I am still learning, just like everyone else. Relative to several of the veteran landlords here, I am a rank amateur. However, I've done a few deals now, made a few mistakes, and hopefully learned something from them. I have a few cash flowing properties, and each has been more successful than the last as I raise my standards, learn how to anticipate some of the trouble areas, and most of all, have greater confidence in my ability to oversee all aspects of a deal. I figured I would share how I am currently evaluating deals and it may help some people. Discussion of my analysis may also help me to learn some things and get even better outcomes in the future.
On this forum, we frequently get questions about whether or not a given property is a "good rental." Though this is a highly subjective question, many rentals people consider are virtually guaranteed losers. This is usually because people fail to consider all the possible costs of buying and owning a rental, and/or because they are overly optimistic about vacancies, repairs, etc.
And now for some assumptions: My own real estate investment strategy is buy and hold for cash flow. The goal is to build a steady stream of income that compliments the safe withdrawal rate from my stock and bond portfolio. Thus, my analysis makes bottom-line cash ROI the most important factor versus appreciation. That is not to say that quality of neighborhood, tenant, and prospects for the city aren't just as important-- they're just things that I consider before I ever get to evaluating the raw numbers. I'm a California resident and have found that the best deals in my price range are out of state, even after accounting for property management.
My analysis spreadsheet is based on the J Scott Single Family Home analysis spreadsheet on biggerpockets. Here's a link to that:http://www.biggerpockets.com/files/user/JasonScott/file/20-sfh-rental-analysis
I've uploaded my modified version, which corrects a few Excel issues with the original, and enhances it somewhat to allow for evaluating duplex/triplex/small multifamily units. I've put it on Google Sheets and all the formulas seem to have made the leap properly. The version I put there contains real numbers for a property I'm in contract on in the city of Cleveland, Ohio. This version also has some tweaks that are specific to the area/property management but if you decide to use my copy as a basis for your own, it should be pretty easy to figure out.https://docs.google.com/spreadsheets/d/10XGrJTyn-xDbPulj9t3STtshNd3Clx-2Ck1XQbLwd0w/edit?usp=sharing
The sale price is $65,000. It's a 2/1-per-unit duplex located in a C+ neighborhood with somewhat below standard schools. The average household income for this part of the ZIP code is approximately $40K. The unit was priced too low for the market and was pending within 24 hours of being on the market. That deal fell through and I moved on it quickly. The duplex is in above-average condition for the neighborhood and will rent for approximately 650 per unit.
Now, let's start plugging in numbers I feel comfortable with. Again, these are my actual numbers. You could do better/worse/differently with more exotic financing, but these are fairly standard, which may help those with no idea what to expect.The NumbersDownpayment %
: Because this will be an investor mortgage on a multifamily, I will need to put down 25%. Fannie Mae requires that investor + multifamily be 25% through the first five financed properties. It's 20% on single family for investors. Thus, my downpayment amount is $16,250. Interest Rate
: Also because it is a investor mortgage, the interest rates are slightly higher than consumer. The rate I'm getting on this property is 4.65%. Roughly in the same ballpark I've gotten on my last few properties. My middle credit score is a 750 or so.Improvements
: Any improvement needed to get the property ready for rental. Remember, the goal is to be in good, safe, and clean condition, with amenities appropriate for the neighborhood
, not amenities which you would demand for your own home. Initial forecasts for improvements were conservatively $1000. After the inspection, I learned that there are some electrical issues needing repair (missing grounds and a few knob-and-tube issues) so that has been revised to $2500. This is an up front cost that I will incur shortly after closing.Closing Costs
: I paid $349 for the inspection, and the expected costs to close the financing are currently $2966, which includes the escrow of the first few months of taxes and insurance. This property's taxes are lower than originally expected, so this number will come down slightly.Per-unit market rent
: This will be $650 per unit. This is on the medium-high end of average for the neighborhood, which is justified by the extremely good condition of the property. Median rent in the area is about $612. Don't delude yourself about rents if you don't know the area! At *least* use rentometer, check Zillow and Craigslist for rentals, and get somewhere in the ballpark. I'm satisfied that $650 should be possible, but the numbers are still good enough if I have to go to $625. $615 is the bottom I would be happy with and shouldn't be necessary. Try the whole range of possible rents and make sure it still works. A unit in the same floorplan two doors down is on the market for $750 a month right now.Vacancy/Loss Rate
: Set at 10%. Average vacancy for the area is 4-5%, but I prefer to estimate high and use any extra income from low vacancy to fill reserves quicker. This is one of the areas that I consistently see people underestimate. There are always hand-wavy arguments about how "the market is really tight in the area" or "it seems like everything fills up quick around here." It costs you nothing to estimate conservatively. At worst, you might pass on a deal that could be good but falls on the wrong side of the bubble because of being too conservative. At best, you only pick the cream of the crop because of high (but not unrealistically high) standards.Property Taxes
: $1551 per year currently for this unit. Cleveland taxes are normally very high, but this area has ~25% lower taxes than some of the others I have considered.Insurance
: $904/year. This is 1 million in liability coverage, full replacement value, DF1 insurance. The deductibles on repair/replace are $2500. I knew about what I wanted to spend on insurance, so went back to the insurance broker 4 times to get adequate liability (first quote was 300K), adequate property value (first was 53K) and a higher deductible (first was the lowest/most profitable for the company). The DF1 policy covers fire/wind/smoke, but excludes things like flood, war, etc. Maintenance and Repairs
: 1% of property value for year is my estimate, so $650. This is one area where I may not be conservative enough, but I hope for my conservative estimates elsewhere to help provide some margin for error. I also have income from other properties that can help compensate for unexpected high expenses.Property Management
: The property management is 10%. You may want to manage your own property, but for a variety of reasons I believe it's best to build it into the budget anyway. You may want/need to move. You may want to travel long term in retirement. You may become disabled. Again, the only risk in being too conservative is that you pass on a deal that might otherwise have been profitable. Don't be a motivated buyer.Annual re-leasing fee/tenant placement
: This is another critical element to consider if you will be using property management. Many/most property managers charge you something, often half or all of the first month's rent, to place a tenant. This is a large percentage of your cash flow if you turn over tenants too frequently. As our friend NoNonsenseLandlord consistently reminds us, the most important thing you can do is place quality tenants. If you're turning over tenants every year, or more often, something is wrong and it's going to eat even the best profitable-on-paper deal alive. This property manager charges the full first month's rent to place a tenant. I am wary of this as I pay half a month elsewhere, but I have been frank about my expectations and made it clear that if I see a pattern of poor tenants, they will lose my business quickly. $1300 for the first year, with an expected one turnover per year after that. This should be an overly conservative estimate with good tenants (and being a good landlord).Annual Inspection
: Read your property management agreement! You need to account for every cost. The PM offers an optional annual service to change air filters, inspect appliances, smoke detectors, radon detectors, change batteries, and do some light maintenance. I'll probably use it, so it's on the budget. $130.Sewer Service
: What utilities is the landlord obliged to pay? How much do they cost on average? Cleveland landlords must pay water and sewer, though there is some gray area about whether they can charge them if the amount is "excessive." $800 per year per unit for water and sewer is average. If it's too much beyond this, I'll bill the tenant. I will be putting this in the lease.Water Service
: See above, same deal.Lawn Care
: Code enforcement requires trimmed lawns and at a duplex, the landlord is responsible. Lawn service twice a month for seven months out of the year will run $66.Putting It All Together
Let's see how it stacks up against the 1%/2% rule:
65000 (purchase price) + 2500 (improvements) + 3315 (financing/inspection costs) = $70,815 Total Cost
(1300 rent * 12) * .9 (estimated vacancy) = 14040
(($14040/12) / 70815) * 100 = 1.652%
Nice! Now let's do a more detailed analysis.
Accounting for all these costs, which are quite a bit higher than some areas, the total annual expenses in year 1 are $8000 even. Accounting for vacancy, the rents are $14040. Thus, the Net Operating Income (NOI) is $6040. After mortgage ($3008), the cash flow is $3032, for a cash ROI of 13.74% with a fairly conservative analysis. Throw in the equity gained and the total ROI is 17.23%.The Cash Flow
The monthly cash flow with all of these assumptions is $253. I'm personally looking for about $100 per month in cashflow per $10,000 of my own money invested, which this meets. I'm very happy with this deal. If any one of the very conservative variables tips in my favor, I'll fill my reserves that much faster.What if it all goes right?
The temptation would be high to see greater than the $253 "safe" cash flow coming in and to use it for something. Resist! Vacancy will come. A roof replacement will come. There will come a day when I have filled my reserves so much that I can start to skim off a little more cash flow, but that day is still far off.
My current plan reinvests all the cash flow in future properties. I'm buying 2-3 a year for the next 5 years. This will be a serious pull-up for the first two years, after which the cash flow starts buying properties for me almost as fast as I can on my own.What if it all goes wrong?
Hopefully my conservative estimates give me breathing room if it does, but if not, I have 6 months of PITI for each property just in case right from closing.
Anyway, just thought I would throw this out there. Maybe it will help people to think of some of the variables that don't immediately occur to them when considering getting into Real Estate Investment. I continue to learn as I go, but feel like I'm starting to have some confidence and I'm having a lot of fun-- all while making money. :)