Note: This is a reworked version of a post previously made at Mr. Money Mustache. If you haven’t been there yet, you owe it to yourself to check it out. It’s really the Mecca of the lifestyle we aspire to live.
Knowing how to evaluate rental property by the numbers is as important as picking good property management and placing good tenants.
I am still learning, just like everyone else. Relative to many veteran landlords, I am a rank amateur. However, I’ve done a few deals now, made a few mistakes, and hopefully learned something from them. I have a few cash flowing properties, and each has been more successful than the last as I raise my standards, learn how to anticipate some of the trouble areas, and most of all, have greater confidence in my ability to oversee all aspects of a deal.
I frequently answer questions about whether or not a given property is a “good rental.” Though this is a highly subjective question, many rentals people consider are virtually guaranteed losers. This is usually because people fail to consider all the possible costs of buying and owning a rental, and/or because they are overly optimistic about vacancies, repairs, etc.
My own real estate investment strategy is buy and hold for cash flow. The goal is to build a steady stream of income that compliments the safe withdrawal rate from my stock and bond portfolio. Thus, my analysis makes bottom-line cash ROI the most important factor versus appreciation. That is not to say that quality of neighborhood, tenant, and prospects for the city aren’t just as important– they’re just things that I consider before I ever get to evaluating the raw numbers. I’m a California resident and have found that the best deals in my price range are out of state, even after accounting for property management.
My analysis spreadsheet is based on the J Scott Single Family Home analysis spreadsheet on biggerpockets.
I’ve uploaded my modified version, which corrects a few Excel issues with the original, and enhances it somewhat to allow for evaluating duplex/triplex/small multifamily units. The version I put there contains real numbers for a property I recently purchased in a major midwestern market. This version also has some tweaks that are specific to the area/property management but if you decide to use my copy as a basis for your own, it should be pretty easy to figure out.
The sale price is $65,000. It’s a 2/1-per-unit duplex located in a C+ neighborhood with somewhat below standard schools. The average household income for this part of the ZIP code is approximately $40K. The unit was priced too low for the market and was pending within 24 hours of being on the market. That deal fell through and I moved on it quickly. The duplex is in above-average condition for the neighborhood and will rent for approximately 650 per unit.
Now, let’s start plugging in numbers I feel comfortable with. Again, these are my actual numbers. You could do better/worse/differently with more exotic financing, but these are fairly standard, which may help those with no idea what to expect.
Evaluate Rental Property Based on the Numbers
Downpayment %: Because this will be an investor mortgage on a multifamily, I will need to put down 25%. Fannie Mae requires that investor loans on multifamily properties be 25% through the first five financed properties (after which it becomes a 30% downpayment). It’s 20% on single family for investors. Thus, my downpayment amount is $16,250.
Interest Rate: Also because it is a investor mortgage, the interest rates are slightly higher than consumer. The rate I got on this property with a 750 credit score was 4.625%. Roughly in the same ballpark I’ve gotten on my last few properties. My mortgage rate for new properties will rise as the Fed raises interest rates, but should be affordable for some time.
Improvements: Any improvement needed to get the property ready for rental. Remember, the goal is to be in good, safe, and clean condition, with amenities appropriate for the neighborhood, not amenities which you would demand for your own home. Initial forecasts for improvements were conservatively $1000. After the inspection, I learned that there are some electrical issues needing repair (missing grounds and a few knob-and-tube issues) so that was revised to $2500. In the end, my repair costs ended up being $2,140.
Closing Costs: The total costs to close, including inspection, were $3,251. Due to the issues found during inspection, I was able to negotiate a $500 seller credit at closing, and $187 towards the seller’s portion of the title insurance.
Per-unit market rent: The desired rents for this property were $650 per unit. This is on the medium-high end of average for the neighborhood, which is justified by the extremely good condition of the property. Median rent in the area is about $612. Don’t delude yourself about rents if you don’t know the area! At least use rentometer, check Zillow and Craigslist for rentals, and get somewhere in the ballpark. Ultimately, I ended up accepting $625 from the existing tenant (up from $550) in order to get them onto a new lease and avoid paying a tenant placement fee. I placed a second, new, tenant for $650.
Vacancy/Loss Rate: Set at 10%. Average vacancy for the area is 4-5%, but I prefer to estimate high and use any extra income from low vacancy to fill reserves quicker. This is one of the areas that I consistently see people underestimate. There are always hand-wavy arguments about how “the market is really tight in the area” or “it seems like everything fills up quick around here.” It costs you nothing to estimate conservatively. At worst, you might pass on a deal that could be good but falls on the wrong side of the bubble because of being too conservative. At best, you only pick the cream of the crop because of high (but not unrealistically high) standards.
Property Taxes: $1551 per year currently for this unit. City taxes are normally very high, but this area has ~25% lower taxes than some of the others I have considered.
Insurance: $904/year. This is 1 million in liability coverage, full replacement value, DF1 insurance. The deductibles on repair/replace are $2500. I knew about what I wanted to spend on insurance, so went back to the insurance broker 4 times to get adequate liability (first quote was 300K), adequate property value (first was 53K) and a higher deductible (first was the lowest/most profitable for the company). The DF1 policy covers fire/wind/smoke, but excludes things like flood, war, etc.
Maintenance and Repairs: 5% of rents per year is my estimate, so $689. This is one area where I may not be conservative enough, but I hope for my conservative estimates elsewhere to help provide some margin for error. I also have income from other properties that can help compensate for unexpected high expenses.
Property Management: The property management is 10%. You may want to manage your own property, but for a variety of reasons I believe it’s best to build it into the budget anyway. You may want/need to move. You may want to travel long term in retirement. You may become disabled. Again, the only risk in being too conservative is that you pass on a deal that might otherwise have been profitable. Don’t be a motivated buyer.
Annual re-leasing fee/tenant placement: This is another critical element to consider if you will be using property management. Many/most property managers charge you something, often half or all of the first month’s rent, to place a tenant. This is a large percentage of your cash flow if you turn over tenants too frequently. The most important thing you can do (aside from picking decent property in the first place) is place quality tenants. If you’re turning over tenants every year, or more often, something is wrong and it’s going to eat even the best profitable-on-paper deal alive. This property manager charges the full first month’s rent to place a tenant, and $195 to sign a new one year lease. I am wary of this as I pay half a month elsewhere, but I have been frank about my expectations and made it clear that if I see a pattern of poor tenants, they will lose my business quickly. I anticipate that I will re-sign one lease a year, and replace one tenant a year. This should be an overly conservative estimate with good tenants (and being a good landlord).
Annual Inspection: Read your property management agreement! You need to account for every cost. The PM offers an optional annual service to change air filters, inspect appliances, smoke detectors, radon detectors, change batteries, and do some light maintenance. I’ll probably use it, so it’s on the budget at $130.
Sewer Service: What utilities is the landlord obliged to pay? How much do they cost on average? Landlords in this city must pay water and sewer, though there is some gray area about whether they can charge them if the amount is “excessive.” $800 per year per unit for water and sewer is average.
Water Service: See above, same deal.
Lawn Care: Code enforcement requires trimmed lawns and at a duplex, the landlord is responsible. Lawn service twice a month for seven months out of the year will run $66.
Putting It All Together
Let’s see how it stacks up against the 1%/2% rule:
65000 (purchase price) + 2140 (improvements) + 2564 (financing/inspection costs) = $69,704 Total Cost
(1275 rent * 12) * .9 (estimated vacancy) = 13770
(($13770/12) / 69704) * 100 = 1.646%
The 1.646% number is the amount of our purchase price we collect in rents each month. Some people aim for 1%, I aim to be as close to 2% as possible. So, 1.646% is pretty nice! Now let’s do a more detailed analysis.
Accounting for all these costs, which are quite a bit higher than some areas, the total annual expenses in year 1 are $7,557 even. Accounting for vacancy, the rents are $13,770. Thus, the Net Operating Income (NOI) is $6,213. After mortgage ($3008), the cash flow is $3,205, for a cash ROI of 15.30% with a fairly conservative analysis. Throw in the equity gained and the total ROI is 18.97%.
The Cash Flow
The monthly cash flow with all of these assumptions is $267, but I’ll be pulling out $270 per month knowing that I have estimated most numbers here pretty stingily. I’m personally looking for about $100 per month in cashflow per $10,000 of my own money invested, which this meets handily. I’m very happy with this deal. If any one of the very conservative variables tips in my favor, I’ll fill my reserves that much faster.
What if it all goes right?
The temptation would be high to see greater than the $267 “safe” cash flow coming in and to use it for something. Resist! Vacancy will come. A roof replacement will come. There will come a day when I have filled my reserves so much that I can start to skim off a little more cash flow, but that day is still far off.
My current plan reinvests all the cash flow in future properties. I’m buying 2-3 a year for the next 5 years. This will be a serious challenge for the first two years, after which the cash flow starts buying properties for me almost as fast as I can on my own.
What if it all goes wrong?
Hopefully my conservative estimates give me breathing room if it does, but if not, I have 6 months of PITI for each property just in case right from closing.
I hope that his article will help you in more fully understanding some of the pitfalls and hidden costs when getting into Rental Real Estate, and how to evaluate rental property more confidently on your own. Nobody knows what the future will bring, but by doing the correct due diligence, it’s possible to make real estate a reliable and profitable investment.
Here again is the link to the property evaluation spreadsheet on Google Sheets.
What do you think? What are critical considerations when beginning to evaluate rental property?
If you’re getting started with Rental Property, consider supporting this blog by setting up a free Personal Capital Account. It’s a great way to track savings for a downpayment, or the fluctuating value of your investment with Zillow Estimate integration.