Deal Analysis - How Do You Determine Whether To Buy?

Question

Good Morning...

I am contemplating purchasing my first rental property (I have  lot of real estate experience as both a Broker, and an Investor...on the fix and flip side).  For the first time in my life, I have a strong desire to hold onto some properties, and start building  a portfolio.  That said, I've never been a landlord, so am not sure what the numbers need to be for them to make sense.  The current deal I'm analyzing is a side by side duplex, in a nice town, and on a cul-de-sac.  The property is located in a town of mostly single family properties.  The asking price is $369K (seems a bit high, but again, I'm not usually looking at rental investments).  The property has been completely renovated, and it needs absolutely nothing.  Both units have tenants in place who are locked into a lease at $1600.00 per month, giving a total of $3200.00.  I am in a position to put 20% down, but the property taxes are $6000.00 per year, and I'm figuring in another $1500.00 for homeowner's insurance.  It looks like when all of my expenses are paid (and this is before factoring in vacancy or repairs), I would have $500.00 left over each month.  My hunch tells me that probably isn't enough, but I'm not sure if there is some sort of formula that many of you use, when it comes to this.  I will say that based upon where this property is (very desirable location), I'm not terribly concerned about the demand, and the ability to find very good tenants.  I'm also not terribly concerned about any major repairs, given that everything has been renovated in the past year.  That said, it's a property that I would probably hold onto for many years, so I'm just trying to see what makes financial sense.  Any and all feedback is most appreciated.

John

Michael Clemson · Answer

Gross Rents: 3840050% to expenses: -1920030-year 4% Mortgage (75% of $350k): -15036Cash flow: 4164

Your cash to get into the deal is $87,500 (25% down of $350k sale price), plus closing costs, initial repairs and other costs. But if we just assume you make $4,164 on a $87,500 investment, it's a paltry 4.7%. You are better off buying a Vanguard fund. Your hunch is correct, that $500 left over each month really isn't enough to justify such a substantial investment.

I would look for something that is a better return. A few notes: the 50% rule of thumb is based on the experience in the industry, but it will be between 40% (self-managed, tenants pay utilities, newer home) and 60% (PM managed, you have some or all utilities, older home or deferred maintenance). The 50% includes a "cost" for vacancy, as well as costs for property taxes, insurance, utilities, admin/overhead, property management, and maintenance/repairs.

I'm newer here, maybe someone else can chime in on whether location matters as much for tenants. I think you may be looking at the property the way a realtor/buyer would ("cul-de-sac," "desirable location"), but renters may not value those same things.

In contrast, I'm about to close on my first deal and should be able to make the same return you are predicting on an investment of just $27,500.

John White · Answer

Account Closed

I've also looked at 4plexes (there aren't nearly as many in my area).  The most palatable part of this duplex is simply the location.  It's a very unique property, in that there are almost never rentals in this particular town, and it's a town that people absolutely want to live in.  I visited the property yesterday, and both units are very nice (fully renovated, with very nice kitchens and baths...definitely not "builder grade" stuff), and the property is the last house on the cul-de-sac, surrounded by very nice properties, and this is the only multi in the neighborhood.  I'm still reviewing the numbers and assessing the seller's desire to negotiate.   Thanks again for the great feedback.  The knowledge on this board makes it the absolute best resource on the planet!

Account Closed · Answer

Hi John,

On my first property, I just ran the numbers (that I verified, not the sellers) and they made fiscal sense. If it may be close, I would look for other properties.  Here is a short side-note that may be of interest on a duplex vs. a four-plex (which is what I own). If I have 3 units rented and 1 vacant, I am still positive cash-flow. In your duplex if you have 1 vacant for a month or two, how will that affect your bottom line? Just something to think about.

Dan

John White · Answer

@Andy Hailey

Let me preface my comments by stating that I'm not a CPA, and that the U.S. Tax Code makes my head hurt.  That said, those who know far more about the tax side of the business than I do have told me that there isn't a profession that gets more tax benefits than the one of being a Landlord.  For starters, you're able to depreciate the property you purchase over 27.5 years (I didn't even know about this gem), meaning that you can actually write off several thousand (obviously that number will vary depending upon which part of the country you're in.  Beyond that, most Landlords (at least the ones I know) show no profits (at least on paper), so they're not paying income tax on their investment, while someone else is building their equity for them.  There is a reason that many of the most wealthy people have built their wealth through real estate holdings.  On another note, it appears that another Investor beat me to the punch on the property that I originally posted about when I started this thread, so my search continues.

John

Andy Hailey · Answer

@John white

I am also currently considering my first buy and hold deal, but I come with a lot less experience in the real estate world than you. I was wondering about the tax advantages for landlords that you speak of. Could you provide some insight as to what advantages you are referring to? Thank you!

Raymond B. · Answer

@John White,

To Make the @ work do the following:

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Click on the name of the person that you want notified via an email that you responded to them.

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They will be notified via an email about your post in this thread.

Raymond

Brandon Hall · Answer

@John White I completely understand your concerns about out-of-state investing. I cheated and have family in the area where I am investing and I know the area well.

However, its your money and potential wealth at stake. Don't invest in an area that provides lousy returns if you can instead network with individuals for a few months and really get to know the ins and outs of a cheaper market offering higher returns.

Florida for instance - there are plenty of people on BP that can probably tell you the good areas and the bad areas, the expense areas and the cheap areas, etc. etc. Do a bit of networking and research before you sink your money into an investment of any sort.

Bonus tip - Start by checking out a city's CAFR. The report will tell you the city's income growth, population growth, changes in unemployment, who the biggest employers are, growth plans for the city (i.e. how they will use taxpayer money), risks the city faces, crime rates, and I could go on and on. If a city has a bad or mediocre CAFR, as in it's not growing, then skip that city and move on to the next.

John White · Answer

Thanks @Brandon Hall and @Bill Jacobsen.  I have considered the out of state angle Brandon.  I'm just not sure my comfort level would be very high with that solution as I'm just jumping into this.  I'll continue to educate myself about the pros and cons of finding a management company to make that a more realistic possibility.  Your point about the cost of entry isn't lost on me.  I've looked at Florida (because after this miserable Winter, that's where I'd like to hang out 4 months a year), but because I'm not that familiar with the state (I've lived in the same area my entire life), it's a bit of a challenge to ascertain what the strong rental areas are (beyond seasonal rentals, near the attractions).

Brandon Hall · Answer

@John White I'm in line with @Bill Jacobsen in that I also look at the debt service as an addition to my annual returns. However, I like to see a cash-on-cash return of at least 15% and once coupled with the mortgage paydown, a total return of 18-20%+.

Also, if your market is too expensive, look elsewhere. I live in DC and my market is crazy expensive. However, I set my sights on North Carolina (where I'm from and went to school) and the returns quadruple. Not to mention, the cost to get in decreases substantially.

Of course there are risks to investing our of state, but they can be carefully calculated risks.

Bill Jacobsen · Answer

Michael uses cash flow of $4,164.  To that you could add 2% inflation or $7,380 and mortgage pay down of $4,613 or $16,157 return on your investment of $87,500.

The way I look at it is NOI/(price + rehab) compared to cost of money.  I want at least 3 percentage points above my costs.

Good Luck.

Bill

Deal Analysis - How Do You Determine Whether To Buy?

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