Using simple math to locate the best properties
You think you found an excellent potential rental property to acquire. Now it’s time to crunch your numbers to determine how much you should offer for it. If your return on investment (ROI) looks good on paper, then by all means move ahead and place an offer. (You can also use a basic investment property ROI calculator. The one I supply on this site is quite excellent.) You’ll find with experience, you’ll be making many offers every week in order to arrive at one good deal. By determining your property ROI on each potential investment property acquisition, you’ll find that you’ll be able to compare it with other properties, as well as other assets too.
What’s the ROI of my investment property?
First, start with the rent roll…Let’s examine the income side of the equation, namely, the rent roll. If the rental property you’re considering making an offer on is already fully rented out, then you obviously won’t have to impute a projected amount for any existing vacancy. However, make sure you’ve confirmed the actual rent roll by asking to see copies of the seller’s leases with his tenants. In addition, check to see that they are indeed current market rents. You don’t want to have a seller’s friends or family receiving some lesser rent as a break for their relationship with him. Be sure the gross monthly rent is an actual rent, and not a made-up one, designed to help the seller increase the price for his property. If you feel an actual rent is way under market value, then you can adjust your numbers accordingly, as long as there are no long term leases associated with the property that are currently in place.
Part of your due diligence is to check on what constitutes market rent for each of the units in the building. For example, try checking out ads for other, similar units currently being offered for rent in your area, as well as visiting some of them to make sure they are similar to the property you’re considering making an offer on. Ads can be located in your local papers, Craigslist, or other online classifieds for your area. Also check with local real estate agencies to see what they have listed for current rentals.
Sites like Trulia, Zillow or Realtor.com can also provide you with this invaluable information. You can also obtain prices of actual rentals – what the units actually rented out for, through the same sites and/or your local realty agency. Most multifamily or apartment unit rentals tend to rent for the same amount, or slightly less than their advertised rents. However, in the case of single family home rentals, be sure to check for their actual rental price, since they may have a much larger disparity between advertised and actual rents. Also, if you feel you can make some modest renovations and repairs to bring the units in the building more in line with current market rents, then figure on the higher rent roll as well.
The expense side
When you’ve got your rent roll numbers down, you can next concentrate on the expense side of your pro forma income statement. From the top, you’ll state your total estimated gross monthly income. On the other side of the ledger, you start subtracting all your monthly costs. These include your fixed costs like property insurance, taxes, any property management fee, homeowners association fees, and other maintenance items that you are responsible for. This may include landscaping, snowplowing, or, in some cases, heat or water charges. As with the rent roll, be sure to ascertain the exact expense figures. Double check the seller’s numbers by asking for proof of all his prior expenses. Then, pore over them again as a means of double-checking his numbers.
Don’t forget your vacancy rate
It is critical to never forget to include a rate for vacancies in your particular area. When a tenant’s lease ends, and you begin looking for another replacement tenant, you’re going to have a vacancy. Maybe it’ll only be a couple weeks…Most usually it will be at least a month. In a good area where there are many tenants available (as in an urban area), a standard vacancy rate would be 7%. In a more rural area, where tenants are harder to come by, you may want to bump up this figure. Either way, you’re going to have some vacancy when a tenant leaves, and you need to build this number into your calculations to show an accurate picture of cash flow over the life time of your ownership of the particular investment property you’re analyzing.
Mortgage costs to be added in…
You’ll also need to add in your total monthly mortgage amount, assuming you’re not paying all cash for the rental property. Consider the fact that property investors are charged higher interest rates than homeowners…usually about one to one and a half percent higher on average. Also, expect to make a higher down payment than a conventional home loan. Thus, instead of twenty percent down for a conventional home loan, non-owner occupied rental property can start at twenty-five to thirty percent down in most cases. (With poor credit, it can go up to forty or fifty percent down, depending upon the lending institution and their lending standards.) You’ll then need to subtract your mortgage payment based on what you intend to offer on the property to determine your net cash flow per month. Naturally, if you’re paying all cash, there would be no mortgage payment figure to subtract. The greater the positive cash flow it shows on paper, the more attractive the property will be to make a bid on.
Figuring your return on investment
Now, to determine your return on investment (ROI), you’ll need to divide the annual positive cash flow amount by the expected total amount you’ll be putting into the property when you buy it. This will include your down payment (or, the total amount if you’re paying all cash) plus all closing costs on the purchase. This ROI is also sometimes referred to as your “cash on cash” return on the investment property. It will enable you to compare buying this particular asset with other types – whether they be another property you’re interested in, or other investment choices like REITs, stocks, bonds, etc. Of course, this simple analysis does not take into account the other benefits of property ownership, like market appreciation, tax benefits that include the ability to depreciate your asset, and the overall barrier against inflation that property usually confers on investors.
An example of a cash return ROI
As an example of the cash on cash return method, consider you want to acquire an investment piece of real estate for $500,000. Assume the property will throw off a conservative positive cash flow of $15,000 annually. If you put 30% down on the property, and therefore invested $150,000 of your own money, the return on investment would be 10% ($15,000/150,000). ROI’s above eight percent would make for excellent investment property returns these days…
Unless you’re specifically trying to offset other income by buying negative cash flow property (where the aim is to use investment property as a tax shelter), you shouldn’t be considering wasting your time on investment properties with cash on cash returns below five percent. There’s simply too many things that can go wrong for you to accept a smaller ROI investment property. Always remember to analyze your numbers conservatively, and definitely stay above this five percent ROI level. This simple method will then hold you in good stead as you move forward in making new property acquisitions.
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