How to Evaluate a Potential Rental Property
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Rental real estate can be a great way to generate income and build wealth, but few new investors know how to evaluate a potential rental property.
Buying your first rental property is a major financial decision and should not be taken lightly, so it is important to understand the numbers since most people don’t have much a cushion in case something goes wrong.
We are going to take a look at the factors that make a difference between a strong cash flowing property and strong equity gains vs so-so returns.
How Your Rental Can Make You Money
There are two ways to make money with rental property. It can generate month-to-month income (cash flow) or it can build up equity. As your mortgage principle balance goes down and the property appreciates over time, equity increases.
Many experts advise investors to focus on cash flow and there are good reasons for this. Equity appreciation can be extremely difficult to project, especially over a short period of time and the reduction in mortgage principal can be extremely small in the first few years of ownership. This can be expedited by decreasing the length of the loan.
Both cash flow and appreciation are incredibly important if you plan to hold on to the property for any length of time. If you hold on to the property for any length of time, the appreciation could be the larger of the two and combined with depreciation is what make real estate such a great investment.
In the long term, real estate prices tend to rise slightly faster than inflation. Therefore, if you plan to hold a rental property for 25 years, it is expected to increase in value at that rate if properly maintained. However, it is impossible to predict fluctuations in property values over time with any level of precision.
Although appreciation is a factor not to be overlooked, cash flow is the more important of the two and here is why:
- Property values is a given are tend to rise or fall at the same rate, given they are in similar condition and size. If you are looking at 5 potential duplexes in the same area their value should be roughly the same in the next 15 years.
- Provided you get the same type of mortgage on each property and you have the same repayment schedule, you built in equity from paying the mortgage will roughly be the same with each property given that taxes and insurance are the same.
After taking this into consideration, the largest variable and place that you can gain the most on your rental property is the cash flow. The cash flow will be the biggest factor in determining is one rental property is better than another.
How to Analyze Your Rental Cash Flow
A properties cash flow is pretty simple to calculate. It is the income you make minus your expenses. Although it is simple to understand, many investors end up losing here because they either don’t take everything into account that they should or they underestimate their expenses.
Here is a list of the items you need to consider when performing your rental income analysis:
- Mortgage Payment: Your Mortgage Payment is the payment for the loan you have on the property, if you have one. Most lenders will require you to escrow taxes and insurance. If they do you can skip them below, but if they don’t be sure to include them.
- Utilities You Pay vs Tennant: Depending on the setup you have in your rental and the way your utility company will allow you to operate. You, as the landlord may cover some utilities while requiring your tenant to pay for some. Don’t forget to take your utilities into account when figuring in expenses.
- Property Management Cost: If you decide to manage the property yourself you will not have anything here. If you either own your own management company or find one yourself you will need to include their costs. Your cost here will vary depending on your market but remember not all management companies are created equal so be sure to shop around.
- HOA Fees: If your property is in a Homeowners Association be sure to include this in your analysis. Always make sure that if it is, rentals are allowed, many people don’t check on this and find out their new asset is worthless as a rental property. Make sure to find out what the HOA fees include as this may decrease some of your expenses in other categories. I have seen some HOAs that cover your insurance.
- Taxes: Everybody loves paying taxes, right? Unfortunately, they are a part of all of our lives and if you don’t pay them it can get bad in a hurry so don’t forget.
- Insurance: Most people complain about insurance until they need it. Don’t skimp here because some day it may keep you from having to declare bankruptcy.
- Vacancy: It is difficult to put an exact number on vacancy. At some point, your rental will sit vacant, at least for a while. In an ideal world, you or your property manager would have a new tenant standing in line before the old one moves out, but it doesn’t always work out that way. Depending on the nature of your property and current market conditions, it is a good idea to set a vacancy rate of 5-10% of the rent to offset the cost and set aside that portion of the rent. Even though there is no tenant, you still have to pay the bills.
- Maintenance: At some point the property’s HVAC unit is going to go out. You may have to pay for a new roof. Winter will bring snow and someone will have to remove it. Set a portion of the rent aside to cover these expenses if you need it. I recommend 10% for maintenance allowance to start with.
- Other Expenses: This is where you account for anything else that you can think of. It could include lawn maintenance, pest control, any ongoing upkeep to the property that is required. Maybe the property has a pool and will require constant attention. Plan on paying for these yourself but I would recommend making the tenants pay for as much as you can.
Here is what your Cash Flow Analysis Should Look Like:
Example:
If you have a four-plex (four units) with a total rent of $3,000 per month. Your taxes and insurance are escrowed into your payment each month. There is no HOA and you pay for water, sewer and trash.
Lest assume the property is 10 years old so we will use a 10% maintenance allowance and I always recommend an 8% vacancy allowance until a reserve is built to cover future vacancies.
Taking all of this into account, here’s how you break it down on paper.
Item: Income/Expense:
Total Rent $3,000
Mortgage (PITI) ($1,900)
Landlord-Paid Utilities (Trash/Water) ($85)
Property Management ($300)
Maintenance Allowance ($300)
Vacancy Allowance ($240)
Cash Flow $175
The number one thing to remember is that your property needs to have a positive cash flow from day one. It will take you looking at several properties in order to find one that works.
You can’t become emotionally attached to a property. You don’t have to buy the pretties property, although it is best to make improvements to the property while you own it. This will help with your appreciation when you go to sell it.
You have to remember that this is a business and the only thing that matters is the numbers and the money made on a real estate transaction is during the purchase. You may have to negotiate on several properties before you can purchase one for a price that fits your model.
A lot of people say you’re crazy, I can’t find deals like this where I live and they might be right. They might live in a market where these deals are far and few between or they might have to get creative to find these deals but they do exist and you might have to look outside your immediate area to find them which makes finding a reliable management company even more crucial.
How Much Income Will My Rental Property Generate?
In order to create a reliable cash flow analysis, you need to know how much your property can generate in rent. If the property is currently rented this makes things pretty easy.
If the property is currently rented, ask the current landlord for a detailed rental history. This will not only let you know the amount of rent generated but it will also give you an idea of the vacancy time. If the property if professionally managed by a good company you can usually get a very detailed maintenance record as well.
This will give you an idea of what your annual maintenance cost will be as well as any recent improvements to the property or any that you may need to plan for if they haven’t been addressed for a while.
If the property is vacant or owner occupied it can be difficult to determine the fair market rental value. If you have a few rentals and have a good relationship with a property manager in the area ask them to come look at the property with you and give you their opinion.
If you don’t know any property managers in the area but are looking for one call up a few and ask them if they would be willing to look at the property and give you an estimate. This gives you an opportunity to vet potential management companies. If they are not willing to, they are probably not a company you want to work with.
One other option you have is to get a rental appraisal. Appraisals are expensive but if you are financing the purchase, your lender may require you get one anyway.
Always be conservative, err on the side of caution. Never guess, always hope for the best and prepare for the worst. As a responsible investor you need to know exactly what a property’s cash flow will be just in case things don’t work out as planned.
A Few Things to Consider
Know the area
Some municipalities have different tax rates for owner occupied vs rental properties, which means landlords pay higher property taxes. Make sure that if the property you are buying is currently owner occupied, your property taxes won’t change.
One other thing to consider is the political climate. Make sure that if you are finding a lot of good deals in one area it’s not for a reason. Make sure that the local government isn’t adding any rental regulations to the local market.
Cash-on-Cash Return
This is essential in learning how to evaluate a potential rental property. Your cash-on-cash return is the annual return you generate relative the amount paid to acquire the property. In order to calculate your cash-on-cash return, divide the annual cash flow by the amount you paid for the property. This includes closing costs, payments made for improvements to the property, and any other expenses you made to get the property ready for a tenant.
Example:
If I paid $85,000 to acquire the quadraplex in the example above including the down payment, closing costs and say it needed a new roof. First, I would need to calculate the Net Operating Income (NOI). The NOI is simply the annual rental income minus the operating expenses.
$3,000/month X 12 = $36,000
Most people will use a factor of 2/3 annual income to calculate the NOI. If you know it exactly that is even better.
NOI = 2/3 X $36,000 = $24,000
If you have a loan then we need to calculate the debt service. If you are lucky enough to be able to buy the home in all cash you can skip this step. Let’s assume we our interest rate on the loan is 5% and we put down 20% with a purchase price of $250,000.
Debt Service= 5% X $200,000 = $10,000
Next, we will need to take the debt service into consideration for our NOI.
NOI = $24,000-$10,000 = $14,000
We are now ready to calculate our Cash-on-Cash Return for this property.
Cash-on-Cash Return = $14,000/$85,000 = 16.4%
One of the best ways to use cash-on-cash return in your evaluation is when you are looking at properties that require different amounts of cash up front. For instance, if you were wanting to buy a single-family house that you could buy in all cash or you found a small apartment building with 5 units you had to finance. You could use cash-on-cash return to determine which one would give you a better return on your money.
What Is a Good Cash on Cash Return?
Most experts disagree on what constitutes a good cash-on-cash return. Some would say that anything over 8% is good, and that they aim for a rate between 8-12%. There are some investors out there that wouldn’t even consider a rental property if it doesn’t promise them a cash on cash return of 20% or more.
It is completely up to you to determine the amount of return you are willing to take. Just remember that your return in one area may vary greatly from one area to another and will also be different depending on the type of property you are looking at.
Capitalization (Cap) Rate
You calculate this by using the annual pre-tax cash flow (excluding mortgage payments) and divide that by the purchase price. Using the example, we have used previously, the Cap Rate would be NOI of $24,000/Purchase price of $250,000 plus any expenses you will need to make right away including closing costs and capital improvements.
Cap Rate = $24,000/$285,000 = 8.4%
When you are first looking at properties you generally will not know your financing details and using the Cap Rate is a great initial evaluation. If you are just starting out and learning how to evaluate potential rental properties, this is a great place to start.
Generally, you will not know how much you will be putting down on your financing or any improvements that will need to be made to the property when you are just browsing for properties and this is a great way to narrow down properties you would like to look into a little deeper.
Gross Rent Multiplier
If you are looking in a market that has hundreds of potential properties to choose from, you don’t have time to analyze every single one to determine which one is the best deal. This is where the gross rent multiplier comes in.
The gross rent multiplier is an expression of a properties price as a multiple of its monthly rent. If a property costs $100,000 and its monthly rent is $1,000 the gross rent multiplier is 100. The lower the number the better.
There of course is disagreement over the use of this calculation. Many investors won’t even look at a property if the number is over 100 and others will use a number that they have come up with from their experiences or a reasonable number for a particular market.
One strategy I like to use is to calculate the gross rent multiplier of all the properties and look at those that are in the bottom 10 or 20 percent, depending on the number, and evaluate them a little closer. With this market you are comparing the market at a whole and this is based off of asking price, not necessarily what you could pay for the property.
Summary
You must remember that there is no one right way to apply these methods to your property analysis. The best method that is best for you is dependent on your priorities, risk tolerance and goals as an investor.
If you are looking to live off the cash flow from your investments versus someone who is looking to gain more from equity building and appreciation you both will evaluate a property in a completely different way. Someone who is looking at residential properties versus commercial property will approach their analysis totally different and the thresholds for those two markets are completely different.
You just have to remember when you are learning how to evaluate a potential rental property is that everyone is just trying to pay their bills and what seems like a good deal one person may not be for the other. Try to figure out what is best for you and get to work.
