My sister recently went to look at a potential investment property. This visit was followed by a note in my inbox asking for my thoughts on the property. In my opinion, evaluating a property for potential investment can be decided mostly by numbers, but the final key piece of the puzzle requires the property to be evaluated based on curb appeal. Some properties fail the numbers test, and are immediately discarded, while some pass the numbers test but fail the curb appeal, and finally some properties pass both examinations, and are then added to the real estate portfolio.
First, lets examine the numbers. (All are based on the actual property she is considering)
The two big numbers to start with are the asking price and the projected rent. The projected rent should be a least 1% of the asking price, or at least 1% of what you would be willing to pay.
Example: 100,000 property = rent of 1,000 / month.
If the property passes this test, we can continue with our evaluation. The next step is to examine the taxes and insurance costs. Taxes vary wildly from location to location, and in my area, they can vary widely from house to house on the same street. I like to break the tax out to a monthly cost even though its usually only paid once or twice per year.
Example: 3,000 total tax bill / 12 = 250 / month
I do the same for insurance, except you must estimate this cost. You could get an estimate by calling an insurance agent or two, using online tools, or estimate based on previous experience. Older homes will often have a higher insurance cost, because of the types of materials (brick / stone) they were built with are much more expensive today.
Example: 500 insurance / 12 = 42 / month
Next, since you plan to rent the property, you will need to consider the utilities, and if you will pay for any of them. This is often influenced by the local rental market, and can vary depending on other landlords in the area. In my location, I pay for the trash, and the tenants pay for everything else; water/sewer, electric, and gas or oil. The water bill is a bit tricky, as the property owner is responsible for any unpaid water balance. Therefore, I keep the water bill in my name, and have the tenants reimburse me, this is a bit more work, but it prevents the ugly situation in which a bill goes unpaid, incurs large fees, and then the tenant moves out leaving me with the bill.
Example trash: 205 year / 12 = 17 / month
I now calculate the principle and interest payments, which are going to be influenced by the amount of your down payment, and the interest rate. Typically an investment property requires a 25% down payment and the interest rate will be slightly higher then your primary residence.
Example: 100,000 property = 75,000 loan @ 4.5% interest = 380 / month
So far, things are clear and easy, either the numbers are working in your favor, or the expenses are adding up to more then the expected rent. But, now things are about to get muddy. We still haven’t calculated for repairs and vacancy rates. Some say to budget 1% of the purchase price for repairs each year, but I don’t put to much stock in that estimate, as a water heater costs the same regardless of the cost of the property, so I don’t think those numbers are really related. Also, do you plan to fix anything yourself, or are you going to call a repair man to fix everything? As for vacancy rates, they are tough to predict until you have experience and multiple properties. I’ve owned two properties since 2012, one is still lived in by the original tenant, while the other is on the 3rd, but the current tenants have been there since 2014. As this demonstrated, turnover can vary wildly, and when only starting out with a few properties, this isn’t something that can easily be averaged out and fit neatly into a budget. I simply recommend that a beginning investor keeps an emergency fund worth 3-6 months of expenses, this should cover anything that pops up, but also allows you to move on once this level is reached.
Lets add up the monthly costs:
Mortgage 380 + Taxes 250 + Insurance 42 + Utilities 17 = 689
Projected Rent Range: 950 – 689 = 261
1100 – 689 = 411
Your potential monthly cash flow with this example is between 261 and 411 per month.
So the property passed the numbers test, it will have a positive monthly cash flow, so why not buy it? The second part of our analysis is harder to quantify, but is equally important. I start this analysis with a simple question, would I be willing to live in the property at this location?
If not, then I wouldn’t buy the property.
If I would be willing to live there, I now do some further analysis concerning the properties size and location. How many bedrooms does it have? How will that affect my potential tenant pool, and do I really want a 6 bedroom house filled with a huge family and the corresponding wear and tear? Is there off-street parking or easy access to main roads, schools, and stores? Is the neighborhood stable, increasing or decreasing in value? Can I make a educated guess as to its future direction?
Some of these questions are easy to answer, while some offer no clear response. I try to go for walks or since I’m a runner, runs around the neighborhood. I try to do this on different days and at different times in order to get a feel for the surroundings. Is the area clean? Are there any businesses or new construction? Are the people I meet friendly and respectful? All this information will create a feel for the area, and it will help you to visualize who your potential tenants might be. At this point, it is either time to put up or shut up. Buy the property, or move on. Property can always be sold, so if you make a mistake, count it as a learning opportunity, that hopefully wasn’t to expensive, avoid making an emotional connection, and move on, putting your newfound knowledge to work on your next deal.