First Deal Analysis - Please help

General Real Estate Investing
1

Hi,

I’ve been interested in real estate investing for some time and have been doing research on my local market. I came across a property that looks like it might be a good first buy. My goal is to buy property and hold it for passive income.

Property details:
Type: Single story, full brick, four-plex
Built: 2007
Sq Ft: Approx 3360 sq ft total; each unit is approx 840 sq ft with 2BR, 1BA
Parking: Each unit is allocated 2 spaces
Plus: Very close to an elementary school

The numbers:
Purchase Price: $225k
Down payment: 25% or $56k
Loan Amount: $169k
Monthly Principle & Interest for 30 years at 4.25%: $830
Monthly Taxes: $190
Monthly Insurance: $110
Monthly maintenance: $50 for exterior lights in parking lot
Property Management: $0 - I live in the area and plan to manage the property
Repair estimate: $?
Vacancy estimate: $?
Other?

Have I forgotten to factor in any other costs? Thanks in advance for your help and analysis!

2

If you’re gonna go do the management, then figure 40% for overhead, before debt service, over time.

You want to take into consideration the appreciation you expect for this farm area over the next five years as it effects the future cash flow.

Inflation is likely to be significant, and will also push the cash flow, eventually.

After that, you want to consider how fast, and how much, you can retire the debt as you increase the rental income.

It’s not easy to predict the future, but it’s a fair guess that inflation will be a major factor over the next five years, and especially over 10 years.

If you have fixed rate financing on the property, that element alone will become an ‘asset’ to the investment.

Meantime, we make money several ways with income property:

I might miss something, but…

  1. Appreciation.
  2. Inflation.
  3. Mortgage pay down.
  4. Rental income increases.
  5. Forced appreciation (improving marketability/increasing rents).
  6. Tax treatment.
  7. Equity capture at time of purchase.
  8. Repositioning of asset in the market. (Rehab/rezoning, etc.)
  9. Value added elements (undeveloped land included with purchase, under-market (lower-than-retail) rents, easily-solved management-induced vacancies, ??).

There might be more, but better minds will have to contribute here.

P.S. If this project doesn’t make sense with a 40% overhead (much less 50%, with professional management) and investors are ‘still’ buying similar units at a certain, lower CAP (capitalization rate) and higher GRM (gross rent multiplier), then most likely there is an appreciation/inflation play being considered that outweighs the potential, intervening negative cash flow (or an extraordinarily high down payment requirement).

This is the case where I live. We have very low CAP rates, high down payments, and little, immediate, COC (cash on cash) returns. Why?

Because there is a belief that there will be significantly higher appreciation and inflation that will overcome any immediate lack of return on cash flow or debt reduction.

So, this means again, that these investments represent higher than average prospects for appreciation, which would overcome the intervening negative/neutral cash flow in the short term.

That all said, most investors will invest what’s necessary to eliminate the negative cash flow, on paper. And many banks will insist there be enough equity (down payments) in the project to reduce/eliminate potential negative cash flow.

OK, that’s all I be havin’ for you today.

3

Javipa, Thank you for the quick reply.

You recommend 40% for overhead, before debt service, over time.

With the deal numbers I listed, is this 40% of the gross rents or net? Am I missing the point all together?

Is the 40% to pay for my time or something else?

Thanks again!!!

4

I wish you would have included the rent amounts. That would have made the analysis complete. Here are my thoughts:

  • Expenses: The rates for insurance and taxes seem very low to me. You will want to double check these. Remember that the property taxes will be reassessed based on your purchase price rather that the current assessed value. When calculating the cash flow, you should set aside 50% of the gross income to cover vacancy (10%), taxes, insurance, owner utilities, capital reserves, maintenance and repairs. The 50% rule does not include property maintenance or any loan payments.

  • Cash Flow: Based on the purchase price, loan information and the 50% rule, you target is to have each unit earn you $100 profit each month. Anything more that that only creates a better deal. To earn a total of $400 each month, you will need to have rents be at least $620 per month. You need to find out what is the market rents in your area and the terms and lengths of the current leases.

Here is a consideration, if you are going to manage the units yourself, you should be paid for the time and effort to do this. This would be above and beyond your $100 profit. Typically a property manager will charge 10% of the gross rents. If this is your payment then your expenses will total 60% of the gross income. To include this, your rents would need to be $775 per month to earn your $100 per unit profit.

If your expenses are really that low and you can get market rents, this has the potential to be a good deal. Much depends on the rental amounts.

5

Overhead (expense) is based on the gross schedule rents (at market value).

The only thing your missing is listing the gross scheduled rents.

The GSI is always your starting point when analyzing the numbers. Everything falls from that number.

Of course that number may not reflect market rents, but existing rents. And that’s another reason why we need to know our market well enough to recognize a bargain by the rental rates currently being charged.

6

Thanks very much for the feedback thus far. I can’t believe I forgot to add the rents.

The building is fully leased. Each tenant is under a lease and each has agreed to sign a new one year lease if we purchase.

Each unit rents for $650 per month and each tenant pays their own utilities. I think the units could be rented for $675 each without a problem.

The building is in an area with top ranked schools and stable business base.

I verified the taxes with the county and got a quote from my insurance company.

Taxes are $182/month and insurance will be $95/month.

Your thoughts?

Thanks!

7

Frugal, you’ve got enough information to answer your own question. :beer

Take your “market rate” GSI (the market rents, not the existing rents) and divide that by two. This figure will represent your “actual” net operating income before debt service, all things being equal.

Subtract your projected debt service from that “actual” NOI to see what the pre-tax cash flow is/would/should be today with no increase in rents.

Then you can add the rental increases to the bottom line, and easily see what the future cash flow will be like after you raise the rent to market value.

Meantime, the expenses should normally be based on 50% of the market rent, not the actual rents (unless the market rents are actually lower than the existing rents). This can happen if a nearby complex is drawing customers away with a fresh remodel, etc. But then this collapse in rents might be temporary.

Meantime, we stick with the “50% of market GSI” rule of thumb, so that our expenses won’t skew artificially downward, and cause us to believe the building is more profitable than it actually is/would be.

Everything hinges on our knowledge of market rental rates.

FWIW

8

Thanks for the rents and the expense verification. To run the numbers I used 10% for vacancy and repairs and 5% for capital reserves and 3% for owner utilities. Factoring your loan information will give you a NOI before tax of $837 per month. That is double the investors requirement of $100 per unit/per month!

You are looking at a 8.9% cap rate (good) and a 17.8% cash on cash return (excellent). This sounds like a very good investment.

9

We always do a 15% vacancy 10% maintenance and another 10% for management… If you do the management pay yourself but make sure you have this figured in before pulling the trigger as you have 30 years before your note is paid off and you might need to move, decide you dont like to manage or become unable to manage.

10

I want to thank everyone for their feedback and advice. We signed a sales contract yesterday and will be meeting the tenants tomorrow. We’re very excited about this new adventure! Thanks again!!!

11

Hi, can you explain how you arrived at the cap rate?

Using cap rate = NOI / Value

and using $675 per unit x 4 units x 12 months = GSI of $32,300

@ 50% expenses, NOI estimate is $16,200

$16,200 / $225,000 = 7.2%

Thanks!

12

Yes the cap is NOI/Purchase Price.

I used the buyer’s provided expenses since they were verified.

Purchase Price: $225,000
Rent: $2,600/month
Vacancy: 10%
Property Insurance: $95/month
Property Taxes: $182/month
Repairs/Maintenance: 10%
Owner Utilities: 3%
Capital Reserve: 5%

NOI: $19,140 Annually
Cap Rate: 8.5%

The 50% rule is a starting estimate to analyze for viability. Once actual expenses are verified, the CAP should be adjusted to reflect that actual investment.

13

You can always ask your tenants to sign new leases but they are not required to do so, especially if you are raising the rent. Under most state laws, tenant leases convey with the property. You have to honor the terms and conditions of the existing leases. When the existing leases expire, then you can implement your rent increases if the market will bear it.

Don’t forget to have the current owner give you a credit at closing for all the security deposits. When you become the new owner, you are liable to your tenants for the security deposits even if the former owner kept them. Before you go to settlement, make sure you review the leases, verify the security deposits, and confirm with each tenant the terms of their lease and the amount of their security deposit.

14

I really appreciate the great advice and wanted to update you on my progress.

I hired a professional home inspector to inspect the property with me. He’s a licensed framer and retired firefighter so he knows the city building codes well. He found a handful of minor repair items that the Seller agreed to correct.

Also the Seller agreed to lower the purchase price to $223,000 and pay $4500 toward buyer expenses.

I shopped the loan and got a great (I believe) loan for the property. On a non-owner occupied investment property, 30 year fixed at 3.875% with -.250 points (about $800 lender credit) . My monthly PITI should be $1058.

I spoke with each tenant and let them know that I would not raise the rent in the first year with us.

I also learned that the property has a commercial fire sprinkler system that services each unit. Do you think an insurance company will lower their premiums because of this?

We’re getting excited but a bit anxious too.

Thanks again!

15

Great work! Sounds like you are really on top of things. Not raising the rent for the first year was an EXCELLENT move. This creates tenant trust and loyalty - something that can reap lots of benefits in having long term tenants.

As to the commercial sprinkler system, I believe that it should lower your premiums. It will not be by much but make sure you mention it none the less.

16

I don’t understand why you made arrangements with the tenants to keep their rents under retail.

What’s the point?

17

That’s a fair question.

When I met the tenants for the first time, they asked if I’d be raising the rent immediately. I told them no, but I would raise the rents after their first lease with me expires. After the meeting, I found out that I could charge a little more now but since I’d already told them I wouldn’t, I decided to stay with that decision.

It’ll be my first year as a Landlord and I’ve received good reports about the tenants from the current owner. They pay on-time, watch out for each other, and take care of the property.

I’m in it for the long-term so I plan to make up for any shortfall over time.

Thanks!

18

I can understand you’re wanting to abide by the existing lease.

However, tenants expect a rent adjustment with a change of ownership, all things being equal. And you know me, I like to give people exactly what they expect. :beer

As far as relying on the previous owner’s opinion of the tenant’s…

That’s iffy.

Might a seller fudge a little regarding ‘how easy’ his tenants are to manage? Might he forget to mention that he spent two months chasing delinquent rents from the deadbeat wanna-bees in unit A?

Sellers will say ‘anything’ to get us to pay more, if not buy their management headaches. …even if it means lying out their butt about what sweet angels his tenants have been all two months of the last fourteen they’ve been living there.

Yeah, well, show us the monthly deposit history, by unit, and the expenses listed on your Schedule E. Then we’ll make up our mind. :banghead

Of course, I’m not saying you didn’t properly verify everything the seller told you. I’m sure you did.

We just don’t take anything a seller tells us at full face value without verifying what they’re saying.

In the case of a month to month tenancy that we’re assuming in the purchase, we’ve got two issues (at least) that require immediate attention.

  1. The existing rental agreements don’t conform to our policies.
  2. The existing rents are always too low.

So we deliver new rental agreements to the m/m tenants, outlining an adjustment in the rents, along with a 30-day notice to vacate, if they choose not to approve the new agreement within 24 hours.

It doesn’t take long for a tenant to say “yes” to our offers, or not (and we need to know asap if we’ve got a problem, a misjudgment, or not).

Meantime, we do the same with those on lease agreements, if the agreements have a clause that allows us to modify the agreement, prior to it’s expiration.

Most leases allow this. So, in effect everyone all the month-to-month tenants get a 30-day notice to vacate, or the choice to stay, by approving the new rental agreements.

We can’t adjust the rents on existing leases, otherwise they wouldn’t be called leases.

So the rents don’t adjust on those until the terms expire, and then those tenants receive an option to either sign a new lease, with the new rent, or accept a 30-day notice to vacate.

As an aside, the wiser approach to this whole thing is to begin making cosmetic improvements to the building a day, or so, before we begin delivering notices to everyone.

FWIW

19

GRM = 86, so fair IMO, although I try to get 75 or less properties.

At minimum vacancy on a 4-plex, consider 1 month, so $2,600 a year; likely less, but it’s a safe estimate.

Property management is never zero, even if you do it yourself - for one, at minimum, you want a PO Box (you do not want your tenants to know where you live), a cell phone, business cards, office supplies (ie. leases, printer, computer), fees if you do online payments, setting up an LLC (if you use one) etc. - you will incur expenses for “managing” your property.

I calculate maintenance as 25% of gross rent each year on newer properties (ie. 2000-2012 built), 30% for 1990’s, and 40% for all others that are 1989 or older.

You may also want to consider the expense of a CPA and attorney each year, I have both and they’re not cheap, but they do make things easier.