Analyzing Rental Property: The Ingredients of a Good Buy
Twenty-five years ago, Sam, a friend of mine came to live in this county. He had no credit and no money. He found a job that just paid his bills but he was grateful to be here.
Sam bought a run-down duplex with an FHA loan, rented one of the units, and lived in the other. The property was in an area of Washington, D.C. with a high crime at the time. Now it’s considered a trendy neighborhood. Sam saved from not having to pay rent and the extra cash went into buying another unit.
Today, my friend owns properties valued at over 10 million, and a large portion of his portfolio is paid off.
When Sam started he didn’t understand cap rates nor did he understand gross rent multiplier. All he knew is that he wanted to buy a property at a large discount and have a positive cash flow.
Real Estate investors have been using this commonsense approach for years.
I call this: The Cheesecake Method of Analyzing a Rental Property.
Think of the rental property as a cheesecake, the cash flow is the base and the topping is the appreciation.
A cheesecake base tastes delicious even without the topping. But the topping is what makes it extra special.
You can’t build a cheesecake without the base and you can’t have a good rental without positive cash flow.
Why buying for appreciation only doesn’t work?
Counting on appreciation only requires that you have to time the market. Very few of us if any, are good at this.
So, build your base first: buy at discount and look for positive cash flow.
Let the appreciation be the extra touch.
How to find out if the rental property will be cash flow positive?
First, before calculating your cash flow gather your ingredients.
You will need:
- Rent Price plus Any Additional Income from the property
- Vacancy Loss %
- Repairs and Maintenance and Capital Expenditure
- Utilities (if paid by you)
- HOA Fees
- Mortgage Payment (principal and interest)
- Property Manager
In cooking, the quality of the ingredients determines the yumminess of the dish.
The same applies to calculating your cash flow. If your data is garbage, the result will be garbage too.
You should know some of the ingredients: like the PITI ( your principal, interest, taxes, and insurance) You can get that from your lender and your local tax appraiser website.
Most investors are not certain where to find the vacancy loss percentage, maintenance, CAPEX, and how to find out what they can rent their property for.
Let’s start with the rental price. Estimating rental price is no different than determining the sales price of a property. If you don’t have access to MLS, go to Zillow and pull properties that are for rent, choose properties that are comparable (remember apples to apples).
Tenants generally don’t negotiate on rental prices so in most cases, active listings will do.
Next, call a property manager and ask them what they think the property will rent for, explain that you are thinking about a potential purchase. While you are at it, ask about the current vacancy rate and what would be the maintenance for a property in this condition. Good property managers have this data available.
For example in our area, the vacancy currently is 3%.
Maintenance as a rule of thumb is 1% of property value per year or $1 per sq. ft.
For example, a 2000 sq. ft property will have $2000 maintenance and CAPEX expenses.
What about a property management fee? If you hire a property manager the cost for a good one is around 10% of the monthly rent. A bad one costs the same so shop around.
Don’t forget to include the Home Owner’s Association or Condo fees. Those fees are usually in the listing.
So now that you have all the ingredients and you know where to get good ones, just use this formula to get your cash flow.
Rental Income – Expenses Very= Cash Flow
Once we have the base: Positive Cash Flow, let’s see if we can add something extra to make this deal special.
Let’s look at the potential appreciation.
Having a positive cash flow and great potential appreciation is tough but worth pursuing.
Find an area where you can have both: cash flow and appreciation. Many times those areas are on the fringes of areas that are currently growing fast. As some investors would say: Buy before Starbucks opens a store.
There are many other ways and formulas to evaluate a rental property but I wanted to keep it simple and actionable.
Here a link to our free rental calculator. You can also calculate NOI (net operating income, cash-on-cash return, and cap rate.)
If you have any questions join me every Sat at 1 pm EST for a Q&A on our channel Passive Income through Rentals.
Here is our Q&A video on this topic.
Questions from the Q&A Video:
Is there a way to increase the cash flow after I buy the property? I found something I like but the cash flow is negative.
You can increase the cash flow either through increasing the rent income, maybe charging additional fees like move-in fees, pet fees, late fees. Or upgrading the property so that you get more rent.
The other way is by decreasing the expenses and there are many ways to do that. Vacancy loss is the biggest expense, reducing that number will reduce your expense.
How much cash flow is good?
Aim for a minimum $200 per unit. If the rental rate decrease or if there is a tax increase, you will have some cushion.
If I can’t find a property to cash flow why not buy for appreciation. In my area, there was a 6% increase over last year.
Relying entirely on appreciation for your investment to be profitable requires you to be able to time the market. In 2008 we saw many investors who lost everything because they were overleveraged and relied on appreciation in order to make money.
Find an area where you can have both: cash flow and appreciation.
What is Cash on Cash Return? Why use it?
Cash-on-cash is calculated by dividing your annual before-tax cash flow by the cash invested. This measures your return on cash invested.
You can increase this return by either increasing the cash flow or decreasing the cash invested. That’s why leverage is great for real estate.
Increasing your leverage increases your cash-on-cash return.
Let’s say you bought a $100,000 with 20% down, and your cash flow is $6000 per year. Divide the cash flow by downpayment (20,000), your cash-on-cash return is 30% which is way above what many investors consider a good CAC return. 8-10%
If you bought the same property with 5%, down, your CAC is 120% . This is the power of leverage.
Is there any time I can buy for appreciation?
I really wouldn’t recommend buying purely for appreciation. The only exception is when buying multifamily and you do forced appreciation through the increase of rent. Any type of forced appreciation, buying a discounted property and flipping it.
What are the important numbers to look for when analyzing rental property?
The most important number for SFHs and duplexes is cash flow and CAC.
I think about this like building a cake, the cash flow is your base and everything else like appreciation is the topping. You can’t build a cake without a base.