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Uh Hello, Don’t Forget to Calculate the Profit on an Investment!

8 min read
Uh Hello, Don’t Forget to Calculate the Profit on an Investment!

Shut up, I’m not even kidding. Do you know how many people approach me and ask me what I think of a particular deal? Mind you, I’m a very open-minded person. Even if a deal isn’t one I would necessarily pursue personally, either for interest or niche reasons, I’m always open and eager to hear about deals other people find. I’m especially excited if a deal seems really good and the person goes after it (I get really excited for people going after killer deals -- and even more if they actually get them!). But... Of all those people who approach me wanting to hear my opinion on deals, do you know how many have absolutely zero clue what the anticipated profit on the property will be? Uhhhhh, hello! What do you think we are in this biz for? Profit. Don’t you want to know what your profit on a property will be? _ Related: _ More logistically, how are you (or me) supposed to know if a deal is a good one if you have no idea what the profit is scheduled to be? I have three case studies to help show my point. In each case, figure out what information is missing in order to determine if it’s a good deal or not. Not only look for the missing information, but also look for red flags in each deal.

Case #1

Investment opportunity:

Single-family home, Orange County, CA_$270,000 asking_

  • Not a full fixer-upper, but needs extensive updating and cosmetic work
  • Income: $1200/month
  • Expenses (property taxes, insurance, repairs): Unknown

Pros:

  • It’s Orange County, CA. Enough said. Amazing place to own anything (assuming you can afford it)!
  • Potential for appreciation in Southern California is high.

Cons:

  • No profit! None of the expenses associated with this property are known. But in this case, the taxes, insurance and repairs don’t have to be known to already know you will lose money on this property. The mortgage payment on this property alone is likely to be right at the rental income or higher depending on the terms. Boom, negative cash flow.

What if you pay all cash for the property, you ask. Well, then calculate the cap rate on that. Taking into account NO expenses, you will be looking at a 5% cap rate. But no expenses isn’t realistic at all. You will have to pay taxes, insurance, repairs and vacancy. And this house needs extensive updating to even make it rentable. All of that will no doubt put you in the red on this property.

Red Flags:

  • It just flat won’t profit. No questions asked.

Case #2

Investment opportunity:

Duplex, Hollywood, FL $190,000 asking $183,000 accepted offer

  • Units: 2/2 downstairs (older, not remodeled), 2/1 upstairs (fully remodeled)
  • Income: Downstairs $1000/month, upstairs $1250/month
  • Expenses (property taxes, insurance, repairs): Unknown
  • Notes from buyer: Seems to be some deferred maintenance, possible roof leak, wood frame building, downstairs unit not in great shape, very old, and has an odd flow.

Pros:

  • Duplex! Excellent! Duplexes are great investments.
  • Amazing location. Hollywood, FL is great, lots of industry, it’s a “sexy market,” lots of planned development.
  • At first glance, the numbers beat the 1% rule at least, which is pretty impressive for an area like Hollywood.

Cons:

  • Unknown profit! None of the expenses associated with this property are known. And more than a lot of areas, the expenses for a property in this area could be very severe. Property taxes in Florida are typically very high. Insurance is usually high in Florida because of hurricanes; Hollywood is in primo hurricane territory AND the house is made out of wood. Wood + hurricanes = high insurance, I would assume!

It is already known there is “deferred maintenance,” an old and low-quality lower unit, and a possibly leaky roof. How much money is all of this going to cost the buyer? It could be very low -- or it could be upwards of tens of thousands of dollars.

Red Flags:

  • Taxes and insurance expenses in Florida should be a red flag in themselves.
  • The property was listed earlier this year for $295,000 and has seen six price drops since then, and it’s still not sold.
  • Within 0.5 miles of this property, there are 10 single-family homes listed between $160,000-$320,000. If you would have to pay that much for a single-family home, how in the world is a duplex listed at $190,000? Those aren’t big single-family homes either, they are max two bedrooms.

Case #3

Investment opportunity:

Five single-family homes, Houston, TX_$320,000 (for the package of all five)_

  • All houses located in a golf course community
  • Income: $4200/month total between all five houses
  • Expenses (property taxes, insurance, repairs): Unknown
  • Notes from buyer: Supposedly a turnkey purchase, little to no maintenance required

Pros:

  • The numbers easily beat the 1% rule
  • Very affordable asking price for five houses in Houston ($64,000/house)
  • Houston is a well-known investor haven right now. Great macro-market!
  • Golf course, hello! Golf courses typically add a notch of flare to any property quality

Cons:

  • Unknown profit! None of the expenses associated with this property are known. Two major expenses regarding these houses, both of which could very quickly knock any cash flow out of the water: property taxes and HOA fees. Property taxes in Texas are typically very high, but oftentimes they are still doable so those may not prove to be a deal breaker (but should still be looked at for sure), but where the big one here is: potential HOA fees!

A golf course community? Oh boy, could the HOA fees be out of control. Those could easily blow the cash flow out of the water. Those are the two expenses that seriously need to be looked at, and then of course still calculate the insurance cost because insurance in Texas isn’t known to be overly cheap for insurance.

Red Flags:

  • Single-family houses in Houston on a golf course...that cheap? Houston is such a popular market right now that I can’t imagine good houses being priced that low, especially ones in a golf course community. It is possible, I suppose, if a developer bought them in bulk very cheap and fixed them up and can then resell cheap but you better really confirm that is the case. Otherwise, the price is a huge red flag.

The point is, just owning a property isn’t necessarily profitable. I think most of us grew up thinking that as long as we own property, we are financially smart. I thought that up until the point I started looking into buying rental properties. For the longest time I couldn’t figure out where the "supposed" profit was (because I was looking in Southern Cali) that everyone assume automatically came with owning rental properties. _ Related: _ It wasn’t until I got deeper into real estate that I learned that most properties actually don’t profit. Then I learned how to really calculate rental property profits. The key lies in subtracting all of the expenses of the property (taxes, insurance, management, repairs and vacancy) from the income. If you are financing, take out that mortgage too. For an easy method of calculating rental property numbers, check out Rental Property Numbers so Easy You Can Calculate Them on a Napkin Maybe one or more of these three properties presented will in fact produce profit. But there should be a lot of research into each one before anyone goes for them, that’s for sure!

Conclusion

Anytime you are looking at potential rental properties for investment, make sure you understand how to know if the property is actually projected to produce a profit. If you don’t know how to figure that out, or you don’t know the expenses associated with the property, don’t move forward until you do! Don’t ever estimate expenses either. The only ones you should be estimating or on-going repairs (which doesn’t include initial repairs or deferred maintenance!) and vacancies. Otherwise, know all the numbers. Taxes, insurance, initial repairs...get all of those. The only time this advice doesn’t apply is if you are blatantly buying for emotional reasons or because you are speculating on appreciation. In those cases, you’re on your own. What are misconceptions you always had about real estate investing that you have now realized aren’t true since getting into real estate investing? Let us know in the comments!