The real estate market is pretty hot right now, but deals can still be found. How can you tell? There is no one size fits all answer. Nor is there a set formula because everyone and every piece of real estate differs. The best way to determine a deal is to work backwards from the rent.
Investment properties are investment properties because they generate some type of income. For our discussion here, I want to focus on rental income for the buy and hold investor. I will also assume that you plan to manage the property yourself, so no management fees are included here either. If you plan to use property management simply add those costs on, but be aware they can vary greatly.
Let’s begin to put pencil to paper (or clicks on a keyboard) and work backwards from the rent to determine if a property is a good deal. Let’s see if the asking price is anywhere close to what you can offer.
How Much Rent
The first number you need to write down is the estimated rent the property will generate. Write it down as a yearly and monthly number. This number will be gross rent.
Rental rates are determined by a lot of different factors. Location, location, location are the first three. After that, items such as size, condition, number of beds and baths and other amenities come into play.
You may know your market very well and be able to guesstimate rent quickly. If not, start looking online. Use general websites like zillow and rent-o-meter to get a general idea. Then look for local property management websites. You want to try and find nearby properties that are or have been recently for rent to compare prices. Your goal is to find pictures of comparable properties so you can examine their condition. Condition can sway rent ranges significantly.
How Much Cash Flow
The next step is to determine how much positive cashflow per month you want. Even though this is the last number you will see in the process of determining if a property is a deal or not, you need to figure out what you want it to be ahead of time.
You can think of cashflow in terms of rate of return or cap rate. But I just like to use a dollar figure, say $100 to $150 per unit per month. I find such a number easy to use and work with. It translates easily. For example, if I want to replace $2,500 of monthly W-2 income, I can quickly determine how many units at $150 per month will I need to acquire to replace it. It is easy to calculate and easy to see your goals.
How much cash flow you want and are able to get is going to depend on many things. It will depend on your goals, it will depend on your market and it will depend on how you choose to finance your acquisitions. For now, just remember that this number can be a bit fluid.
The Hard Numbers
The next step in your analysis is to write down the hard numbers. These numbers are easily determined. I prefer to break these numbers down into monthly amounts. They are:
- 10% of gross rents for maintenance.
- 10% of gross rents for vacancies.
- 10% of gross rents for reserves.
- Monthly property taxes (be aware this number might increase after a sale).
- Monthly property insurance.
The Not So Hard Numbers
There are a two numbers that still need to be factored into your analysis. These are more adjustable depending on your personal preferences and how you run your business.
The first number is the cost of repairs. Often we investors buy properties that are distressed and in need of repairs. They may need new roof or HVAC equipment along with new paint and kitchen counters. How much to do is up to you and what your market will bear. Keep in mind of course that if you want to get top dollar in rent the property usually needs to be in tip top condition.
The second number is the cost of using other people’s money (OPM). One of the great things about real estate is that we investors often use other OPM. You can use your own money of course, but it often makes sense to use someone else’s.
Most times using OPM results in a principal and interest number and is based upon the rate of interest charged for a loan. The loan amount can vary based on what you intend to offer to purchase the property and the amount of repairs you want to finance. This number can vary based on the interest rate and the amount financed. And don’t forget to include points, holding and closing costs.
Obviously this number can vary greatly depending on loan terms and the deal structure. There are many ways to structure a deal and use OPM. However you do it, just be sure to include these costs in your calculations.
The Sum Up
Once these numbers are arrived at, it is just a matter of some simple math. The key is to arrive at your preferred cash flow by working backwards from the rent after subtracting all of the above. If you find that you hit your cash flow target, look again and make sure your numbers are right. Then make an offer. Next time I’ll go through an example. I will also write in the future about how a deal that looks good on paper may not actually be so good. Stay tuned.
