That's why it's generally accepted here that we evaluate properties based off 50% operating expenses. You build in that extra buffer. You may not need it now, but in the future something may come up.
I would just like to point out that throughout the United States, operating expenses run 45% to 50% of the gross. There is no buffer in using 50%. In any given year, for any given property, operating expenses could easily be significantly higher than the 50% number.
Mike
If I recall correctly, Property Manager’s book as a list of A LOT of the operating expenses. I’d suggest purchasing that book. It’ll really help you out
Yeah, I’ve seen lots of people recommend Mike’s book on this forum. I plan to pick it up once I finish of this other book I’m reading now.
Is the book ‘1 Minute to Rental Property Riches’?
Scott
Nah it’s actually called, “The Wall Street Journal Complete Real-Estate Investing Guide Book” by David Crook. It actually reads pretty good, and I felt like I was getting good advice until the mention of 25%-45% operating expenses. Most people here don’t agree with that, and I can see why. Otherwise though it’s not bad.
It actually reads pretty good, and I felt like I was getting good advice until the mention of 25%-45% operating expenses. Most people here don't agree with that, and I can see why. Otherwise though it's not bad.
Unfortunately, expenses and cash flow are just about the most important issue with rentals! Get it wrong and you lose your butt!
Mike
Yes, Mike’s (propertymanager) book is 1 Minute to Rental Property Riches. Click on the link in his signature to order the book.
You have to consider the date of the material you are reading. Pick up Robert Allen’s No Money Down book, written in the early 1980s, and you will not be able to implement his favorite subject to technique – the non-qualifying loan assumption – today because lenders stopped originating non-qualifying assumable loans in 1988 and 1989.
David Crook wrote his book in 2006. Two years ago we did not have the same real estate market we have today and the same rental market we have today. Two years ago, the lower overhead percentages could have been achieved in many rental markets because rents were strong and property taxes and hazard insurance premiums were lower as a percentage of gross rent.
Today, property taxes and hazard insurance premiums are higher. Gross rents are down because vacancy periods are longer and landlords, competing with a glut of rentals on the market, are decreasing their rents to fill their vacancies.
In strong real estate markets with strong rental markets, you might achieve a 30% of gross rent overhead cost. In a softer real estate market which is usually accompanied by a softer rental market, your overhead costs as a percentage of gross rents will be higher.
I posted somewhere in these forums that increasing property taxes and hazard insurance premiums coupled with decreasing rents and longer vacancies have pushed my overhead costs to 54% this year (from 45% last year).
There will be good years when your maintenance and repair costs will be low, your vacancies short, and your rents high. There will be lean years when just the opposite will be true. On the average, over time, you should find that your overhead approaches 50% of your collected rents.
silly question: do you use this $100 cash flow per unit metric just for apartment units, for SFRs also? thanks
Another silly question: Do you usually count management expenses and repairs by contractors as being included in your 50% of GOI operational expenses?
Yes, I use $100 per unit per month for both apartments and SFHs. Yes, management and maintenance (not the initial rehab) is included in the 50% expense number. However, that assumes that you use a competent manager and maintenance company that are not ripping you off (easier said than done).
Good Luck,
Mike
And assuming I do my own managing and do most of my own repairs and save a lot of $$ by doing that (besides appliances) I would be able to knock off between 10% and 15% off of the assumed 50% operating expenses? Then they would be 40% or lower.
And assuming I do my own managing and do most of my own repairs and save a lot of $$ by doing that (besides appliances) I would be able to knock off between 10% and 15% off of the assumed 50% operating expenses? Then they would be 40% or lower.
Do you work for free? I DON’T!
Mike
Yes, when I work for myself. And actually it’s very little work.
Please remember that this 50% rule is an estimating “rule of thumb”. If you are planning to use professional property management and know the management fee and all the associated fees that would pass through to you, then use the actual numbers in your cash flow analysis.
Your OWNERSHIP costs and your rental OPERATING costs are lumped together under your “operating expenses”. You won’t know the percentage of gross rents to allocate to your operating expenses (overhead) until you do a detailed cash flow analysis.
While you are just screening properties to consider adding to your rental portfolio, you won’t go too far off track if you estimate your overhead cost at 50%. This leaves 50% of your gross rent to cover your debt service. If you have enough left over to meet your cash flow criteria, then you might consider doing a detailed cash flow analysis to nail down the numbers.
What Mike was getting at is by doing the work yourself, you may not be “paying” anyone else to do the work, you are using up your time. By using up your time you can’t be looking for deals and thus aren’t making any more money. So it is not free labor.
Free labor would be if you could get someone else to manage your property and not have to pay them. 
Capitalization rate (or “cap rate”) measures the ratio between a properties net cash flow and its purchase price. The Cap can also be re-measured at the properties current market value, as in the case of refinancing.
The rate is calculated in a simple fashion as follows:
Annual Cash Flow / Purchase Price = Cap Rate
For Single Family Houses, the better way to quickly determine if is a good deal or not is to use
the GRM or Gross Rent Multiplier.
You calculate the GRM by Dividing the Purchase Price by Annual Gross Rents.
Your desired GRM number will vary by market, type of financing available to you, insurance costs, etc.
Once you have established YOUR desired GRM, you are able to do very quick calculations in your head as to whether or not you should investigate a property further.
Here’s an example:
Call comes in about a duplex.
Rents are $600 a side and the person is asking $140,000
First, you multiply rents by number of units: $600 x 2 (duplex)
Second, you times that number by 12 to account for the year. 1,200 x 12 = $14,400
Third, you divide that number into the sales price: 140,000 / 14,400 = 9.72
In this example 9.72 is the GRM
My general “Let’s take a look” GRM is between 4.75 and 6. The number I run in my head is 5
In this example I would quickly the $14,400 to $15k and multiply that by 5 in my head…$75k
If that same caller had phoned in with an asking price of $82,000…I’d have a contract out to him within an hour and someone over to inspect it within a day or two.
Hope this helps,
Matt Gerchow
I think Matt has too many irons in the fire. I am guessing that stress and lack of sleep scrambled his brain just when we wrote this.
He really meant to say
[b][i]To figure out cap-rate, divide net operating income by market value. When you are buying, market value is your purchase price. When you are selling, market value is your expected sale price. The formula for cap rate expressed as a percentage is:
Net Operating Income / Market Value x 100% = Cap Rate[/i][/b]
As a practical matter, cap rate calculations are not meaningful for a single family dwelling. The market value will be set by comparable sales and your net operating income will be largely determined by market rents.
To compare single family dwelling investments with each other, the first year cash on cash return is probably more meaningful than cap rate. For example, let’s say that you are considering purchasing one of two properties for your rental portfolio.
The first property will cost $50K, will require $15K in rehab, and the market rent is $900 per month. The second property will cost $75K, is rent ready, and will rent for $1040 per month. No matter which property you decide to purchase, your lender will give you 6% financing on a 30-year fixed-rate loan with 20% down.
Using the 50% rule, property 1 has an NOI of $450 per month and will generate $210 monthly cash flow after $240 monthly debt service. The cap rate is 10.8% ($45012/$50000100%). Property 2 has a $520 NOI and $160 monthly cash flow after $360 monthly debt service and an 8.3% cap rate ($52012/$75000100%).
Which property is the better use of your money?
Your out of pocket investment in property 1 is $15K for rehab and $10K downpayment for a total of $25K. Your $240 monthly cash flow is $2880 in the first year. Dividing the cash flow by your out of pocket investment, your cash on cash return is 11.52%. Property 2 required no rehab, so your initial investment is limited to the $15K downpayment. At $160 per month, your annual cash flow is just $1920. Dividing the annual cash flow by your initial investment, the cash on cash return is 12.8%.
The way I see it, the higher cash on cash return suggests that property 2 is the better use of your investment capital even though it has a lower monthly cash flow and a lower cap rate.
Dave - Great analysis. Thank you. Would it be fair to say that property 2 would be a better investment during the first few years, but in the long term property 1 would turn out to be a better investment because of the higher cap rate? I believe at some time the benefits of higher cash on cash return of property 2 would be outpaced by the higher cap rate of property 1. Am I thinking about this right?
Thank you.
Well, let’s think about it.
Cap rate is really used to determine the value of a property you want to purchase or sell when there are no comparable sales to establish value. If you are the buyer, you want the purchase price to be as low as you can negotiate. If you are the seller, you want the sale price to be as high as you can negotiate. The cap rate corollary to this is: A buyer wants to purchase at a high cap rate, a seller wants to sell at a low cap rate.
Remember, a few of us have already said that cap rate is not really relevant for a single family dwelling unit.
That said –
Once you own the property, a higher cap rate means you either significantly raised the rents, or your property declined in value, or maybe both.
If raising the rent improves your cap rate, it also improves your cash on cash return. If I am getting the same dollar increase in my rent, I would rather be getting it from the property with the higher cash on cash return. If the property gets cheaper, your cash on cash return is not affected as long as you can maintain the current rent.