Author Topic: Yet another First rental question - check my math  (Read 3793 times)

mrshudson

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Yet another First rental question - check my math
« on: January 17, 2015, 03:39:03 PM »
First post after lurking here for months. By way of background, our current savings rate is around 60% of take home pay. Could use some improvement. Spouse and I are in good steady, high paying jobs. Both of us are engineering doctorates, so reasonably good at math. :)

We came across an investment property that is currently asking $295,000. It's a duplex with ~ 2600 sqft, 2 car garage, 1950s construction. The rent is $2200 ($1100 per unit), and the area is a high-demand one because of proximity to several college campuses, downtown, transit (new light rail), and close to everything with a high walkscore. Properties in the area seem to go for about 77% of the listing price. Long-term tenants, with one tenant living in the area for over 10 years. We've lived as tenants in the area in the past, and properties do get rented pretty quickly. The owner seems to have done the following repairs/updates:

High Efficiency Furnaces installed in 2011
Property reinsulated with R19 used in all walls and R49 in the roof
Weather stripping added to all windows throughout property
Updated electrical to 100 amp circuit breakers
Roof Replaced in 2008

We are cautiously interested in this property. If we plan to make an offer, it would be no more than $230,000 (max) based on comps in the area (more on that in a minute). If we do end up buying, we would plan to put 25% down. Lender quotes investment property mortgages of 3.625% for a 15 year mortgage. With taxes and insurance, the monthly payment would work out to about $1750.

The owner's (does not live there) current expenses:
Taxes: $325 monthly
Insurance: $87 Monthly
Water/Sewer/Garbage: $125 monthly

We are currently living about 35 miles from that area. But we like the neighborhood enough that eventually want to move there (after 8-10 years) after reasonably close to FIRE (unable to move now because of job situation). If we do, we might wind up living in one and renting out the other. Our philosophy has been that we're having our tenants pay our mortgage until we're ready to move in.   

Assuming we'd hold the rents somewhat steady (not raising the rent unless the tenants move out), does this seem like a good investment? My estimates lead to about 7-8%, yield potential once paid off. In other words, comparable yield to low cost index funds over a long period of time. No real ROI incentive over stocks/index funds. A decent incentive is the diversification of portfolio. Can assume property to appreciate and rents to increase at about the same rate as inflation.

Now, on the comps. Only a couple of rental properties in our comps. The rest are just regular single family homes, and somewhat skew the estimate to a higher price. Tax estimate is based on a home value of about $180,000. Unless we do an appraisal, we probably don't have a good estimate to base our offer price on so we're relying on the fact that properties sell at 77% of listing price in the area, 1% rule and comps, while considering all the repairs/updates seller recently did.

Would you consider or pass this property? Appreciate any insights.

iamlindoro

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Re: Yet another First rental question - check my math
« Reply #1 on: January 17, 2015, 04:15:16 PM »
Here is my analysis with the following assumptions:

$230,000 purchase price
$4,000 closing costs
25% downpayment
3.625% interest rate
15 year mortgage
$2,200 monthly rent
10% vacancy rate
$3900 Annual property taxes (325 * 12)
$1044 Annual insurance (87 * 12)
$1500 annual utilities (125 * 12)
$2300 annual expenses

So, I get:

$26400 - $2640 vacancy = 23760 Gross Income
- $8744 Annual Expenses
- $14925 Mortgage
-----------------------

$91 Annual cash flow (~$7.58 a month)

So, a %0.15 cash ROI, which would be a big-time no-go for me.

What I usually see when the numbers look like this is a counter of:

* No way will it be vacant that much
* No way will it have that many expenses
* I'm in it for the appreciation

I personally don't see any of these as valid arguments.  You simply *must* budget for 8-10% vacancy and a few K a year in expenses/maintenance, because eventually you WILL get a bum tenant, a long vacancy, lost rents due to uncovered damage, or something outside your control.  Eventually a roof will leak or a boiler go out.  They WILL happen and they'll exceed a single year's budget for maintenance/vacancy.  Lots of places have properties that survive and thrive when budgeting for these items, so there's no reason to buy a property where you have to rely on the best case scenarios.

So anyway, I'd pass.

mrshudson

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Re: Yet another First rental question - check my math
« Reply #2 on: January 17, 2015, 04:17:36 PM »
Thanks for confirming - that's what I thought too.

iamlindoro

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Re: Yet another First rental question - check my math
« Reply #3 on: January 17, 2015, 04:24:23 PM »
No problem!  Maybe there's something in the area that's a little more distressed?  Could you find something with the same or similar layout that needs to be gutted for ~100-120K and spend $20-30K on the renovation?  That would start to make the numbers (assuming everything else were the same) pretty nice indeed.

marty998

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Re: Yet another First rental question - check my math
« Reply #4 on: January 17, 2015, 04:25:24 PM »
Ahh, no.

Do not count the mortgage repayment as an expense.

Count the interest, but not the principal repayment. Principal is essentially building equity (which in turn then lowers your return on equity)
Here is my analysis with the following assumptions:


So, I get:

$26400 - $2640 vacancy = 23760 Gross Income
- $8744 Annual Expenses
- $14925 Mortgage
-----------------------

$91 Annual cash flow (~$7.58 a month)

So, a %0.15 cash ROI, which would be a big-time no-go for me.


iamlindoro

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Re: Yet another First rental question - check my math
« Reply #5 on: January 17, 2015, 04:32:33 PM »
Ahh, no.

Do not count the mortgage repayment as an expense.

Count the interest, but not the principal repayment. Principal is essentially building equity (which in turn then lowers your return on equity)
Here is my analysis with the following assumptions:


So, I get:

$26400 - $2640 vacancy = 23760 Gross Income
- $8744 Annual Expenses
- $14925 Mortgage
-----------------------

$91 Annual cash flow (~$7.58 a month)

So, a %0.15 cash ROI, which would be a big-time no-go for me.


You count the entire mortgage if you are calculating the *cash* ROI, which is what I did.  I understand that the real estate environment in Australia is different, but generally speaking here in the states we invest for cash flow.  Equity is good, but it is not realized income until the property is sold.  Again, we have tons and tons of places where you can have your mortgage paid by tenants *and* cash flow a few hundred bucks per month per unit.  There is little excuse only to invest to build equity when the same investment could be building the same amount of equity and producing income.

SaintM

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Re: Yet another First rental question - check my math
« Reply #6 on: January 17, 2015, 06:40:03 PM »
What about a 30-year loan to increase positive cash flow?

iamlindoro

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Re: Yet another First rental question - check my math
« Reply #7 on: January 17, 2015, 06:59:02 PM »
Yeah, a 30 year mortgage would help.  The interest rate would rise (I'm using 4.5% for the test calculation).  It's possible you could get away with 20% down, too.

With those variables changed, the cash ROI becomes 7.66% ($319/mo, though the property still doesn't hit the 1% rule) and the total ROI in year one becomes 13.59%.  To me it still wouldn't be a very appealing investment, but I would definitely take the longer mortgage were I dead set on the property.

mrshudson

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Re: Yet another First rental question - check my math
« Reply #8 on: January 17, 2015, 11:16:03 PM »
Okay, so here's a comparison: would additional cash flow from a 30 yr mortgage, when reinvested say in low cost index funds grow to an amount that justifies the additional interest paid as a result of the longer term and the higher interest rate? For the above scenario

30 yr mortgage at 4.25%: total interest paid = $123,974.90
15 yr mortgage at 3.625%: total interest paid = $51,381.91

Assuming about $300/mo in positive cash flow with a 30 year mortgage, when invested returns $391,759.91 at the end of 30 years  assuming 7% returns.
However, if the investment property is paid of at 15 years, and all net cash flow thereafter (i.e., ~ $15000) is reinvested would return $400,083.87 at the end of 15 years assuming 7% compounding.

So if I were to go with the 15 year mortgage and pay off early, and reinvest all of the net rental income, I'd end up with about $9000 (at the end of 30 years) more than the scenario involving 30 yr mortgage and reinvesting the positive cash flow AND save about $70,000 interest paid.  Net gain of about $80,000 possible if settling for the shorter mortgage.

And no, we're not looking for immediate cash flow. Our goal is to a) somewhat diversify; b) steady source of income in FIRE even accounting for a decent vacancy rate.

I'm still not too excited about it - it's been sitting on the market for 90+ days, and ROI doesn't seem to beat the stock market, so our only goal would be diversify. Seller doesn't appear too motivated, and we're in two minds about putting in a low-ball offer (about 78% of asking price, even though that's how much properties in the area seem to go for).

Thanks for the analysis. 

Mazzinator

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Re: Yet another First rental question - check my math
« Reply #9 on: January 26, 2015, 12:47:48 AM »
Why does it matter how much interest you're paying? (Not trying to be snarky, i just don't understand) aren't you counting it twice?

Also, i think you can deduct the mortgage interest, as an expense, from your rental income, which could lower your income taxes. (Schedule e)

Thanks!!

I ask because we are in a similar boat...
Quote
And no, we're not looking for immediate cash flow. Our goal is to a) somewhat diversify; b) steady source of income in FIRE even accounting for a decent vacancy rate.
« Last Edit: January 26, 2015, 12:54:16 AM by Mazzinator »

Fishingmn

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Re: Yet another First rental question - check my math
« Reply #10 on: January 26, 2015, 09:29:35 AM »
There's no reason you "must budget for 8-10% vacancy".

It really should depend on your market and how much in demand that particular type of unit will be.

I've been a landlord for 5 years - 11 units. The most I've ever had is 1-2% vacancy (some years none). Certainly your risks go up the fewer number of units you have but at least in our market the whole Twin Cities is extremely easy to find tenants.

That said, not sure the numbers work on this one. On a financed deal I'd walk unless I was getting at least a 10% return and ideally closer to 15%.

FarmerPete

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Re: Yet another First rental question - check my math
« Reply #11 on: January 26, 2015, 09:51:23 AM »
There's no reason you "must budget for 8-10% vacancy".

It really should depend on your market and how much in demand that particular type of unit will be.

I've been a landlord for 5 years - 11 units. The most I've ever had is 1-2% vacancy (some years none). Certainly your risks go up the fewer number of units you have but at least in our market the whole Twin Cities is extremely easy to find tenants.

That said, not sure the numbers work on this one. On a financed deal I'd walk unless I was getting at least a 10% return and ideally closer to 15%.

If you removed vacancy from the equation completely (a bad idea IMHO), you'd be looking at cash flow of ~$2700 a year.  That's assuming absolutely nothing goes wrong and the units are never empty.  Seems like a bad deal to me.  Are you sure you can't charge more for rent?  Either the building is over priced or the rent it too low.

Fishingmn

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Re: Yet another First rental question - check my math
« Reply #12 on: January 27, 2015, 08:45:10 AM »
I'm not advocating budgeting for 0%.

I started out budgeting for 5% and now budget for 3% even though even that's high. When analyzing a deal though I'd never assume less than 3 and probably would plug in 5.