Evaluating A Rental Property

As you may know I like to make the beta reading of my book open sourced so the community that will be using them can actually gain the information and request changes or additional information to be added as the book is being written.

This post is One Chapter of my coming book, “GET THE DEAL”. Which the idea has it’s origins from the live training with the same name that I have taught to thousands of real estate investors all across the country and have had time to refine the information to answer the questions most asked at those trainings. Without further ado I want to encourage you to read this chapter and leave your suggestions in the comments below!

Chapter Twelve

Evaluating A Rental Property

“Someone’s sitting in the shade today because someone planted a tree a long time ago.”

– Warren Buffet

Finally we have made it to my favorite class of real estate! You’ve heard the old saying, “the best time to plant a tree was 20 years ago, and the next best time is today”. Well the same goes for real estate. Don’t wait to buy real estate, buy real estate and wait!

Rental property and passive income was always the goal for me even before I bought my first move-in-flip. I can still remember a conversation I had with my father about the different businesses I could start that wouldn’t involve me having to work hard the rest of my life.

I had been focusing on the concept of passive income for weeks and ran across a blog about rental properties and how it was not only the best store for wealth and long term appreciation, but it was also the birth-place of passive income. The article painted a picture of how you could easily acquire one rental property per year for 10 years and essentially retire from the cashflow of this collection of cashflow machines!

Being a certified excel wizard it didn’t take long before I was building a rental property calculator and plugging in the numbers from all the properties I saw on the market back in 2010 which btw ALL seemed to cash-flow back then.

Once I had established a solid base-line for what an average rental property required for a down-payment and how much cashflow I could expect it was time to create a new spreadsheet that allowed me to plug in multiple properties over a given timeline of 10 years.

This was where I first discovered the power of compounding combined with the leverage that only real estate can proved. It was like taking two of the most powerful tools in the financial world and putting them together to create a net-worth and cashflow machine!

As I explained to my father if I just buy 1 property per year, for 3 years I could in theory start buying 2 rental properties per year. After 2 more years I could be buying 3 properties per year and either decide to retire OR continue building my empire.

I remember seeing the amazement on his face as the excitement in my voice began to rise and it all became so clear to me that all I had to do was stick to this very simple, yet rarely traveled path of acquiring real estate each year.

To my fathers credit he just smiled and told me that he knew that I could do this and that he wished my mother had supported his dreams of buying real estate and financial freedom. It was in that moment that I decided that I would not allow anyone, stop me from realizing my dream of financial freedom.

Looking back I now see that I could have found a healthier way to take this lesson and it did end up costing me my marriage. If you’ve read my first book, “Broke To A Quarter-Million” you know how that worked out. The best advice I can give you is that rental property is something that you CAN do with your spouse and that there is always a win/win way to accomplish your financial freedom goals that includes you keeping the person you love with you along for the journey.

That being said. I am extremely happy with the way my life has turned out so far and I have attracted the most amazing people into my life, business and personal relationships. I owe a lot the freedom I have to my growing rental portfolio and my desire to help other investors and future millionaires learn how to invest in real estate and become millionaires through owning rental property.

Ultimately you want to be a passive investor in other peoples rentals (OPR), but you have to build up the capital first through owning some of your own. This all starts with understanding how to analyze a rental property and the more doors the better!

How to Analyze Rental Property Investments

Rental real estate can be a great way to generate income and build wealth, but there are not enough new investors that know how to evaluate and select properties. Purchasing your first rental property is a major financial decision and must be taken very seriously, so it’s important to understand what you’re doing.

Here’s an overview of what aspiring landlords should know about cash flow, equity appreciation, and a few other factors. Smart analysis can be the difference between years of strong income and lots of accumulated equity versus “below-average” returns.

How your rental properties (could) make you money

There are two basic ways you can make money with a rental property. It can generate current income (cash flow) or it can build your net-worth which is measured by your equity. As your mortgage balance declines and the property becomes worth more over time, your net-worth rises and this is called equity.

Many experts tell real estate investors to focus on cash flow. There’s good reason for this. Equity appreciation can be extremely difficult to project, especially over shorter time periods. Also mortgage principal reduction can be depressingly low during the first few years of ownership. I often say that looking at my loan’s amortization schedule was the most depressing memory I when closing on my first rental property.

To be clear, both are extremely important to your long-term returns. In fact, if you hold a rental property for a decade or two, equity appreciation could easily become the larger of the two components.

Over long periods of time, real estate prices have grown slightly faster than inflation. So, if you plan to hold a rental property for 25 years, it’s reasonable to expect its value to grow at this rate if it’s properly maintained. However, property value fluctuations are impossible to predict over short periods of time with any level of accuracy.

Even though appreciation is important and potentially lucrative, cash flow is the more important part of your analysis. Here’s why:

  • Property values in geographical areas tend to rise and fall at roughly the same rates. If you’re looking at 10 potential duplexes in your local market, their values should rise at about the same rates over time.
  • Mortgage repayment occurs at roughly the same rate for each property, assuming you get the same type of loan with the same interest rate. Say you buy two properties with 30-year fixed rate mortgages at 6% interest and 20% down. The proportion of each loan you’ve paid off will be the same after five, 10, and 20 years.

While equity is important, cash flow is the main differentiator. It’s the factor that makes one rental property investment better than another. It’s also the secret to being able to hold these properties for the Long-Term. Without a healthy amount of cashflow and a long-term approach rental property investing can be very “dangerous” and should be avoided by anyone looking for fast returns within a year or two. Some years these returns can be massive, but they are the exception and not the rule.

Analyzing Your Property’s Cashflow

Cashflow is a simple concept to understand. Your property’s cashflow is the income it brings in minus the expenses associated with owning, managing, and maintaining the property.

While it’s a simple concept, the calculation of rental property cash flow can be complex. Many inexperienced investors have trouble with it. Specifically, many of them dramatically underestimate the costs of owning a rental property. Things you need to account for in your cash flow analysis include the following:

  • Your Mortgage Payment: Most lenders require property taxes and insurance payments with the mortgage payment. Be sure to include that in your calculations. If they are not included with the mortgage, you will have to account for them separately.
  • Any Utilities You Pay: Tenants usually pay their own electric bills, but landlords often pay for water, cable, sewer, and trash collection. This is especially true if the property is a C class multi-unit building. If the property you’re considering is already rented, find out what utilities the landlord pays. Then conservatively estimate how much they’ll cost.
  • Property Management: If you plan to hire a property manager, account for the expense. The industry standard is 10% of collected rent.
  • HOA Fees: If the property is part of a homeowners’ association, budget for this expense as well. Find out what’s included with the HOA fee. For example, in some condominiums, the HOA dues include water and some even include basic cable.
  • Other Expenses: Account for anything else you’ll pay for on an ongoing basis. Examples could include pest control, lawn maintenance and in cold weather zones snow removal. Don’t count on your tenants doing any of these things on their own. Plan on paying for them yourself or making it the tenants’ responsibility as part of the lease.
  • Vacancy: This gets tricky. At some point, your rental property will likely have units that sit vacant for a little while. In a perfect world, you or your property manager will have a new tenant lined up before the old one moves out, but it doesn’t always work out that way. Depending on the nature of your property and current market conditions, it’s smart to assume a 5–10% vacancy rate and set aside this portion of the rent to offset the cost. After all, you still have to pay the mortgage and other expenses when your property is vacant.
  • Maintenance: At some point, things will need to be repaired or replaced. The property’s HVAC unit is going to die. You’ll need to pay for a new roof. Winter means you’ll have to hire a snow removal company. Set aside part of the rent so you’ll have reserves when you need them. I use 10% for a maintenance allowance and 5% for a vacancy allowance and adjust as necessary. For example, a 5% maintenance allowance could be plenty for a new construction, but you may need 15% for an older building.

An Example Of Cash Flow Analysis

To illustrate this, I’ll use a real-world example of a rental property I bought in 2013 in Fall River, MA.

Here are the details: The property is a triplex (three units) with total rent of $2,425 per month. I pay taxes and insurance as part of my mortgage payment each month, I pay for water service, and the property isn’t part of an HOA.

Despite the age of the property (about 200 years), I use a 10% maintenance allowance because it was previously renovated in the 80’s, but I use a lower 5% vacancy allowance because it’s located in a strong rental market.

With all of that in mind, here’s how I analyzed the cash flow of the property:

ITEMIncome (Expense)
MORTGAGE PAYMENT (Principle & Interest)($1,600)
CASH FLOW$168.75 per month

My only strict requirement is that after a thorough and exhaustive cash flow calculation, the property produces positive cash flow from day one. Ideally, the cash flow I get from a rental property will be more than I could get from a savings account, CD, or other risk-free place to park my cash.

As I mentioned earlier, comparing the cash flow situations of different properties can be a great way to analyze deals. You can use the Rental Property Calculator I created for my own analysis on my website at: GualterAmarelo.com that will generate the cashflow you can expect if you have that accurate information from the seller or experienced investors in your local market.

Also remember that this is immediate cash flow and that it should rise over time. Historically, rental rates have increased in line with inflation over long time periods. Your rental income will probably increase while your mortgage payment remains the same. The bottom line is that if you start with positive cash flow, you will be setting yourself up nicely for the future. You still won’t lose money if the real estate market has a slow year and rent doesn’t rise as expected because you are buying for cashflow upfront.

How Much Rental Income Will The Property Generate?

For your cash flow analysis to be accurate, you need to know how much rental income a property will generate.

If the property is already rented, this is easy. This was the case with the property I used for the example. All three units were already rented when I bought the triplex, so there wasn’t any guesswork involved. Better yet, if the property is occupied, ask the current owner for a detailed rental history. This not only lets you know how much rent has been generated by the property but can also give you good insights into vacancy trends.

On the other hand, things can get tricky if the property is vacant, owner-occupied or has long standing tenants that could be well under market rent. A rental history is a good indicator for a property that’s vacant but had previously been used as a rental. If no rental history is available for that property, check rental listings for comparable properties in the area. You can also ask a local property manager for their opinion, or get a rental appraisal done. Appraisals can be expensive, but most investment property lenders will require one.

Always stay on the side of caution and be conservative when estimating rent in your analysis. If the property ends up renting for more than you think, great, but remember that as a responsible investor, you want to know what the property’s cash flow will be if things don’t work out perfectly.

An Important Thing To Know About Property Taxes

For the most part, I don’t look at taxes when I evaluate a rental property. After all, property tax rates tend to be roughly the same within the same geographical market. Also your rental income will be treated the same from the IRS regardless of which property it came from. Sure, higher cash flow might translate to a higher tax bill at the end of the year, but that’s a good problem to have!

However, there’s one potential tax issue that is worth mentioning. Many jurisdictions give special tax treatment to owner-occupied properties. That means investors pay higher tax rates than owner-occupants for the same home. The difference can be dramatic and will vary from city to city.

For example, I have investors that live in North Carolina, where property taxes are notoriously low. One of the reasons they’re low for owner-occupants is that rates given to investors are dramatically higher. An investor would pay three or four times what an owner-occupant would pay.

Here’s the point. If you’re thinking of buying a rental property, find out if it’s currently used as a rental or if it’s occupied by the homeowner.

If the latter is true, your tax bill could be much higher than public records indicate. Your real estate agent should be able to give you a good idea of how property taxes for investors versus homeowners work in your target market. It’s an important factor to include in your analysis.

Other Important Metrics And Analytical Concepts To Know

When I analyze a rental property, cash flow is the number one factor I consider. If a potential property has negative cash flow, I don’t pursue it any further or conduct any further analysis.

However, if a property has an acceptable level of cash flow, I use a few other metrics and concepts to evaluate them. The first of which is “Cash-On-Cash Return”.

Cash-On-Cash Return

This is the annualized return you generate relative to the amount of money you pay to acquire the property. To calculate your cash-on-cash return, divide the property’s annual cash flow by the amount of money you paid to acquire it. That includes closing costs, property improvements you paid for, and other expenses incurred when purchasing the property.

For example, I paid a total of about $60,000 out of pocket to acquire the triplex in my example, including my down payment and all other costs. Dividing the annual cash flow of $2,025 by $60,000 shows that I’m getting a cash-on-cash return of about 3.4%. This isn’t great by any means, but it’s more than I could get from a savings account. Plus, keep in mind that this doesn’t account for future rent growth or any accumulation of equity over time.

One of my favorite ways to use cash-on-cash return is to compare properties where you need to put different amounts of money down. For example, let’s say you’re comparing two $100,000 properties. The first one should net about $300 per month while the other should only produce cash flow of $100 after expenses.

Imagine your lender wants a 20% down payment for the second property, while the first is in poor condition and has to be an all-cash deal. Cash-on-cash return helps show which property provides the better annualized return. (It’s the property with the lower cash flow in this case.)

Capitalization (Cap) Rate

This metric is a property’s pre-tax annual cash flow (excluding mortgage payments) divided by its acquisition cost. For example, a property that generates cash flow of $7,000 per year and costs $100,000 would have a 7% cap rate. A higher number is better when using cap rates.

Cap rate is a widely used real estate metric especially in the multifamily arena. It’s especially handy for rental property investors if you don’t know the details of your financing yet. If you don’t know how much you’ll need to put down or what interest rate you’ll be paying, it’s impossible to know for sure how much your monthly mortgage payment will be.

For our purposes, when you’re examining a particular property’s cap rate, calculate its cash flow exactly as we did earlier, but this time, exclude the monthly mortgage payment (include property taxes and insurance). Then divide by your expected acquisition cost, including closing expenses and property repairs or improvements you’ll need to make right away.

Narrowing Down Your Search

There’s a lot of information to consider before buying a rental property. Why would you make a 6-7 figure financial decision without understanding what you’re getting into?

However, if you live in a market where there are dozens or hundreds of properties that meet your criteria (like I do in the cities I have chosen), it’s too time-consuming to conduct a complete cash flow analysis for all of them.

One smart way to narrow down your list is by looking at each property’s gross rent multiplier. This is a property’s price expressed as a multiple of its monthly rent. For example, a property that costs $100,000 and generates $1,000 in monthly rent would have a gross rent multiplier of 100. In the case of GRM lower numbers are better.

There are differing opinions on how to use the gross rent multiplier to narrow your search. Many investors won’t even look at a property with a gross rent multiplier of more than 100 or some other fixed number.

I use a different approach, as gross rent multipliers vary by market and can change with economic conditions. If I have a long list of potential properties, I’ll narrow down my list to those whose gross rent multipliers are in the lowest 10–20% of the market.

When you do it this way, the gross rent multipliers are based on each property’s asking price, not on the price you could actually purchase the property for. Some sellers will be significantly more flexible than others when it comes to negotiating, so this is an imperfect way to assess properties. Even so, it’s a good way to narrow down your search. Then you can conduct more intensive analysis on each property and it prevents any dangerous, “analysis paralysis”.

There’s More Than One Way To Evaluate And Choose Rental Properties

Keep in mind that there’s no one right way to apply these methods to your own rental property analysis. The best method for you depends on your priorities, risk tolerance, and investment goals.

For example, there are many income-oriented real estate investors who would consider the cash flow of the triplex I recently purchased as too low. A friend of mine who also invests in rental properties insists that all of his properties produce at least a 6% cash-on-cash return.

Neither of us is necessarily wrong. He relies on his rental portfolio for income to pay his bills and other living expenses. It makes sense that he wants more cash flow. I take a more long-term view and focus on the potential for future equity appreciation and an income stream that grows over time. Since I don’t need current income from my portfolio, I’m willing to take on a bit more debt to maximize long-term appreciation and returns.

The analytical methods discussed here are pretty universal, and it’s up to you when it comes to cash flow, cash-on-cash return, or cap rate standards. Make sure that a deal makes sense for you, and that it’s better than the alternatives available in your target market, and you should be just fine.

Alchemist Insights

The richest people in the world have made their fortunes in many ways, but there is one common thread for many of them: They made real estate a core part of their investment strategy. Of all the ways the ultra-rich made their fortunes, real estate outpaced every other method 3 to 1.

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