Buying First Rental Property Any Formula?

[Adrian Williams]

Hello everyone and Happy Thanksgiving it seems to have been quite awhile since I was on Biggerpockets. But my question is I have been trying to put together this deal on a 2/1 in Kansas City my plan is to do the minor repairs the home needs myself while living in the home and then renting it out. The owner will carry the financing. I was just wondering is there a formula anyone uses to evaluate possible Income producing propertys,...Any help would be great! Happy Thanksgiving ! :D

[Jon Holdman]

Yes. There are multiple formulas. There are lots of posts that discuss this topic, some that get pretty heated.

But here's mine.

First, I'm a big believer in the "50% rule". That says that operating expenses plus capital expenses plus vacancy will average out to about 50% of the gross scheduled rent. That's a long term sort of number. If you own 50 properties for 10 years these three items will be pretty close to 50%. OTOH, for one property and a specific year, they can be much more variable.

Some expenses are very predictable. Taxes, insurance, property management. Some less so, like routine maintenance. Some big ticket items are less predictable still. Like roofs and furnace replacements. Some, like nasty evictions, are even less predictable. Unpredictable isn't the same as unlikely, though, and you still have to account for these things.

So, start with 50% of the gross scheduled rent for an estimate of your NOI (net operating income). Out of that you'll have to make your P&I payment. Taxes and insurance are in the 50%. Rent is the factor you control the least, so always start by figuring out what you can get in rent. Take off 50%. That's the most you can afford for a P&I payment.

But you usually want to make some money. So, now subtract off your desired cash flow. $100 is a common number. Notice that doesn't depend on the rent. A tenant's a tenant whether the rent is $400 or $1400. The work required is roughly the same. If anything, in low rent properties ($300-500), you may have more problems and turnover than in nicer properties, meaning they take more time and effort.

Now you're down to what you can really pay. So take you max payment, rate and term and compute the max loan amount. That's the present value (PV) function in Excel or on a financial calculator. If you're unfamilar with that function and its siblings, take a few minutes and figure out how they work. These are your core tools for dealing with real estate.

Now you have your max loan amount. Here's where people often go wrong. They say "I have to put in a 20% down payment, so I'll add that onto this amount." NO! That's equivalent to saying "I have this cash but I'm willing to put it into this deal and get no return." Not me. So, use the max loan amount as your max price. If you do have to put in a down payment, your cash flow will be higher. That additional amount is the return your cash is generating.

Now, if you need to do repairs, you want to subtract those off. You'll likely have some closing costs. Two percent of the purchase prices is a good starting estimate, plus 1% of the loan amount if you're getting a loan. As you get closer to a deal, you can start honing these estimates with the actual costs (appraisal, inspections, any certifications, title company closing costs, recording fees, etc.) You may want to subtract all these off your price, too. They may be less with an owner financed deal, but they should not be zero. If the owner refuses to use a title company and do a proper, well-documented transaction, run away.

In a nutshell:

NOI = Rent * 50%
Max payment = NOI - desired cash flow
Max loan amount = PV (rate, term, max payment)
Max price = max loan amount - repairs - purchase costs

I've looked at KC a little bit, and I'm quite confident you can find deals that work with this forumla.

There are two other considerations before you buy - demand and value.

You want to be sure there is demand for the property you're buying. Drive the area and look for "for rent" signs. Check the newspaper (if anyone still uses those) and craigslist. Call the numbers and ads and get the details on the properties. If you're bold, pretend to be a tenant and go have a look. At the least, drive by and have a look from the outside. Watch these properties. If they come and go quickly, you know there's strong demand. If a few linger, figure out what's wrong with those. Wrong size, no garage, too high, poor condition. What ever it is, try to figure it out then don't do that. If there are lots of properties available, and the set empty for a long time, you know there's little demand. Avoid such an area.

The final criteria is value. You want to buy at a discount. Ideally, at a pretty significant discount like 30% or more. Figure out values for similar properties by looking at recent sales. Look at listings on the MLS. If you're paying retail, that is, the price it would bring on the MLS, you're paying too much. You want some protection if prices fall. Further, buying and selling, especially selling, is expensive. You lose about 10% of the sales price to do a transaction. These days, you typically have to give concessions to get a buyer, and that will cost you another 3% or more off the top. So, buying at 90% of the price you could get if you had to sell is probably still a loser. You need to be below 85% just to break even. Being at 60-70% protects you against continued price declines and lets you undercut other listings if you need to sell quickly.