Locating Rental Properties
Areas to Target
When you go out on your hunt for rental property you must keep things in perspective. First of all, you are not going to live there, your tenants are. What you perceive as being acceptable may or may not be acceptable to them and vice versa. As a result, if you find yourself saying, “I could never live here, let’s go,” then you are already in trouble.
A good rental area may not be an area where you would live, but it may have some of the same characteristics such as the proximity to schools, shopping, bus service, parks, major highways, hospitals, police stations and fire houses. Generally speaking, it is good to be near schools and parks. It is also good to be close by shopping and transportation. While you don’t want to be miles and miles away from hospitals, police and fire protection you also don’t want to be only a block away from them either. You do not want to be too close to industrial sites, directly behind shopping centers or storage facilities.
How to Find the Right Neighborhood
Focus on where you will get the best return on Investment (ROI)
By now, I’m sure you have questions and maybe even concerns. If so, please call me at 1-800-931-2605 or email Gary@WinReatyAdvisors.com. You can also learn more by visiting MyInvestmentServices.com
Fear not. Millions of others have walked your path before. Here is a brief explanation of the different socio-economic classes of neighborhoods. You may be surprised to know that there are rentals in all of these areas including luxury high end.
Low income neighborhoods usually work well as rental neighborhoods. Notice I did not say bad neighborhoods, I said lower class. What I mean by that is lower on the socio-economic scale.
If you would like to learn more about this process, please call me at 1-800-931-2605 or email Gary@WinReatyAdvisors.com. You can also learn more by visiting MyInvestmentServices.com
Analyzing Rental Properties
The first and most critical research to perform is the financial analysis. The first ratio is that when you add the cost of purchasing a property to the cost of rehabbing a property the total of these two costs must not exceed 70% of the After Repair Value (ARV) of the subject property. This is the minimum acceptable ratio. The less money you have in purchase and rehab costs relative to ARV the better.
Financial Analysis – The following is an example of a property I owned and sold to a fellow investor. I actually sold it for $65,000.00 so it was an even better deal. Let’s take a look and break it down.
3834 Brighton: Large up and down duplex with, new and separate G + E and new furnaces. Tenants pay G + E, I pay water. Residential neighborhood. List for 79,900
Income: 1125/mo ( 1st fl 1 bedr = 450, 2nf + 3rd fl 3 bedr = 625, garage = 75) = 13,800 yr
Water: 1388.50/yr ( includes sewage and garbage )
Net Operating Income: 899.46/mo = 10,793.54 yr
Purchase price: 70,000, Down payment: 14,000
Loan: 56,000, 20 yrs, 5 %
Debt Service: 369.58/mo
Cash return: 529.88/mo = 6358.56/yr
Cash on Cash return rate = 45%, Cap Rate = 15.4%
Notice that I provide the gross income first. Then I give the basic routine expenses of the property on an annual basis. Then I provide the net operating income (NOI). This format follows closely the IRS Schedule E format. This is for a very good reason. It is a pretty good format to use when analyzing properties and it is also in the format the tax accountants and the IRS use.
After the NOI, I provide a projected financing scenario based on the current lending environment. The terms may change with the economy but the math is the same. This gives a prospective investor a pretty good picture of what to expect. It also allows me to project income on a cash basis and the cash on cash ratio. The cash on cash ratio is the cash income after all expenses plus debt service (loan payment of principle and interest) divided by the capital outlay to purchase the property (down payment or out of pocket cost to acquire the property). This ratio is what you can use to compare to returns on other types of investments like stocks and bonds. This to me is one of the most important ratios to look at when analyzing a property.
The next important ratio is the capitalization (CAP) rate. The cap rate is the NOI divided by the total purchase price (down payment plus principle amount of any loan) or sales price of the property. In this ratio debt service is not factored in. So, the NOI is used before debt service is paid for. The CAP rate is the industry standard for evaluating a property particularly from a lender’s perspective. It is used to compare properties against each other. CAP rate also reflects the relative risk of a property. So a property that has a high CAP rate may be in a less desirable neighborhood and naturally a low cap rate may reflect a property in a good neighborhood. The CAP rate is an inverse ratio. In other words, the lower the cap rate the more expensive the property and the higher the CAP rate the less expensive the property. I suggest you get used to using both ratios. I personally put more emphasis on the cash on cash return because cash is king and I want to know how much is coming in and how much is going out to get the cash coming in.
Here is another way to view cash flow analysis:
Cash flow Worksheet
Maintenance and Repairs:
Net Operating Income (NOI) = Gross Rent – Expenses
Cash flow = NOI – Mortgage Payment
Cash flow Formula: Rent – Expenses = Cash flow
Gross Rent – The highest amount you can get monthly from the property.
Expenses – The total amount of necessary payments for the property.
Cash flow – The amount of money you pocket after all expenses and mortgage payments are paid from the rent.
If I like the return I next have to determine if I like the property itself from a physical perspective.
Physical Analysis – Once you have identified properties is priced at or below market value for the neighborhoods they are in and with negotiating you can get the prices down even further (more on this later) it is time to do the physical inspection (after you do drive-bys) of the property to determine what is needed for rehab and how much it is going to cost.
Making Offers on Rentals
This is where the rubber meets the road.
You have come a long way and now it is time to make the offer. You should not violate the maximum allowable offer (MAO). If you trespass beyond this line you will be tempting fate and less profit. The MAO is the most you should offer for a property. MAO is the ARV of the property less your 30% profit margin, then less your rehab costs. So, if you have a property with an ARV of $100,000.00, and subtract the 30% profit margin, that leaves $70,000.00. Then if your rehab costs are $20,000.00 you subtract that from $70,000.00 to arrive at an ARV of $50,000.00. I suggest starting out offering less than $50,000.00. Depending on the market I would offer from 5-20% less than the MAO. In a market where there is a lot of inventory I would offer as much as 20% less than MAO, $40,000.00 in this case. In a market of tight inventory I would offer 5% less than the MAO or $47,500.00 in this case. ARV is arrived at by looking at comparable sales, comps, from the area. Either you or your realtor needs to be the expert in the area in which you are investing. I cannot emphasize how important this value is. If you project too low your offer will not get accepted. If you project too high then you risk paying too much for the property. You have to get it right. Period. The following is a chart you can use in your efforts:
Maximum Allowable Offer (MAO)
Less Costs (30%):
Starting Offer (MAO less 15%):
Formula: ARV – 30% – Repairs = MAO
ARV – After Repair Value. This number is derived from Comps, CMA’s, and other appraisal tools.
Costs – These are the costs to get into (and sometimes out of) the property. The table below depicts the cost breakdown. Costs average around 10% and include commissions to real estate agents, carrying costs and closing costs.
Repairs – These are the estimated repairs. Use the supplied Rehab Worksheet to get your initial estimate.
MAO – Maximum Allowable Offer. This is the theoretical maximum you can pay and NOT leave any of your money in the deal after refinancing. This is NOT a requirement to do a deal, however what is acceptable to leave in will be different for everyone depending on your own cash flow and financial ability.
Starting MAO – Get this number by subtracting another 15% from your MAO. This is a decent starting point to begin your negotiations. If you get no counter offers at starting MAO, you will need to increase your initial offer. Market conditions will always impact starting MAO.
Before going over the forms to use let’s look at a plan for you to follow when going on your hunt:
Instructions for new Win Realty Advisor students – rentals
This is the exact plan I followed when I made all of my investments. It is the plan I used when teaching several hundred students and it is the plan I follow when I teach real estate agents how to work with investors. It is a good plan. Follow it.
1. First we will have a telephone conversation to go over goals. At this point you need to have available cash or credit to continue .
2. Send in email to me: your name, email address, and phone number.
3. I will set up your search criteria on the MLS system.
4. Initially you will get an email with a link to the MLS system. The first property matching the search criteria will be shown with a drop-down box at bottom left allowing you to scan forward to other listings. You will be receiving the “FULL” listings. This first email will consist of several hundred listings.
5. Next, you will separate the good from the bad. Your objective is to narrow the list down to about 30 properties. You do this by comparing the list price to the market values for the area. The list price should be below the market value. Also, look at the photograph(s) of the property, the lot size, room sizes, and other characteristics of the property. This will take a few passes of the listings. As you narrow the list down also use the county web site for further research. This is a process that you will get better at with experience.
– For multi units my experience shows me that I should get $400-500 for 1-bedroom apartments, $450-650 for 2-bedroom apartments, $600-750 for 3-bedroom apartments. Taxes can be obtained from the listings. Insurance should be 0.5% of value annually ($100,000 property is $500 per year). I try to keep price per unit to $35,000 or less per 3-bedroom unit, $30,000 or less per 2-bedroom units, $25,000 or less per 1-bedroom unit. *NOTE: different areas will have vastly different models. Study your area and make adjustments accordingly*
– There are variables here like the condition of the property (turn-key verses rehab).
– Trust your instincts to focus on what you think are better deals and eliminate the rest.
– You will get better with experience and I will be guiding you.
6. The resulting list of 30 or so properties is your drive by list. Now you will drive by the properties to further narrow your search down to 10 to 15 properties.
7. At this point you will email to me the MLS #’s (in a string separated by commas) of these 10 to 15 properties. At this point I will review your homework and narrow the list down further. I will make notes to show you my work. This will typically result in 7 final properties.
8. Now we will schedule an appointment to go see the properties.
9. After viewing the properties you should have a list of 4 to 7 properties that you will fill out the MAO, CASHFLOW and cost sheets for.
10. I will review this work and with my help you will decide which properties to make offers on.
11. We will fill out the sales agreement, make a photocopy of your hand money check, and provide both with your proof of funds to me. I will provide comps to verify your ARV(s).
12. Now we make the offer(s) !
As you can see, in the way I teach investors and the Real Estate agents who work with them, most of the work is performed by the investor! You get a commission when they buy the property and they are repeat customers. You also can get the commission when they sell their rentals. You can even earn money by managing their rentals. What’s not to like?
To really grasp this process I recommend you take the accompanying training course for buying rental properties. To learn how Please call me at 1-800-931-2605 or email Gary@WinReatyAdvisors.com. You can also learn more by visiting MyInvestmentServices.com.
Written by Gary Wilson, June 11, 2014