Rental Tales – Part III: Choosing The Property

Welcome to the third in a series of seven posts about how I found my newest rental property, made a successful offer, closed the loan, rehabbed it to make it rent ready, and placed great tenants to make it a profitable monthly income source.

Last week, I introduced all of the members of my team and how I came to know them. At that point in the story, I was monitoring MLS listings every day to try to act quickly if a good property came on the market.  Because it was the dead of winter in a snowy state, new listings were pretty rare.  Every property I sent my agent to take a look at had at least one major problem that was a deal breaker for me.  One was beautiful and updated, but had a serious foundation issue that was discovered by my contractor.  One had huge upside potential, but wasn’t habitable, so paying for the property and doing a major rehab would have been an all-cash adventure.

Then, one day, a property popped up on my MLS feed that looked absolutely beautiful.  It was back on the market after having been under contract twice.  A little concerned about that fact, I had my agent speak to the seller’s agent, who explained that two successive buyers had been unable to secure financing.  My agent and I decided that the property merited a second look.

The property was a side-by-side duplex in a B-/C+ neighborhood, and it was listed for $84,000.  Each unit had three bedrooms, a full bathroom, and an additional shower in the basement.  The attics were quasi-finished, and could easily be used as a fourth bedroom with little effort.

Side-by-side duplexes in the city are extremely rare, and they tend to rent for more because each tenant has a private attic, living space, and basement.  The roof, furnaces, electrical, and windows had all been replaced within the past five years, leaving only the hot water heaters at the end of their useful life.  One unit was occupied for $600 per month, and the other was empty.  Prior to making an offer, we were only able to see the unoccupied unit.

The empty unit was absolutely gorgeous.  We found that the owner’s daughter had lived there for almost five years, and the seller had poured money into improving that side.  The kitchen had granite countertops, a glass tile backsplash, and the entire property had a mix of hardwood floors and new carpet.  These amenities are uncommon in the neighborhood, and my agent and property manager estimated that the unoccupied unit should rent for at least $700 to $750.  If the other side was in the same condition and I could get the property for the right price, it would be very profitable.

Another element that played into my analysis was the fact that I had recently decided to fire my property manager and move to a new one based on the first PM’s unwillingness to use a lease where the tenant paid for water.  My previous purchases in the city involved paying quarterly water and sewer bills, and the variability of that cost was making predicting safe monthly income difficult.  A good friend had recently been hit with an $800 water and sewer bill for a single quarter!

Based on what we had seen, I did a thorough analysis of the property based on my usual analysis method.

My Analysis

I already had a pre-approval in hand from my lender for up to $100,000 at 4.75% interest on a 30 year mortgage.  Because the property was a multifamily, Fannie Mae underwriting guidelines required that I make a down payment of at least 25%.  I used $5,000 as an estimated rehab budget, $3,500 for closing costs, $1300 for monthly rents, and 7% vacancy (average for the city).  As usual, I started my figuring my gross rents for a year, minus expected vacancy.

$1,300 x 12 Months = $15,600 Rental Income

– $1,092 Vacancy Loss (7%)

Gross Rental Income: $14,508 Per Year

Next, I totaled up all the expenses I expected.

$2,152 Property Taxes

$680 Insurance

$1,450.80 Maintenance and Repairs (10% of Rents)

$1,450.80 Property Management (10% of Rents)

$650 Tenant Placement Fee (Expect to place one tenant per year)

$200 Lease Renewal Fee (Expect to renew one lease per year)

$280 Lawn Care (7 Months at $40 per month)

Expenses: $6,863.60 Per Year

Finally, based on a purchase price of $80,000 and a rate of 4.75, I had a monthly mortgage cost of $312.99, or $3,755.88 per year.  Having these figures allowed me to determine some important statistics about the property.

Gross Income – Total Expenses = Net Operating Income

$14,508 – $6,863.60 = $7,644.40

Net Operating Income – Mortgage = Total Cash Flow

$7,644.40 – $3,755.88 = $3,888.52 (Yearly)

$3,888.52 / 12 = $324.04 (Monthly)

Down Payment + Rehab Costs + Closing Costs = Total Cash Outlay

$20,000 + $5,000 + $3,500 = $28,500

(Annual Cash Flow / Cash Outlay) x 100 = Cash ROI Percentage

($3,888.52 / $28,500) x 100 = 13.64% Cash ROI

So, not including equity gained or appreciation, if I could get the property for $80,000 or less, keep my rehab budget minimal, and get an average rent of $650 per unit, I would have a cash ROI of over 13%!  Usually I try to get 15% or better cash ROI after all expenses are figured, but I believed that it was probably possible since I was underestimating rents and hoped that I was overestimating rehab budget.

No doubt about it, to me this property was worth an offer… which we will discuss next week!

What do you guys think?  Would this deal be attractive to you?  Why or why not?  Let me know in the comments!

This Post Series Continues in Part IV.

7 thoughts on “Rental Tales – Part III: Choosing The Property

    1. The Vagabond Post author

      Hey, Brian, thanks for the comment! So, a B-/C+ neighborhood is solidly working-class, but not at all a warzone. This is actually the type of neighborhood all of my properties are in. To give you some idea, some of my tenants work as office admins, a dental assistant, an elderly caregiver, and a number of contractors. As you might expect, cash flow goes up as tenant quality goes down (greater risk = greater reward), and this middle ground neighborhood is about where I’m comfortable in terms on risk tolerance.

      Eventually you end up evicting someone no matter how good your neighborhood is, but if I moved up into A/B+ houses, the return isn’t good enough to justify investing in real estate versus just plowing it into index funds for me. The key is just to be realistic about your vacancy and repair/reserve numbers so that when an eviction or an ugly clean-up job happens, it’s been built into the budget and you aren’t paying for it out of cashflow. A lot of real estate investment companies and blogs seem to do analysis with absolutely optimal numbers (ultra-low vacancy, no tenant placement fees, no lease renewal fees, etc) that make things look far too rosy. I prefer to do my analysis bordering on pessimistic and then be pleasantly surprised. What I calculate as a $324/month cashflow, many places on the web with an ulterior motive (to sell you something) would probably call $400+/month, because they’d fudge the numbers by cutting out the stuff mentioned above.

  1. Pingback: Rental Tales - Part IV: Offers and Inspections - The Frugal Vagabond

  2. Casanova

    Dear Vagabond,

    New to rental properties and still thinking about making my first purchase. Your analysis spreadsheet is very helpful. Just wondering: If you had some worst case scenario and had to sell, how would things look, especially with closing fees, etc…

    Thanks,
    Casanova

    1. The Vagabond Post author

      Hi Casanova, thanks for your comment.

      For me it would depend on the property. Obviously, the closer you buy to full retail price, and the sooner you sell, the bigger your chance of losing money. I have one property that I bought turnkey that wouldn’t turn a profit if I sold it. The others would all make small to moderate amounts due to me getting good deals and subsequent appreciation.

      That said, my advice would basically be “don’t have an emergency,” which is obviously easier said than done! What I really mean here is not to buy (especially on the first couple properties) until you have sufficient cash reserves to handle a few emergencies. There’s *always* a risk of a major expense compelling you to do something drastic (major medical emergency, etc.) but obviously having substantial cash reserves AFTER putting down 25% and closing costs gives you a greater level of flexibility to handle those emergencies.

  3. Pingback: Rental Tales – Part II: Assembling a Team - The Frugal Vagabond

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