In evaluating rental properties, it is important to account for unknowns and other operating costs. A lot of new investors optimistically evaluate properties and do not consider all potential costs. Once they realize what it costs to own and maintain the property, they may end up realizing that the numbers don’t work.
Two important questions:
- How much would it rent for?
- You can answer this question by looking at comparable rentals in the area of the property you are analyzing. Rentometer.com is a good source or even just looking in Zillow for rentals in the area. Your realtor can also provide you rental comparison analysis for your area of interest. The DealCheck app I mention at the of this post is also great resource for this.
- How much would it cost to maintain?
- This is key in determining whether a property is a good deal or not. Below I provide a guide of expenses to keep in mind when doing your property analysis.
Common Rental Property Expenses:
Real Estate Taxes – Look at the property appraiser website or even websites like Zillow, Redfin or Realtor.com have records of what the taxes are. Keep in mind that if the property is owned by an owner-occupant, they might have tax breaks due to homestead exceptions. These are not available to investors; therefore, you need to true-up your number.
In order to get a better feel for the property taxes in the area, look at the real estate taxes for a few properties and then make an estimate. Even if the property was a rental property before, you still want to account for an increase. Property taxes go up every year and are expected to go up if the purchase price of the property is significantly higher than the last sale price.
Insurance – Real Protect will give you a free quote estimate for insurance. You can also ask around to see what insurance costs would be for a house of the same size in the city. This is an investor friendly insurance broker that we use for all of our properties. This company has saved us thousands of dollars when compared to the standard customer insurance brokers. Websites like realtor.com and zillow.com also provide estimates, but they are not as accurate.
Capital Expenditures (CapEx) – At some point, you will be required to replace the A/C, the roof, etc. This is an amount that you keep as a reserve in the event of any unknown big repairs. The rule of thumb applies here. Generally, estimate to reserve 5%-10% of rental income.
Maintenance & Repairs (M&R) – As a landlord, you are responsible for maintaining the property in habitable conditions. While you can push some cost to the tenants (if you have proper lease clauses), there are some maintenance items that remain your responsibility as a landlord. For example, sewage line issues, A/C maintenance, appliance repair, etc. There are some things you can’t trust your tenants to do. You may end up paying double the cost down the road with mediocre repairs.
Rule of Thumb also applies here. Generally, we estimate that M&R cost will be 5-10% of rental income.
Landscaping – A lot of times this expense is overlooked. If you have a duplex or multi-family this will likely be your responsibility. Unless you have fenced in yard, it is hard to allocate shared yard space with individual tenants. If a single-family property, then the lease can be drafted to shift responsibility to the tenant and can be excluded from your property analysis.
Utilities – Make sure you know what utilities are the landlord’s responsibility. In a multi-unit property, if there is a shared water meter, it will be the landlord’s responsibility and it should be included in the analysis. If you are familiar with what the costs are, you can estimate a ballpark or you may want to ask around (either the owner/realtor or anyone familiar with the city where the property is located).
Management Fees – This is discretionary, but I always recommend analyzing the properties with a management fee even if you plan to self-manage. What if you realize that you don’t want to be managing and then the property can’t afford it? This varies by city/state, but generally between 8-12%. Talk to management companies in the area to get an idea of what the cost is in your market.
HOA – Double check to make sure if there are HOA or Condo Association fees and how much.
In addition to the above, you need to consider loan costs like Principal and Interest payments. If you have a loan, you need to add Principal and Interest into account.
Vacancy costs – this is one expense commonly overlooked, but important to take into account. In an ideal world, you have long-term tenants and minimal tenant turnover, but this is likely not the case. You need to account for the loss of rent incurred when a tenant moves out and you have to get the property ready for the next tenant. Normally, you would want to reserve for one month’s rent. We use the highest of 10% or one month’s rent.
In large multi-family projects, analysis may require more detailed analysis, but for small multi-family and single-family, you should be okay by taking into consideration the above items when doing your analysis.
At the end, you should end up with positive Cashflow and that number should be in align with your investment criteria. If you haven’t setup your investment criteria and strategy yet, be sure to checkout my blog post on how to do this here.
Personally, our analysis criteria looks like this. The ratios below are a percentage of the monthly rental rate.
- 10% vacancy rate
- 10% maintenance & repairs
- 5% capital expenditure (if rent is too low, we adjust to 10%)
- 10% management fee
- Plus estimate of real estate tax, insurance and mortgage costs
Whenever we are looking into a market we are not familiar with, we may increase the percentages above to be conservative.
Other Metrics to Consider
There are few rules of thumb created to help investors perform quick analysis of rental properties. These are not one-size fits all. You should consider all of the facts around the property prior to making a decision based on the metrics below. We’ve bought a few properties that don’t meet the rules below and they are still great investments.
The 1% rule – The price that the property can rent for should be at least 1% of the purchase price. Therefore, in a perfect world, a property valued at $100,000 should rent at least at $1,000 per month. The higher the percentage of rent over income, the better. Keep in mind that this is just a guide. You still want to run all of the numbers to make sure. In some markets like South Florida, California, New York, you are unlikely to find any property that meets the 1% rule, but that doesn’t mean they are bad investments. A lot of times the increase on the price appreciation is much better.
The 40% or 50% rule for operating expenses—This rule is that the operating expenses of a property should not be more than 40% or 50% of the rental income of the property. Again, this is just a rule of thumb. You should still run the numbers in the full scenario.
Cash-on-Cash – The cash on cash is the return you want on your money. Annual Cash Flow/Property Cost The higher the cash on cash % the higher the return. Ideally, you want a balance of cash flow and cash on cash. Basically, the least money you leave in a deal, the higher your returns because your income is growing without much investment. We personally aim for no less than 6% cash on cash, but it’s not a set guideline.
Return on Investment (ROI): It is similar to the cash-on-cash return calculation, except that it takes into account the mortgage paydown of the property. Annual Return (Cashflow + Loan Paydown)/Property Cost. A return on investment of 15-20% is good, but again, should not be the only factor to consider.
Real estate plays a key role in our plan for early retirement. Cashflow is what matters to us. We still analyze all of the metrics when making our decision to buy, but the one providing the highest cash after paying for all expenses is the one we go for. We usually aim for $200-$300 a month.
A tool that has really helped us to step-up our property analysis game is Deal Check. It’s a phone app and all you have to do is copy and paste the address of the property and it will bring up all of the property facts and even provide you with estimated market value of the property and market rents. You can then play with the numbers and it will give you all of the metrics I noted above. Another cool of thing is that you can set your pre-determined requirements and it will immediately tell you whether it meets your criteria or not. It will also calculate the purchase price needed to meet your investing criteria.
We have the pro- version which is the one that includes an automated feed from online sources and it’s only $16 per month.
If you use my link and code you can get a 30% discount. Check it out here: DealCheck/Beyondjustnumbers, enter my promo code: BESTDEAL for the discount.
In the next post of the “Real Estate Investing” series, I will be doing a real example of our analysis process. If you want to be notified of my next post, be sure to subscribe to blog notifications in the subscribe box below.
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Until next time!
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