Is this a good deal?

Question

Hello everyone,

I am new to real estate investing and would like to take advantage of the wealth of knowledge investors on this site possess!  I currently have a deal in the works for 2 townhouses built in 2004 for $220k.  Both units are occupied.  I'll be putting 20% down leaving a $176K 30 year mortgage @ 5.1% ($11,467.08/yr).  Each townhouse rents for $1050 per month ($25,200/yr).  Property taxes are $1859.75/yr (both units).  Insurance is $725/yr for both units.   POAs are $53 per unit ($106/yr).  Security Deposits - $1050.  Termite Service - $85/yr.  Lawn care - $325/yr.  LLC Fee - $150.  I have budgeted in an additional $100/mo ($1200/yr) for any unforeseen maintenance.  I will manage the properties myself.

It looks like I will be netting just over $9325 per year on a $44k investment (21% ROI).

Is this a good deal?  Am I missing anything as far as expenses?

Thanks for your feedback!

Michael B. · Answer

Sorry, I have no super secret formula for inching up rents. It's just good blocking and tackling that's useful in every business.

Keep good communications with the tenant. Respond quickly to maintenance issues. Keep up on what comparable rentals in the neighborhood are going for. In other words run your rental business professionally. And when the time comes don't be ashamed to ask for an increase in the rent.

I guess the one 'secret' that I do have is that I raise the rent on every tenant every year. No exceptions. It may only be a 1% increase if that's all that's warranted, but don't go for years without upping the rent. It's too hard to play catch up after several years of no increases.

Will Barnard · Answer

This may be true, of course every area is different and if it were "easy" then everybody could do it! Keep in mind that due to lower interest rates today compared with years past, you can hit the same cash flow on identical properties paying slightly more than the 2% rule simply because the debt service is lower than before.

Jordan, don't forget that building capital through cash flow will be a long and slow process. There are other means to build capital. Look into doing a few rehab flips, wholesale deals or similar to build capital along the way. This will enable you to buy more doors faster. You can also locate motivated home sellers and structure creative financing deals with them to limit the amount of capital needed, thus creating the ability to build a larger cash flow portfolio quicker than relying on retained earnings from cash flow to acquire new doors.

Jordan Greer · Answer

@Will Barnard - That was very helpful!  Thanks for taking the time to help out a novice.  I have plans to add 2 units per year over the next 5 years and then to bump up to 4 units per year in the 5 years after that (paying for part of the new properties from the cash flow I am bringing in on my existing properties).  Cash flow is extremely important for me to execute my growth plans after the 5 year mark.

@Michael B. - Thanks for the feedback!  I am looking for a long term investment.  What are your strategies for inching up the rents?  That is something I plan to do going forward.  Do you increase based on some formula or is there a standard amount you'll increase by each year?

Michael B. · Answer

Hitting the 2% rule is pretty tough these days. A few years ago it was doable, but now, not so much on good properties.

I guess my thought is that you're probably not overpaying too badly, but you're not getting a great deal either.

This is actually the type of investment I tend to like. There's sufficient cash flow to make it take care of itself, build reserves, and it's new enough that the maintenance shouldn't be too bad for the next few years. The hope is that you can inch up rents a little over the next few years to make the cash flow even better. Hopefully some appreciation will come your way to make it even better.

I don't have a real problem with these numbers, if you're looking for a long term investment.

Will Barnard · Answer

A very good question. Please keep in mind this is not a "rule" but a "guideline". With that said, this guideline and others need be adjusted depending on the specific investment. For instance, as the gross rental rates per door climbs higher and the value of the property is higher, you can certainly obtain real cash flow with a 1.5% rule and vice versa, when the rental rates are super low and property value super low, you may need to do better than the 2% rule. Also keep in mind that part of your strategy may be to gain some cash flow while also obtaining a solid opportunity for appreciation. College towns and inside large and growing metropolis areas are prime examples. Just know that typically, the better the cash flow, the lower the chance (typically) of appreciation and vice versa. Here in many parts of Southern CA, investors kill to buy at a 1% clip, but have greater possibilities of appreciation.

The 50% rule works in ANY area, it is not a guideline that only works in some areas. However, that said, the rule is based on an average, consisting of many doors, over many years, and over different areas. Some areas like TX have higher property taxes but lower costs of other expenses, thus it often "averages out" to be similar as Colorado, etc. Can you own 10 doors over 20 years and average lower than 50% expense ratio? Of course you can. This is just a quick analysis guideline. You could also own 20 doors over 20 years all of which where owner pays water bill, HOA, and exterior grounds maintenance, all of which would add to the common expenses and perhaps take you above the 50% expense ratio. So like I said, it is all specific investment dependent.

Back to the 2% rule, keep in mind that anyone who bought an investment using the 2% rule back in 2007 when interest rates were around 7.5% for non owner occupied loans and someone buying using the 2% rule last year where you could get a loan for say 4.25%, the investor buying last year would have higher cash flow even if the properties were identical because the debt service was lower. So, if you can lock in a deal where your 30 year interest is much lower, you can bend the rule at purchase. The rule you should not hinder from is that you want to shoot for at least $100 per door of real cash flow IF cash flow (income) is the strategy.

Hope that helped.

Jordan Greer · Answer

@Perry L.  - Thanks for the feedback!  The $220K is more than $20k less than any other comparable property in the neighborhood has sold for since 2004 and the $1050 rent is one of the highest.  My brother owns several properties in this neighborhood and seems to think it is a good deal.

@Amit M.  - Thanks for the feedback!  The property is in a very desirable neighborhood for college students that aligns with my investment strategy - within 2 miles (1.6) of a college campus with 25000+ students that grew 53% from 2002 to 2012.  Occupancy rates are 96.5% in this town.

@Will Barnard - Thanks for the feedback!  It appears I am overpaying for this property!!  I can still get out of the deal based on "due diligence" contingencies.  On a side note, the 50% and 2% rule may not work in the market I desire.  In your experience, has a specific market ever merited you stepping outside of this rule?  OR, if you truly want to make money in this industry, is this a rule I should never break?

Will Barnard · Answer

Jordan, I suggest you read up on the 50% rule and the 2% rule. From your numbers, you are paying more than 1% of the gross rents which over a sustained period of time and multiple investments, typically does not equate to cash flow.

Expenses you are missing: vacancies, legal expenses, advertising, repairs caused by tenant damage beyond security deposits, eviction costs, tenant placement fees, utilities during vacancies, accounting costs, etc. on top of that, your $100 per month (only $50 per door) will not come close to covering capital expenses which are roof replacements, HVAC replacements and repairs, and other major upgrades to the properties.

The 50% rule states that 50% of your gross rents will go to operating expenses, capital expenses, and vacancy expenses. The balance 50% is left for debt service and cash flow. By your numbers listed, and using the 50% rule, you have $12,600 left after expenses. You have $11,467 in debt service which only leaves you an annual cash flow of $1,133. You should be shooting for at least $100 per month per door in real cash flow.

Of course none of this takes into consideration the appreciation game/gamble or amortization, however, if your goal is income, you need to be fully educated on operating expenses and all other costs associated with owning rental units.

Amit M. · Answer

perry- that's exactly right, and how I succeeded in SF with my investments. It's so different than the rest of the country. Do you own investments in the city?

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To the OP- cash flow wise your deal looks good. Check with local owners who are knowledgeable about expenses specific to your location. Another plus is that the property is only 9 years old.

BUT, the big question is: what kind of area and neighborhood is it in?  Is it improving in quality, or at least stable?  Is there potential for appreciation?  Making $9k per year is nice, until a roof needs replacing, appliances go out, or you get one nasty tenant that doesn't pay rent plus damages the property. Good areas that appreciate provide a long term buffer to that.

Perry L. · Answer

Only a person in your neighborhood can tell you if it is a good deal. This kind of returns don't exist in my neighborhood. But people here are playing a different game called appreciation.

Is this a good deal?

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