How much net profit to be worth it?

Question

An 8 unit rental building for $255,000. Mortgage is $1600/month. Taking into consideration any repairs, maintenance, and unexpected vacancies, what would I need to be netting from rentals each month in order for the deal to be worth it?

Levi Gale · Answer

I like to look at risk levels to determine how much is "worth it".  Say 10% return in a good area, but if I'm in a less desirable area I'll bump up my desired return.  Hope that example makes sense.

Matt H · Answer

Ya, that's true to some degree. I guess I'm kinda conditioned by our market up here. In Edmonton our houses appreciated by 52% last year. This year so far there up 18% and everyone is predicting at least a 40% increase. Also here in Canada we haven't had the housing turn around like they're experiencing in some parts of the US. So ya do your research for sure.

But my thought is that you should never let fear hold you back from trying something new like buying an apartment. Because you can generally tell in advance how much the building is making based on the statements. So in the absolute worst case scenario which will most likely never happen, then you just sell the building and get your money out, possibly more. But chances are likely you'll never have to worry about that.

The beauty of pretty much any rental property especially apartment buildings that you get paid in so many different ways. Like just the other day I was looking at the rate of my mortgage paydown on a new apartment building I bought and it's starting at $3k per month. I didn't even factor that into the equation, let alone cash flow, and appreciation. Anyway I'm rambling....

Frank Gallinelli · Answer

I'm afraid I'm going to start sounding like a nag around here, but appreciation that is (or isn't) occurring in your single-family home market has almost nothing to do with the value of your 8-unit apartment building.

That value of that property is going to be based on its Net Operating Income and on the prevailing capitalization rate for similar investment properties in that market.  You need to get as good a handle as possible on its actual and potential income, as well as its actual operating expenses (to the extent that you can uncover them) so you'll know what your NOI is.

The fact that home-price appreciation is irrelevant to the value of your property is actually a good thing.  You have no control over single-family home appreciation, but you can create value in a true income property by enhancing its income stream.  What you can do depends on your particular market, but consider a few f'rinstances:  Improve building security, improve outside lighting, give common areas a facelift, upgrade appliances, give away wireless internet service to all the tenants, etc.  If you're not already at the top of your market with rents, you can usually find something that will return more than it costs, increase your income stream and hence create value.

Frank Gallinelli

Michael Rossi · Answer

That sounds good in theory, but isn't quite accurate in the real world.  Over the past several years, the real estate market (in the bubble areas) has gone through an unprecedented runup in prices (appreciation).  That is over.  By some estimates, these bubble areas are 20% overvalued.  Prices could easily come down significantly over the next few years and take a decade or more after that to return to present values, adjusted for inflation.  In fact, if you look at a chart of historic real estate prices, you'll see that after every bubble, prices have dropped, taking about 2 years to reach bottom.  Then it has taken about 10 years to return to the previous high, adjusted for inflation.

Rents are set by the market.  It sounds good that you're one rent increase away from positive cash flow, but raising the rent without increasing your vacancy rate can be difficult.  In fact, rents can and do go down due to market conditions.  So, you could just as accurately say that you're one rent decrease away from negative cash flow.  In addition, expenses are constantly rising and inflation eats away at any rent increase you're able to make.  In fact, unless your rent increases can keep pace with inflation, your cash flow will actually decrease!

All I'm trying to say is that things don't always go up.  I always buy at a BIG discount and always insist on real positive cash flow.  Betting on appreciation and future rent increases is simply speculation.

Mike

Matt H · Answer

It depends how much you're putting down. If you you buy with no money down and you break even after monthly expenses then you're still ahead of the game because you have appreciation, mortgage paydown, and you're 1 rent increase away from positive cash flow. So you're return is therefore infinite.

But if you want to quickly determine what something is making then do this:

Cap Rate: is computed by taking the rental net operating income (NOI) and dividing it by either the sales price or fair market value (FMV) of the property.

Example: A property has a NOI (Net operating Income) of $55,000 and the asking price is $650,000. This yields a Capitalization rate of 8.46%

That means if you paid all cash for the building that you're ROI would be 8.46%

All I try to do is come up with the biggest mortgage(s) I can find and then determine how much cash flow is left each month after expenses and debt servicing. Using that you can quickly determine what you're real ROI is.

Michael Rossi · Answer

You would need to have gross rents of about $4,800 per month if you wanted to have a positive cash flow of $100/unit/month.

Mike