Determining the cash cow
So you think you’ve spotted a real winner of a rental cash cow, and are thinking of making an opening offer on it. Did you crunch your numbers properly before making the offer? Here are some basics you’ll need to do to accomplish this, in order to back in to a number for your offer on the investment property. Once you know your cash flow, you’ll also be able to determine your return on investment. And then you’ll be able to compare the prospective purchase with other properties, as well as other assets classes.
Doing your basic research
First, make sure the gross monthly rent is an actual rent, and not an imaginary, hoped-for rent. 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. Obviously, to get a feel for what market rent is in your area, you’ll need to do a little homework.
This would include 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 like the property you’re considering making an offer on. Ads can be located in your local paper(s), 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 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.
Determining your exact costs
Once you have a good fix on market value for comparable rentals, and also know the exact amount of existing rents on the property, you can come up with your pro forma income statement to determine cash flow. You’ll have at the top 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, home owners association fees, and other maintenance items that you are responsible for. This may include, landscaping, snowplowing, or, in some cases, heat or water charges. Make sure the seller of the property’s figures are accurate when you ask for them about all existing expenses. Always double check them.
Add in the vacancy rate
You’ll then want to subtract an amount for vacancies. In a good, solid area where there are many renters, a standard vacancy rate would be 7%. In a diceyer area, where tenants come and go more, you may want to bump up this figure. Either way, you’re going to have at least a one month vacancy when a tenant leaves, and you need to build this number into your calculations to show an accurate picture of cash flow over time on the particular investment property.
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 sinking 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.
To sum up…
So make sure you crunch your numbers properly, obtain accurate market data as to market rents for your area, as well as confirming all seller-given data as to expenses and current rents and leases. In this way you’ll be able to tell quickly and accurately whether the investment property you think will be a real winning cash cow will, in fact, perform this way.
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