What am I missing in this evaluation?

General Real Estate Investing
1

Hello, long time lurker. Please help by poking some holes and providing insight in my evaluation of this property.

Investment: $85,000
Vacancy Rate: 25%
Vacancy Value: -$3175
Monthly Rent: $2075 (5 units at $375, $375, $650, $300, $375)
Tax Rate (personal): 30%
Property Tax (annual): -$2700
Insurance (annual): -$621
Operating expense (annual): -???
Miscellaneous expense (annual): -???
Mortgage (annual): -$4310
Annual profit: $4,210
ROI: 5%

Vacancy rate is assumed to add a debit.

Please tell me what I am missing.

Thank you!

2

Hi,

Here we go!

Purchase Price - $85,000
Down Payment 25% - $21,250

Income - $24,900
Vacancy Factor 25% - $6,225
Adjusted Income - $18,675
Expense Budget 50% - $9,337
Debt service & Profit 50% - $9,338

Expenses: $9,337 Budget

Property Management
Property Taxes - $2700
Property Insurance - $621
General Maintence
Advertising
Legal
Lawn Service
Snow Removal
Bookkeeping and Accounting
Rental Preparation
Appliance Repair and Replacement
Long Term Replacement Reserve

Debt Service & Profit: $9,338 Budget

Mortgage - $4,310
Annual Profit - $5,028 - 23.7% Cash on Cash Return on $21,250 - 25% Down Payment.

This is a “Great” investment! Make sure you save all expense budget unspent dollars toward reserves!

Good Luck,

                    GR
3

Thank you for the reply. Can you please peer check below? I added some additional expenses. Some are estimates and others are placeholders. I wanted to make sure that I was thorough on the expenses side (especially personal income tax) and properly calculating a rate of return.

Thanks for your time.

(I have this in a spreadsheet but could not figure out how to insert a table propertly)

[tr][td]
Scenario 1
Month Year
ROI 1% 10%
Income - Net $234 $2,809
Purchase Price - $ $80,000
Closing Costs - $ $3,000

Down Payment - % 35%
Down Payment - $ $28,000

Financed - $ $52,000
Income - Gross $2,075 $24,900
Rent - Unit 1 $650 $7,800
Rent - Unit 2 $375 $4,500
Rent - Unit 3 $375 $4,500
Rent - Unit 4 $375 $4,500
Rent - Unit 5 $300 $3,600

Vacancy Factor - % 25%
Vacancy Factor - $ $519 $6,225

Income - Adjusted $1,556 $18,675
Budget - Expense 50% $778 $9,338
Debt Service and Profit 50% $389 $4,669

Expenses - Total $1,322 $15,866
Mortgage $350 $4,200
Property Management $- $-
Tax Property $183 $2,200
Tax Personal - % 25%
Tax Personal - $ $519 $6,225
Property Insurance $70 $840
General Maintenance $25 $300
Advertising $25 $300
Legal Services $25 $300
Lawn Service $25 $300
Snow Removal $25 $300
Bookkeeping and Accounting $25 $300
Rental Preparation $25 $300
Appliance Repair and Replacement $25 $300
Long-term Replacement Reserve - % 10%
Long-term Replacement Reserve - $ $156 $1,868

[/td][/tr]

4

Should personal income tax be an expense? I mean, it’s a real cost that will take away from my profit.

Am I missing something regarding personal income tax?

5

You only pay tax on your net income. Yes, it reduces your cash flow. But, if you are making money, no matter what the venture, you will have to give some of it to the tax man. The consolation is that you get to keep more than the tax man takes.

I think you are making a mistake using income net of vacancy to determine your expense factor. By extension, your approach says that you have no operating expenses when you have a 100% vacancy. I hope you see how wrong this is.

Instead, for estimating purposes, use 50% of your gross SCHEDULED rents as an estimate of your overhead. After all, property taxes, insurance, maintenance, upkeep, utilities, etc. still have to be paid even if you have no income.

6

Thanks for the reply.

“You only pay tax on your net income. Yes, it reduces your cash flow. But, if you are making money, no matter what the venture, you will have to give some of it to the tax man. The consolation is that you get to keep more than the tax man takes.”

Understood. The main gap in my knowledge is what defines “net”. In my first post I included my personal income tax as an expense (my largest). My understanding is that this is incorrect. I was looking at the income derived from the rental property like my current income (from a company I work for). I need to calculate my “net” by subtracting the applicable expenses associated with owning the rental property.

“I think you are making a mistake using income net of vacancy to determine your expense factor.”
Would it make sense to list my vacancy factor value as an expense for evaluation purposes?

“By extension, your approach says that you have no operating expenses when you have a 100% vacancy. I hope you see how wrong this is.”

I agree that is not a smart way to look at things. It was not my intent to show that in the calculation. When I change my vacancy rate to 0% the monthly expenses are still applicable (Tax, Property Insurance, General Maintenance, etc.).

“Instead, for estimating purposes, use 50% of your gross SCHEDULED rents as an estimate of your overhead. After all, property taxes, insurance, maintenance, upkeep, utilities, etc. still have to be paid even if you have no income.”

Understood. Thank you. I will use this 50% as the sanity check. If my 50% # of gross rent is higher than my estimated expenses, than I should not purchase the property?

7

I cut to the chase, and assumed a 50% basic income/expense ratio.

I took into account the stated 25% vacancy rate.

The return is good even with the terrible occupancy factor.

I’m guessing this is an old property in a C minus area and it’s management intensive. So, the management costs will be atrocious in return for a 9% return, before taxes, on an as-is basis.

If we achieve an average 5% vacancy factor, on a six-month rolling average, even if we have to offer lower rents, the return will be significantly better.

For example if we have to lower the rents by 10%, or -$2,400/yr, to get a 95% occupancy factor, our GSI will fall from $24,900/yr to $22,410/yr , but our pre-tax cash flow will go from $2,801/yr to $6,536/yr, for a higher annual pre-tax return of 21.8%

If this property cannot be stabilized to achieve a 5% vacancy factor (without a major rehab job), I would stay away from this deal. It’s too much work, for too little money, for too long a time, and with too much money down.

I would rather leverage into a $300k property, with a 25% vacancy, with my $31,000.

That said, if increasing the occupancy on this project by 20% was possible, at this purchase price, we would fill the building as fast as possible, stabilize it, and then sell the thing asap. We can make MUCH more money flipping this, than settling for $5k a year (with $30,000 buried in the thing). But that’s just me.

Let’s examine the pro forma analysis.

The GSI is down 10%, but the occupancy is now 95%; the cash flow is double what it was; the annual COC return is 21.8% instead of 9%.

NOTE: The pro forma expenses are based on the “new” GSI, not the current one. We could use the current expenses (45% of old GSI, not including vacancy) and the return would be slightly less.

However we like to base expenses here on a 95% occupancy factor for our purposes, to keep things analytically consistent.

This issue is verifying the seller’s numbers. If the seller has recently rehabbed the property (how much is a key), or the property is new …the 50% income/expense ratio maybe too conservative. Here’s a summary of the analysis.

http://jaypalmquist.com/images/analysis-reiclub.png