Investing in Real Estate Part 2: Analyzing Rental Property: Welcome to Part 2 of our series on how to invest in real estate! Part 1 was focused on the two most commonly invested in property types for new investors – single family homes and multi-family homes. After we discussed property types and knowing what options are out there – it’s time to make a decision. What type of property will you be going after? Once you decide, you can move on to the next step.
Analyzing Rental Property Step 1: Pick your area and begin to research.
- Prices: Research is key. Begin to look at your desired market. Whether it’s local or distant, that doesn’t matter. Begin to look for trends, average prices, etc. You might begin to notice that certain property types fall into a certain range (example: 3 bed / 2 bathroom houses in your area sells for $120,000 to $150,000). Having this mental marker of a price range allows you to notice if a property falls below that range. If a property falls below your researched range, it could be something to research further. Having a good handle on the average prices on a property gives you insight into something called After Repair Value or ARV for short. After repair value is the anticipated value of the property once it is updated and in good repair.
- Rents: For the buy and hold crowd, this is the next step. In order for a property to work as an investment, the rents must be higher than the expenses. Before we can go any further, begin to look for how much a property of this type would rent for. The ways you can do this are:
- Research on Zillow, Trulia, etc
- Consider browsing Craigslist in your area
- Research on Rentometer
- Contact a Real Estate agent familiar to that area and ask for “Rental Comps” (Rental Comparibles) for that property type
The 1% rule
A very general rule of thumb when analyzing rental property is something to look into further is what is called the 1% rule. The 1% rule means that the total rent amount should be 1% of the purchase price of the home. An example would be: A property worth $100,000 should rent for $1,000 to be considered a viable deal. Now, this percentage is flexible, you may see properties where the rents are 1.5% or even 2% of the purchase price, which is great.
If you’ve found a property that makes sense for the “1%” (or greater) rule – awesome! Time to move on. If not, keep looking. If the property doesn’t meet the 1% rule, chances are it will have a difficult time covering all your expenses. This is a numbers game, and eventually, a deal will emerge.
Analyzing Rental Property Step 2: Collect additional data
Now we have a property that might be a deal. Time to collect additional information to make an intelligent analysis. Begin to dig a little further and find out the following:
- Financing – if you’re going to have a mortgage on this property, most companies will only lend on 75-80% of the value, meaning you will need to come up with the other 20-25% for your down payment. Using a mortgage calculator, you can plug in the interest rate, amount to finance and length of loan and find out your anticipated mortgage payment.
- Taxes – Find out what the property taxes are for this home. Take this total number and divide by 12 (12 months in a year) – this is your anticipated monthly tax amount.
- HOA dues – Home owner associations are a common arrangement in developments. According to Investopedia, an HOA is “A homeowners association (HOA) is an organization in a subdivision, planned community or condominium that makes and enforces rules for the properties within its jurisdiction.”Without getting too far into the rabbit hole here – find out how much the monthly HOA dues are.
- If you don’t have an HOA on the property you’re looking it – awesome!
- Caution: HOAs don’t just have their association dues. When analyzing rental property you sometimes need to account for “special assessments” that will be charged to the community members. These can be expensive!
- Home owner’s insurance – Insurance, even for a rental – is very important. Always protect your investment!
- Other expenses – electricity, gas, water/sewer. For the sake of clarity, we’re going to say the tenant will be paying them.
Analyzing Rental Property Step 3: Calculate!
Now that we have our data, we can begin to see if this deal is really a deal. Let’s say for example you have a property that has rental comps for $1500 and the After Repair Value (ARV) is $150,000. We put down 25% (or $37,500), meaning our mortgaged amount is $112,500. Using a mortgage calculator easily found online, we can plug in amounts and rates and find our answer. Currently, for a 30 year fixed rate mortgage at 5% on $112,500 our payment is $603.92.
Now lets say our taxes for $4,000 per year. Divided by 12, the monthly taxes are $333.33.
Home owner’s insurance for the year is $600. Divided by 12, that is $50.
Let’s assume there are no HOA dues. (phew!)
Total: $603.92 + $333.33 + $50 = $987.25
Conventional wisdom would say: $1500 (rent) – $987.25 (expense) = $512.75 in profit per month! That so much money, I could quit my job and…
And you would be dead wrong. Let’s think a little more in depth. That rental is not going to occupied for the whole year, especially once you first purchase it. Nor are those repairs from the leaky faucet or toilet going to be free. What about budgeting for a new roof?
The thing that separates a good real estate investor from a failed one is attention to detail. Details make up your investment and you need to pay attention to them. Here is where your money can really start walking out the door. Now, when I’m giving a percentage, it is a percentage based on the rent amount ($1500). Example – 5% of $1500 is $75.
- Vacancy – The rent doesn’t get paid if there is no one there to pay it. Therefore, vacancy must be part of your calculations. Depending on who you talk to, people factor vacancy as a monthly cost around 5-10%.
- Capital expenditures (Cap Ex) – These are your big expenses. Roof, HVAC, Siding, etc. They don’t occur frequently but when they do, it hurts. Consider budgeting ahead of time so you have money to pay them. If most items on the property are in newer condition, consider 5%. If many things are older and you didn’t replace/repair them – 10%.
- Repairs – Things break. Renters typically don’t take care of your property with the same attention as you do. Factor in 5% monthly for those pesky repairs.
Add those calculations in..
Now that reality has set in, let’s recalculate our “deal”.
$1500 (rent) – $987.25 (mortgage, taxes, insurance) – $150 (Vacancy at 10%) – $75 (Cap Ex at 5%) – $75 (Repairs at 5%) = $212.75.
Ouch. Reality hurts. So looking at our amount invested ($37,500) and our monthly return ($212.75) means our Return on Investment (or Cash on Cash ROI) would be 6.81% with a net yearly income of $2553 (212.75 x 12). You’re not exactly setting the world on fire with this deal, but you’re in a safe spot with most expenses accounted for.
Analyzing Rental Property Step 4: Pulling it all together
If this is new to you, this guide can seem overwhelming. Sadly, this was only a brief guide. Rental property analysis goes much deeper and gets more granular as you learn more. One of the best resources for learning this material in depth is BiggerPockets. They offer a wonderful online community of other real estate investors with all sorts of levels of experience. However, the way I personally learned most of this information was through their podcast (found here).
Real estate investment is a large undertaking – you’re basically starting a small business. Like any business, if it is going to succeed, you need to have a solid foundation. That foundation you need to have is analyzing rental property. For real estate investment, there are many variables to consider but if the math is solid – it gives you a much better chance of success. For those who are curious, BiggerPockets offers a real estate calculator (which can be found here). It will be massively helpful when you are evaluating deals.
Have you started to look into real estate investment? Have you already started? Feel free to comment below!
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