These are the real numbers to my first ever rental property (a duplex):
CAP Rate: 36%
Cash on Cash Return: 25.3% per year
These numbers should make you salivate, I was. If not, this is a definite read!
Cash Flow: $600+ per month after considering all expenses (mortgage, tax, insurance, utility share, repairs, vacancies, property management, etc)
It actually produces around $800/month, for a single property.
That’s $800 per month, one property, cash flow after the mortgage and expenses have been covered by the tenants, each month.
That $800 per month is also barely, if at all taxed, with the deductions that are allowed.
Even better? I bought the duplex at 25% less than a conservative estimate of it’s market value. I was up, at minimum, $15k going in.
I put the investor required 25% down, and was able to leverage the rest using bank money.
The bank gets 5% interest on their money on a conventional schedule, I make 25.3%. Per year. Using their money.
Not bad. I obviously still own this property, and have others just like it.
How could I know this property would produce these results?
I knew it was a winner going in.
HOW TO WIN GOING IN
With investment real estate you either run the numbers, get lucky, get screwed or you end up somewhere in between.
There comes a point, and I’m guilty of it myself, when you just know the numbers will work.
Run them anyway.
Your mistake could haunt you for 30 years, or more.
I can’t tell you how many times you’ll be ready to pull the trigger and find that surprisingly, the numbers don’t work when you methodically evaluate a particular property.
For the uninitiated, this will be a good springboard, for the seasoned investor it’ll serve as a refresher and reference.
This article will give you all the basics you need to quickly evaluate a property, and be armed with just about all you can to make the most informed decision possible.
Rental real estate, like any other instrument, is an investment–so you can lose your shirt, but you can also hedge your bet with relatively cheap and easy research. There’s nothing worse than realizing you have a dud when the paperwork has all been signed and you own it.
You can’t out manage a bad deal, and you don’t want to be writing checks, you want to be cashing them.
The numbers will also make you more efficient. You’ll know right away whether to delve further, or take a hike and move on to the next.
If the numbers don’t work, your work here is done my friend. It should be that easy.
So let’s get started.
SET YOUR CRITERIA
What type of construction do you prefer? Brick, siding, stucco, or other? How many bedrooms, bathrooms, etc. What types of property are in demand in your area?
Are you looking for a single or multi-family property? If it’s a multi-family, are the utilities separated? With older properties, especially single families, watch for functional obsolescence, i.e. a 3/1 with no real opportunity to increase the number of bathrooms, etc., it might hinder selling the property later.
SET YOUR AREA
What type of neighborhood are you willing to take on?
Neighborhoods that have higher crime rates and lower socioeconomic status will tend to be more difficult from a management standpoint, but will typically boast higher numbers.
Think about what you’re willing to deal with for the likely duration you intend to hold the property.
A bad area may also hinder your ability to find a good property manager in the future when you want to increase the passive nature of your investment.
What areas do you pass on your commute? What areas are close to your own home?
Where do these areas connect/intersect/overlap? Draw boundaries on a map , with distances you are willing to drive, a 10-20 mile radius is typically sufficient. . Use the scale on the map for a rough estimate for your radius. Keep this map, you can use it again later.
What neighborhoods fit the homes you described in your criteria? Are those areas affordable? More importantly, using the average cost of homes in that area, do the numbers work?
KNOW THE COMPS (Sales/Rental Rates)
Know what people are paying, the fair market rent rate (check your local housing authority website) how long similar properties are staying on the market, and finally what the rental rates and vacancies are like for your targeted area.
BUY ON DISCOUNT
If you’re not embarrassed by your offer, you’re offering too much, period. If it gets shot down, or the counter-offer is beyond your established limit, it wasn’t in the cards.
Appreciation and equity are extras, do not factor them in until the property is successfully sold, closed, and funded.
Both appreciation and equity are as about as close as one can get to speculation. Speculation is a 50/50 chance of going broke, at best.
DO A DOWN AND DIRTY QUICK ESTIMATE, CALCULATE THE GRM (Gross Rent Multiplier)
GRM = GROSS MONTHLY RENT DIVIDED BY PURCHASE PRICE
IF YOUR GRM IS:
1 MINIMUM IF YOU EXPECT ANY CASH FLOW
2 CONSIDERED GOOD, THE STANDARD
2+ LIKELY GOOD. ALSO LIKELY IN A WAR ZONE.
What the GRM does is roughly predict cash flow. Cash flow is king—it’s the safest bet. How do you predict the actual cash flow?
Glad you asked.
PREDICTING A PROPERTIES CASH FLOW
Predicting CASH FLOW comes down income and expenses. It’s that simple. People tend to overcomplicate the “math” and never get in the game because they over analyze their decision.
Here’s the breakdown for the two numbers you will need to predict cash flow. We will start by determining our GROSS INCOME.
This is the total income, namely, rent and any side income (coin laundry on site, etc) . You’re one step ahead in determining the market rent if the property is currently leased, or was, in the recent past.
If that’s not an option, picking the brain of a realtor or property manager, checking local rental ads, AND looking up the municipalities fair market rent Rate (online with local housing authority)—and finding the mean between the three should help you arrive at a reasonable figure.
The second number you will need will be the total MONTHLY EXPENSES. These are critical, it cannot be stressed enough, so I’ll list them:
- Property taxes – Listed on the MLS, appraisal district website, or if worse comes to worse, anestimate will be available on online real estate sites such as RedFin, or Zillow. ESTIMATE: divide by 12 to get your monthly tax expense.
- Debt Service – If you took out a loan, this is your P.I./month (Principal and Interest)
- Insurance – shop around for quotes, vacant properties will cost you more. Ask for a landlord or similar policy so you are covered appropriately.ESTIMATE: divide by 12 to get your monthly insurance expense.
- Property Management Fee – ALWAYS add this in. Even if you are going to manage your own, some day you won’t want to, or the next owner won’t. The numbers have to work for them too. ESTIMATE: 10% of monthly rent.
- HOA – This can be anything, or nothing. THIS CAN BE A CASHFLOW KILLER, BE MINDFUL OF HOA FEES!!! The same goes for condos and townhomes with ASSESSMENTS.
- Vacancy – figure in 10%, your actual vacancies may be less, but this will give you a good cushion. Don’t try to fudge your own numbers, you’re only hurting yourself.
- Repairs – if the property is turnkey, newer or recently renovated, you can go as low as 5% of monthly rent. If it’s older, or not in tip-top condition, you could be looking as high as 25%. A conservative approach will typically serve you best. Assume the worst. Capital expenses can and will happen–ask me how I know.
CASH FLOW = MONTHLY RENT – MONTHLY EXPENSES (which also gives you your NET INCOME)
One easy math problem, two useful answers! You hope this number is positive. If it isn’t, run. Fast. Don’t start re-calculating, don’t start trying to make it work. At some point you will try this. I have. Don’t. Run as fast and as far as your little chicken legs can carry you.
CALCULATING THE RETURNS
These are the numbers that should start plucking at your little investment heartstrings. Namely, they are the CAP RATE and the CASH ON CASH return. The best part? You already have all the numbers to figure these bad boys out.
You will want to calculate both numbers, as one (the Cap Rate) tells you whether or not the property is a good deal or not, and the other (cash on cash return) tells you what kind of return you are getting on your money.
Comparing the Cash on Cash numbers (percentage) between an all-cash purchase versus a financed one will quickly demonstrate the power of LEVERAGING with financing. You get more bang for your buck!
THE CAP RATE
This gives you an idea if the property you are buying is a good deal or not. It compares what amounts to the return on investment to the purchase price.
Typically, the mortgage (P/I) payment is not included. You will need the MONTHLY NET INCOME number you calculated above, and convert it to ANNUAL NET INCOME, BY MULTIPLYING YOUR MONTHLY NET BY 12.
CAP RATE = NET ANNUAL INCOME (without mortgage expense) DIVIDED BY THE PURCHASE PRICE
THIS WILL GIVE YOU A PERCENTAGE (ANSWER X 100). If the number is less than 9-10%, it’s a bust typically. If it’s greater than 10%, you can expect to do reasonably well. Lower numbers are reserved for properties in desirable areas, higher, less desirable–or you found another unicorn–or a property with foundation issues.
CASH ON CASH RETURN
This number lets you know what you are getting in return for the money invested. If you paid cash, the cap rate and cash on cash numbers are the same.
This considers financing andleverage. So with this calculation, INCLUDE your mortgage payment that you subtracted when determining the cap rate.
CASH ON CASH RETURN = NET ANNUAL INCOME (with mortgage payment) DIVIDED BY THE TOTAL CASH INVESTED.
The numbers are just that, numbers. They have to be taken in context as far as where they are applied.
A property in a war zone will undoubtedly produce much better numbers than one in a more desirable location . You have to balance it with your tolerance and strategic goals.
You should always strive to have some cash on hand for emergencies.
Some suggest as much as $10K per property, while others rely on spongy debt with credit, or a combination of the two. Again, it’s all about what you’re willing to tolerate.
These fundamentals should arm you with a solid foundation to evaluate the financials of a property to allow you to win going in. It may seem arduous, tedious, and death from a thousand wounds boring.
I can guarantee, however, that it’s much better than owning a property with negative cash flow, or negative equity and writing a check each week, and stressing about repairs.
Take your time, do the math, apply the fundamentals and enjoy your investment.
Good luck, and happy hunting!