How Much is that Investment Property Really Worth?
These days buying an investment property for appreciation is very long term speculation at best and reckless gambling at worst. Buying for cash flow is where it’s at. Buying a property that cash flows means future appreciation is just icing on the cake. The trick is buying the property right to begin with.
To make the numbers work, you have to start with the rent you expect to collect and work backwards. I invest in the Springfield, Ohio area so the type and quality of rental property I work with may be very different than where you are. Nevertheless, the basic principles are the same.
Calculating Vacancy Rate
The example I am going to use is a side by side double in the city of Springfield. I know that each side will rent for $450 a month – $900 total. The next question is, how many months out of the year can I expect to collect $900 a month? Leases are generally for one year at a time. The prudent plan is to assume that a tenant will move out after 12 months.
Sometimes, maybe 50% of the time, a tenant will stay on for another year. The other 50% of the time they will move out. What is the likelihood that a tenant will move out at say the end of November, and a new tenant will move in on December 1? Zero. What are the odds that a new tenant will move in on January 1? Better, but not something I would count on.
The reality is there will be at least two months at the end of every lease where the property is vacant or between tenants. Some consideration has to be made as well for the likelihood that a tenant will be unable to pay their rent due to job loss or some other unforeseen catastrophe. The prudent approach is to plan to collect rent for no more than 10 to 11 months of the year.
Collecting rent for 10 of 12 months yields a rent collected rate of 83%. Collecting 11 of 12 months yields a rent collected rate of 92%. I generally do my analysis assuming I will only collect 85% of potential rent over the course of the year. Or 10 of 12 months. I never plan to collect more than 90%.
So, I can expect to collect $900 a month, 85% of the time over the course of a given year. This means my planned annual income on the property is $9180. ($900 X 12 Months X .85%.)
Calculating Repairs and Maintenance
Let’s use a best case scenario to start with. A tenant stays two years and leaves the property in fair to good shape. Chances are there are some minor repairs to drains, ceiling fans, paint, wall patching, carpet repair and cleaning, and yard clean up that need to be done. Best case after two years these ‘easy’ fixes can total $500 to $1000.
What about furnaces, water heaters, roofs, new carpet, and basic items like changing furnace filters annually? What about the ‘perfect’ tenant that breaks their lease and leaves the unit a disaster? A major, ‘turn’ can run $2000+.
Repairs and upgrades are tricky things. Purchasing a house in great shape will cost more dollars up front, but cost less over the first three to five years of ownership. Purchasing a house with deferred maintenance will cost less up front, but mean that a greater amount of money every month has to be set aside for current and future repairs.
If we can expect to collect $450 a month on a single unit of a side by side double 10 months out of the year, what percentage of that must be set aside to cover repairs and maintenance? 10% of $4500 is $450. Will that cover the cost of repairs? It might, but a major ‘turn’ could run $1000 or over 20% of collected rent.
Remember, even if you plan to do the work yourself, your time is worth at least what you would pay someone else.
We budget 15% to 20% of collected rent to cover repairs on lower end properties and no less than 10% on any property. 15% of $9000 is $1350 or $112.50 a month over 12 months. As you can see, a new furnace could wipe out your repair budget causing you to bring outside money in to maintain the property. We want our properties to pay for themselves – so plan for the worst, hope for the best.
Other Expenses
Property taxes on our hypothetical double will run $100 a month. Insurance, roughly $45 a month. We generally mow the lawn on doubles so plan for $25 for seven or eight months annualized at $15 a month. Generally, doubles in our area have a common water meter so the landlord pays the water and sewer averaging another $40 a month. In Springfield, we pay $15 a unit for trash pick-up a month that may or may not be passed on to the tenant.
Other expenses can easily run $230 a month over 12 months totaling $2760 a year in fixed costs. This is roughly 30% of what we expect to collect in rent over the course of the year. ($2760 / $9180 = 30%.)
Property Management
At some point the need for professional property management arises. Depending on how many units you have and how much of the work you are able to do yourself, paying 10% of collected rent to a licensed real estate broker to ensure maximum occupancy is a smart move. 10% of $9180 in expected rent is $918 a year or $76.50 a month on average.
Remember, even if you are doing the work yourself, your time is worth at least 10% of collected rent.
Monthly Income and Expense Summary
Potential Rent Unit #1: $450
Potential Rent Unit #2: $450
Total: $900
Vacancy Reserve: ($135) (15%)
Repair Reserve: ($135) (15%)
Taxes: ($100)
Insurance: ($45)
Mowing: ($15)
Water / Sewer: ($40)
Trash Pickup: ($30)
Property Management ($76) (10% of collected rent)
Grand Total Expenses: ($576)
Monthly Cash Flow: $324.
Over the course of a year, we can expect this property to profit $3888. For the purposes of our example, I will round up to $4000.
How much is this property worth?
How much is a rental property worth, if we assume zero appreciation over the next three to five years that generates $4000 a year? Another way to look at the problem is what rate of return do you expect from your capital outlay? In real estate finance parlance, what cap rate (rate of return) do you require? 10%, 12%, 15%? The higher the cap rate desired means a lower purchase price assuming the annual cash flow is fixed.
To come up with a purchase price take the annual projected cash flow and divide it by the desired rate of return or cap rate:
$4000 / 10% = $40,000
$4000 / 12% = $33,000
$4000 / 15% = $26,666
If you think you will be able to raise the rents in the future, you may elect a higher purchase price, and a lower rate of immediate return in anticipation of better days ahead. Don’t get carried away however, increased rents implies appreciation, and we don’t what to bet on that.
I have a personal goal of 12.5%. So for me, this property would be worth $32,000.
I may be willing to pay more if the condition of the property warrants. If it needs a lot of work I have to pay less as I want no more than $32,000 in this hypothetical property.
What About Debt Service?
Everything we have done to this point assumes you are paying cash for the property. Debt service needs to come from the free cash flow of generated by the property. This is why debt service is the last consideration.
If I am willing to devote $300 a month of my $324 monthly positive cash flow to debt service, I can easily afford a mortgage of $32,000. This is based on 15 years at 7% – standard terms these days for investment property.
Chances are the bank will not finance the full amount of the purchase price. Assuming a purchase price of $32,000 (my goal – not necessarily reality) the bank will require at least 20% down or $6400. This leaves a mortgage amount of $25,600. With a 15 year amortization and 7% interest, the monthly note with principle and interest would be $230 a month. With an estimated monthly cash flow after expenses and reserves of $324, that is a comfortable monthly figure.
The key is, don’t let cheap money or an inflated appraisal dictate what a property is worth to you. Do the math and the homework necessary to find these deals.
Summary
Back in the day of cheap and easy money, many investors (myself included) fell into some bad traps and habits. For instance, just because you can buy a house with no money down does not mean that you should. Secondly, banks seldom, if ever, asked for vacancy or repair costs. Valuations were based on comparable sales and the assumption was made that appreciation would ultimately cure all ills. Cash flows were artificially supported by option ARM loans and adjustable rate mortgages. When the monthly payment went up, cash flow suffered.
The new ‘normal’ means that we have to do our homework and make our investments work in today’s market with today’s dollars. Applying the above ideas and formula will mean that you will have to consider more properties, in more depth, in order to find the ones that work – but when you do find the right property, the rewards will be worth the effort.
Do not let anyone tell you these deal do not exist. They are out there. As I have said many times over the last few months, there has never been a better time to be a real estate investor.
Chris McAllister is a real estate broker and investor in Springfield, Ohio. www.themcallisterteam.com He is co-author of _We Lost $1,000,000 In Real Estate in Less Than Five Years – And You Can Too! _ available at Amazon.com. Chris can be reached at Chris@RealEstate2.com.
