How to Determine if a Property is a Good Deal
Some investors are value investors like me. Others like to buy property for appreciation. That is they buy when the market is low, lose money or break even on the property and then sell it when the market comes back up. I like to play it safe and that strategy is waaaaay to risky for me.
Since I am a value investor I like to buy properties as cheap as possible; however, just because a property is cheap doesn't make it a good deal.
What makes a Good Deal?
To me, a good deal is one where I expect to put money in my pocket every single month from the property and where I go in with some equity in the property. I never pay retail for any property I buy. I buy properties that I believe will appreciate but since I'm buying with equity if they don't I've still made money.
Quick Rule of Thumb for ALL Investors
I'm a huge believer in the 50% rule. Simply put, the rule says that over the course of time you will usually end up spending about 50% of the properties rental price on expenses. ** Although this rule isn't absolute and may vary a few percentage points by location it's a really good rule of thumb and can keep you from getting suckered into a bad deal. You will want to run the numbers for your investment area.
What are the Usual Operating Expenses?
- Management Fee - this will usually be 10%
- Repairs - I budget 10% for this also. Even though you won't have repairs every month you still need to put aside money every month for those times when big expenses come up like roof, furnace, etc. and for cleaning the property when a tenant moves out, etc.
- Vacancy Rate - your rental won't be rented every day of every year. There will be times when it sits empty and you won't be getting money from it. Take money out every month to cover the times when the unit is vacant. The usual vacancy rate is between 5% but it could be 10% or higher depending on location.
Warning: If you get a property in a bad neighborhood your vacancy rate will be higher and you will likely have more repair costs.
- Insurance - this varies by location too but it's generally around 1 to 1.5% of the appraised value of the property.
- Property Tax - You can find the exact amount by contacting the tax assessor's office where the property is located. Most offices have this information online so you can get an exact figure.
- Utilities - in some cities it's the norm for landlords to pay utilities, in others it's the responsibility of the tenants. For single family residences and duplexes I ALWAYS make the tenants pay for all utilities. If I have to pay it reduces my cash flow and I don't want that at all. If you have to pay utilities then don't forget to add that to your operating expenses.
Let's look at this in practice: Let's say that the property is a single family residence that cost $75,000 and rents for $1000/month. According to the 50% rule you will likely pay around $500/month for operating expenses. Let's run the numbers and see:
- Management Fee - $100 (10%)
- Repairs - $100 (10%)
- Vacancy Rate - $50 (5%)
- Insurance - $62.50 ($75,000 x 1% divided by 12 months)
- Property Tax - $125
Together that adds up to $412.50 which is just over 41%.
Again, you want to run the numbers for the specific property you are looking at and the area. If your numbers come out to less than 38% then be very careful and make sure that you aren't forgetting an expense that could affect your cash flow.
So, is this property a good deal? Maybe, maybe not. We need to look at how much we will be paying for debt service before we can know for sure. (If you are paying all cash for the property you would want to look at the cash on cash return for the property (i.e., run numbers to see if you would be better off investing in something safe like CD's or Bonds instead)).
Debt Service
Most likely you will be getting a mortgage on your investment property. That way you won't have to plunk down a huge chunk of money at once, you will just need to put down a down payment (usually 10-20%) then you will use money from the rent to pay down the debt.
How much the mortgage payment is will depend on your credit score, interest rates and so forth. The interest rates for investment property are almost always higher than the cost for an owner-occupied home.
If we go back to our example, and our buyer is going to put down 10% of the purchase price $7500 (10% of $75,000) then at a 7% 30 year loan, the loan payments would be approximately $461.
So, let's put all the information from our example together:
| Rent: | $1000 |
| Operating Expenses: | $412.50 |
| Debt Service: | $461.00 |
| Total Costs: | $873.50 |
| Cash Flow | $126.50 ($1000 rent - $873.50 expenses) |
Most investors believe anything over $100/month in positive cash flow is a really good deal so this IS a good deal and one worth investigating further.
Want to see properties for sale that I like and think are good deals?
Got questions? Let me know. If I can help answer any questions you have I will be glad to. kip@realestateoutofstate.com