:
- Net operating income (NOI)
- Finance availability
- Target return set
- Loan to value ratio (LTV)
- Loan factor
Now, we will take a look at the four steps required to complete this analysis
Step 1: Lender’s demand
To simplify the concept of lender’s demand. We need to look at the loan process. The higher the value is the higher the loan will be. Lender’s demand can be calculated by using Loan to value ratio LTV (ingredient 4) and Loan Factor (ingredient 5). It can be calculated by using the following formula:
- lender’s demand= LTV (loan to value)*(loan factor)
Step 2: Buyer’s demands
What matters most to the buyer (other than safe transactions) is down payment and his required cash on cash return. The buyer will only make his decision of buying the property if his target set on cash on cash is met. The formula for buyer’s demand is as follows:
- Buyer’s demand= (down payment)*(cash on cash return)
Step 3: Add them together
As we know that a healthy transaction must satisfy both the lender and the buyer. So we must add these together. The total will represent the capital rate the property needs to generate in order to satisfy both parties.
- Cap rate= Lender’s demand+ buyer’s demand
Step 4: Net operating income
The final but crucial step in the recipe includes the last ingredient, the net operating income. The total income involved in the deal needs to be met. Divide the net operating income by the answer from step #3 to arrive at the optimal price for buying a rental property.
- Optimal buying price= (NOI/Cap rate)
Checking your work
How to know for sure that you have arrived at the right rate? Double check it. By checking and implementing this method you can nail every transaction you do in the real estate market. You can make a worksheet of this method and apply it to the previous transaction or deals you made to check its credibility
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.