I am new to the real estate investment game and want your advice.
I am learning a great deal. Rules of Thumb:
OE shouldn’t be more than 50% Rental Income
Loan payment shouldn’t be more than 50% Rental Income
Cap Rate is nice above 9% and better above 10%
Anyway, we are investigating a quad townhouse new construction investment. Wanted to throw the numbers at you guys and see what you say:
Asking $310,000
Rental Income Potential: $3,130/mth
Operating Expenses: $1,161.91/mth (does not include 10% mgt fee if chosen)
Currently have 11 units rented by builder and OE is based on those units.
They would build in 4 mo time.
Loan $300K, 60K down 7% CR 12.52% payment $1,596.73
For every $10K drop in purchase price, 5K drop in dwnpmt but same payment
First, is this a fair deal and what should the max purchase price be?
Second, if we don’t have all the downpayment what would the best option be: do nothing, investors with rapid bayback from income, or less downpayment and rapid payoff of loan if qualify.
We currently have two rental properties with Equity of $65K and $55K.
Tam. It appears that if you put $60K down, you get a monthly cashflow of $372. That’s only about a 7% return. Tha’s assuming that you manage it yourself. I still think you can get a good idea by applying the 50% rule. Your P&I only should be no more than $1565/mo. You’ll have to include a managmemnt fee wether you do the maint. or not. That puts your OE at about $1474/mo. Is the $1596/mo. pmt. P&I only? If it is, you’re over the “50% rule” but more importantly, when you add up your OE and P&I., that’s $3070/mo. That gives you $100/mo. positive cashflow. Which is only a 2% return on your $60K. I think you can find a property (or maybe even a couple of properties) that can give you a better monthly cashflow. Good luck.
Your payments for $310K for 30yrs @7% are $2062.44
The potential rent you listed is nowhere near what you need it to be for this property. In addition, you didn’t include what your $1161.91 OE entails besides the fact that it doesn’t include 10% for management. I’m going to guess you just included the property tax and insurance in your figure. What about vacancy, advertising, lawn care/snow removal (if applicable), common area utilities, legal expenses, etc?
If you figure $100/mo cash flow per unit, that gives you a total of $2462.44 for debt service and cash flow. This would mean your rent would need to be $4924.88/mo to support this deal at the amount you mentioned. Or you could reduce the purchase price to about $175K to support $100/mo cash flow per unit and conform to the spirit of the 50% rule.
Bottom line is this is no deal considering the amount of rent vs. purchase price.
You need to get your own numbers for hazard insurance, liability insurance, property taxes, and homeowner’s association dues. Factor in one month vacancy for each unit and a contribution to a replacement reserve account.
If you believe that you can get $780 per month rent per unit, then you have $390 for your debt service and cash flow using the 50% rule. If you require $100 monthly cash flow, then you only have $290 left over for debt service. Using your numbers, your debt service will cost you $400 per month per unit so it seems that you are coming up $110 short.
I am a little confused by your financing. You say that you will be financing $300K of the $310K price, but you also say you will have $60K down. I am guessing that you are planning to purchase for $300K and finance $240K, otherwise your debt service would not equal $1596.73
I think your operating expense numbers are a little low. However, just using your numbers, the net operating income (NOI) is $1968 per month which equates to $23616 per year. Dividing $23616 by $300K, your cap rate works out to 7.87%.
For a 12.52 cap rate, your purchase price would have to be $188626. I believe you are dividing your gross scheduled rental income by your purchase price to get 12.52. Cap Rate is equal to NOI divided by Purchase Price.
Once you firm up your numbers and factor in all the incidental expenses in your overhead, I expect you will find that this property is a negative cash flow proposition at this price point.
Justin, Tam’s P&I #'s are correct. They’re putting $60k down on a $300k mortgage. That gives them the $1596/mo. But I agree with the $100/mo/unit profit. I tend to believe that $60K can buy at least 2 properties that can give a better cashflow.
OMG – You guys are sooo good! I have so much to learn.
OK – I will try to fill in a few more details, but this is looking like a a bad way to go. Can the builder be building it for himself and making it pay?
They sent me a Pro Forma based on 2008 operating expense actuals for 11 units they currently have rented. Their Total Annual Expenses were for 11 units and it included 5% vacancy, 10% maint/reserves, assoc dues, insurance, trash, yard work, taxes, legal & office fees, repairs, utilities, postage, meals & entertainment for a total of $38343 annually. I did a crude division by 11 and then multiplied by 4 to get my annual operating expenses. That figure didn’t include the P&I loan or a mgmt fee.
I figured 300K as a starting offer point and the payment amt did include p&I. So I would have to offer between $175 to 188K to make it payoff? That is a lot less than they are asking. Better to walk away?
I was thinking that I could invest $60K in several places and have a better rate of return and cash flow.
Thank you very much. I am going to digest your responses when I get home this evening and probably will be back for more. You are awesome!
If this is new construction, less than a year old, the land could still be assessed as agricultural use or other undeveloped land. Once the property is reassessed, the property tax bill could be a real eye-popper.
How much is the property tax bill for the builder’s 11 units? Remember that the builder’s property tax expense could be nearly a year old. You need to look at the tax assessor’s web site for your county to see the property tax bill will be significantly higher next year.
Although the builder’s pro-forma included a 5% vacancy, that may be too low. 5% of one year is only 18 days. Do you think you can count on having no more than 18 days vacancy in each of your units during the year? Suggest you build in a one month minimum vacancy allowance. If your rental market is soft, build in three months.
Since you are working with a builder’s pro forma, you don’t know what the actual rents are for his occupied units. A pro forma gives you expected rents which may be too optimistic for your market. Contact a few professional property managers in your area and ask them what you might expect for a market rent if they were to manage the property for you. Also ask them what the expected vacancy period would be at that rent.
Rather than abandon the deal completely, figure out what purchase price you would need to get to make the numbers work for you. The cost of labor is cheaper today than a year ago, the cost of building materials and supplies is cheaper today than a year ago. Don’t be afraid to offer the builder $175K for the package if that is the number you need to hit. You might be surprised, the builder might just accept.
No problem. Just remember that this stuff is not overly complicated. You can use the 50% rule and the $100/unit/mo. profit guideline as way to screen potential deals. When you find somethong that fits, you can dig further while doing your due diligence. It’s not unusual to find the the #'s from the seller’s pro-forma are very different from the ACTUAL #'s. When looking into expenses, you want to verify mainte. repairs etc… from the seller’s “schedule E” on their previous tax returns. Also verify all the utilities,taxes, maint. contracts, etc… You can verify the income from the rent roll and the verify all the lease info. A good book that covers this is “The ABC’s of Real Estate Investing” by Ken MKelroy. Here are some other good ones.
“1 Minute to Rental Property Riches” by Mike Rossi (aka Propertymanager).
“The Millionare Real Estate Investor” by Gary Keller.
Yep, Jose got my intentions. I was in a hurry when I posted this. This goes back to the point of not buying your cashflow.
Typically you are not going to find a “good deal” as advertised by the builder when talking about rentals. There are three new construction duplexes in the same town as our apts. that have been stuck on the market for going on a few years now. They rent for $545 per side, but they’re trying to get $130K out of each building. The buildings look nice and everything’s new, but the numbers don’t work.
Tam you will also find on here about how your gross rents per month should be close to 2% of your purchase price to ensure decent cash flow. These numbers are right at 1% on this deal. Since it’s new construction, you can’t go into this thinking you can drastically raise the rents in the near future to help make this a better deal. I’m sure their pro-forma numbers for rent are at least set at the market rent for the area if not a little more optimistic than that.
Dave brought up an excellent point about property tax changing due to changes in land use. Also consider what they listed for allocations for maintenance and repairs. These “pro-forma” numbers may be deceptively low because it’s a new building. They may try to convince you there will be virtually no repairs because it’s new construction. Just remember, your loan lasts for 15, 20, or 30 yrs. The new pieces and parts of that building will wear out before that.
Thank you, everyone. You have all made this very easy for me and I have learned a great deal. I think I am going to step back and do a little more looking around for some other opportunities. I would like to find a couple more rental investments in 2009 but I am going to keep it a little more conservative and wait for the numbers to work. We are in this to make money afterall. It is easy to get caught up in the hype of doing business and not doing it intelligently.
I agree that the #'s should cashflow with 0% down. Putting money down should only improve an already good deal. I was just looking at the #'s that were there. But I think it’s important to note that if you have to put money down ( as you do in today’s lending climate), you should include that in your calculations to have an accurate picture of the financials. I like to calculate the #'s for different scenerios so I can see the different options available. In my area, there are VERY few deals that actually cashflow with the asking price listed. Typically, you’d have to offer about 20% less than the asking price (which always gets rejected). I know I’ve said this before, But all the properties that sold for at,or close to the asking price in the past year, ended up back on the market within 6 months. :rolleyes. This has proved to me that what I’ve learned about property evaluation (on this site) has saved me a TON of money and headaches. I used to think these were good deals and would have jumped on them before I knew better. So far, the best deals I’ve done are the ones that I walked away from :beer. I’m starting to consider investing outside my area. I really don’t want to do that. I’m hoping my persistance pays off. :biggrin
Justin – I wanted to ask you about the 2 percent rule you use. I can’t see where you would find properties that would price out very often. We purchased a quick sale house for $30K cash. It appraised out at $65K, but the rent rate is about $500 in the area for this type of house. That is $100 less that the 30K at 2 percent which is $600. If we raise the rent, we may not get a renter??? Was it a poor investment?
Sizzmo. Did you have to put any money into the property to get it rentable? Rules and guidelines help you to screen potential deals. But the true answer lies in the actual financials of the property. If you’re getting $100/mo./unit minimum., I’d say it’s a good deal. You can refinance the property to get your cash back. A 30K mortgage at 7% is about $200/mo. P&I. Using the 50% rule, you’d fall short on your profit by $50/mo. That’s not a really a “bad” deal. Besides, you already own the property. I’d say if you can get your money back and have positive casshflow, that’s a win. You may be able to increase income and/or decrease expenses to increase your monthly cashflow. Depending on your actual expenses, you may or may not get the $100/mo/unit profit. But you could at least get your original investment back and apply it to another property.
We had to replace the water heater and paint a couple rooms (ourselves). That is it so far. It is a very nice solid little house.
So how much money do you keep in the bank for each unit as backup money? After, that do you put it toward investments in others?
So would it be a good idea to borrow against the paid property just enough to maintain a good cash flow and invest the borrowed money into another property as a down payment? Say 15-20K. Or take the cash flow on the paid property and pay off another property or take the cash flow and save for another property? I guess it depends on if when we come across another property.
I think it’s a good idea to refi to get the 30K back. According to the $65K appraisal, you have a good equity position of abput 50%. Then I’d try to put 2yrs. worth of mortgage pmts. in an emergency fund. For $30K, that’s about $4800. Then I’d put aside another $5K for unexpected repairs. Then you can take the $20K and invest in another property. You could buy 3 more properties like the one you just bought if you put 20% down on each and finance the rest. If the lenders require you to put more down, you could buy 2 properties instead of 3. In the meantime, your first property is getting some cashflow and you have some reserves in case you need it for unexpected prolonged vacany and/or repair. Many people have trouble when they don’t have the cashflow, reserves or adequate equity in the property. If you have enough equity in the property, you can sell it quick if you need to and get your money back. It sounds like you bought this home at a 50% discount. Often times an owner will tap as much as they can from the equity to finance other investments or anything else they can think of. Too much leverage with too little cash is a recipe for disaster. That’s why people are losing their homes and banks and businesses are looking for bailout money to survive.
Tam,
No, I don’t think you made a bad deal. When we bought our first property, we didn’t know of this website and did not have any rule of thumb for estimating expenses. Luckily gut instinct worked out and it turned out to be a good deal. Propertymanager (Mike…a Moderator on here) is the person who developed this as a way to estimate a whole collection of expenses and evaluate potential deals. We’ve adopted this as a screening tool for a baseline evaluation.
I think your decision to re-fi your property or not will depend on the rate at which you want to acquire other properties. As Phlemboy mentioned, you could tap into that equity and probably get another few places without jeopardizing your first property.
I have a good income from a stable job I’m in no danger of losing so I don’t have as big of a cash reserve right now for the properties as some people probably would. We loan the business money when we want to purchase another property.