All Forum Posts by: J Scott

Okay, here's a quick primer on how to determine whether you have a reasonable rental property or not...

First, you want to start by figuring out two things that will be specific to this property: INCOME & EXPENSES

INCOME
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Your income is going to be (in most cases) just from the rent you are collecting. In your case, you say that you expect rent to be $800-1000 for this house.

But, don't forget that your property may not always be rented:

Vacancy: You're not going to have the property rented continuously; you'll need to find tenants when you first acquire the property and whenever tenants move out. Sometimes it could take a month or two or five to rent a place. You need to figure out what % of the time the property is likely to be vacant, and consider that loss of income.

Suppose that for your property, you expect it to be vacant one month each year, on average. If that's the case, your income is actually 11/12 of what your monthly rent is.

So, let's assume that for your property, you receive the best case rental rate, $1000/month, or $12,000 per year. But, with your 8.3% vacancy (one month per year), your income is actually $11,000 per year.

EXPENSES
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There are a lot of things that contribute to the cost of owning a rental property, and you're going to need to account for each of them. Here are the basic expenses you must consider (there are others, but this is a good start):

Property Taxes
Insurance
Maintenance
Utilities (often the landlord pays the water bill)
Upkeep (lawn care, etc)
Advertising (how are you going to find renters?)
Administrative (do you need a book-keeper, attorney, CPA, etc?)
Property Management (will you have someone else manage your prop?)

If you want to own a rental, you'll need to be able to determine what each of these expenses will be. Things like taxes and insurance are easy enough to find out, but about things like maintenance and administrative costs? Those take some experience to be able to estimate. Ultimately, you'll need to be able to accurately estimate those for your specific property.

For the sake of argument, let's be very optimistic, and assume that the expenses for your property end up being $4000/year. In actuality, they'd probably be closer to $4500-5000 per year for this place.

NET OPERATING INCOME
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So, you now have your income ($11,000/year) and you have your expenses ($4000/year). This is enough information to determine your net operating income, for which the formula is:

NOI = Income - Expenses

NOI is the amount of money you have left over after receiving all income and paying all expenses on your property. This is the money you have left over to pay your mortgage (also called debt service) and to provide you profit.

Let's calculate your NOI for this property:

NOI = Income - Expenses = $11,000 - $4,000 = $7,000

Your NOI is $7,000 per year, so you have $7,000 left over after expenses to cover your debt service and profit for the year.

CASH FLOW
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Cash flow is the amount of profit you have at the end of the year. Cash flow is basically figure out as such:

Cash Flow = NOI - Debt Service

We already know your NOI, so now let's figure out your debt service. You say that you want the house to come down to a selling price of $110,000 and you also say that you only have $10,000 to put down as a downpayment.

Best case, you'll agree to purchase the house for $110,000, and your lender will allow you to put down 9% of the purchase price as a downpayment (making your downpayment $9900). Also, let's assume you pay no closing costs, and you get a great rate on a 30 year fixed mortgage -- 6%.

Your payments on this loan will be exactly $600/month, or $7,200/year.

So, now we have the info we need to calculate cash flow:

Cash Flow = NOI - Debt Service = $7,000 - $7,200 = ($200)

So, after all is said and done, you profit on this house is -$200 per year. That's right, you're losing $200 a year on this "investment." And that is assuming lots of very optimistic things, such as:

- High Rental Rate
- Low Expenses
- Low Purchase Price
- Great Mortgage Rate

So, as a rental, if you're looking for cash flow, this probably isn't the place for you...

Hope that helps!

I'd be very careful of taking advice here without consulting your own CPA.

First, using a Roth won't allow you to continue investing tax deferred. With a Roth, you pay taxes just like everyone else, but then you can invest the post-tax money and not have to pay taxes on future gains. Of course, you lose many rights to access this money until retirement.

Second, while there are certain advantages to using a C-corp in general, to use it purely for trading may open you up to some additional regulation, and in general, the downsides to managing a C-corp for businesses without large income (you said you were in the 28% bracket) can easily outweigh the benefits.

Third, don't assume that if you marry a real estate agent that you can take unlimited deductions:

http://www.taxloopholes.com/connect/blog/diane-kennedy/2007/12/real-estate-professional-looph

Actually, my calculations assumed an 8.5% vacancy rate, and then 40% of the net income for expenses.

If you put expenses at 50% of gross income (as you suggest), it actually cash flows about 50% more!

I tend to be very conservative in my pro-formas and don't generally use the 50% rule as most people do...sorry for the confusion...

So, it sounds like a lot of people interpret the 50% Rule to mean:

NOI = (Gross Rent) * .5

Talking to various investors, it sounds like people interpret the "50% Rule" (calculating expenses to be 50% of revenue) somewhat differently. I'm curious how each of you do it?

For example, some people use 50% of gross income, and some use 50% of net income. So, if a house rents for $1000 month with 20% vacancy, some will estimate expenses at $500/month (based on gross rents), for a monthly NOI estimate of $300. And some will estimate expenses at $400/month (based on net rents), for a monthly NOI estimate of $400.

I even know some people that include vacancy in the 50% expenses. They would say, if you charge $1000 month in rent, your NOI is $500/month. I can't imagine this is how most people do it.

Do you other do it?

That's a perfectly reasonable strategy...

Imagine this hypothetical scenario, with hypothetical but completely reasonable numbers where I live (suburbs of Atlanta):

You find a bank owned property in typical area listed for sale at around $82,000. Based on local comps, the ARV of the property is $120,000 and you negotiate a purchase price of around $75,000, including closing costs (this isn't unreasonable for a typical REO).

You find a hard money lender or you purchase the property with your own cash. You spend a month or two rehabbing the property, and put in about $15K to make it rentable. You've now put in about $90K.

Over the next couple months, you work with a traditional property lenders to refinance the property and take $80K out. You now have about $12K invested in the property, if you include closing costs on the loan.

You rent the place for $1050/month, and assuming an 8.5% vacancy rate (a month a year) and expenses of 40% of net income (a little low, but okay since you just rehabbed), you should see the following returns:

- $40,000 in total equity created from the property ($120K valuation minus $80K loan)
- Year 1 Cash flow: $862
- Year 1 Equity Accrual from Payments: $894
- Cash-on-Cash Return: 7.43% (not including equity generated by rehab)
- Total Return: 15.14% (not incl. rehab equity or tax benefits, which are investor dependent)
- Total Return Including Equity Generated by Rehab: 347%

If you choose to keep the property for longer than a year, your total return will obviously drop, but you're still receiving nearly $1000 a year in cash flow, $1000 a year in equity, and still have $40K in equity generated by the rehab.

Rinse and repeat...

Start with the ROI the investor (who is fronting the money) expect. If it is investing 20% of the $2M (or $400K), and he is looking for at least a preferred return of 10%, then he should be getting at least $40K annually of the resulting cash flow.

I don't know what your anticipated cash flow is, but let's say it's $60K. In order for your investor to receive his preferred return, he would need:

$40K / $60K = 66% ownership

There are lots of other factors, but this is one way to look at it...

The key is to generate a return on your investment every month, not just after three years of waiting to sell...

While it's certainly possible that your investment property will increase in value by 6% each year, it's also possible that it won't increase at all for the next 5 years, or maybe even decrease in value.

But, if you're smart about what/how you buy, it's possible to make much more than 6% per year on whatever actual investment you make. Let's say you invest $10,000 to purchase a $100,000 property. If you can generate enough income (rent) with low enough expenses (taxes, insurance, repairs, etc), you could potentially earn $1000-3000 per year on that property (10-30% return on your investment).

Plus, if you happen to get the appreciation as well, that's just gravy!

J Scott

Sorry, but there is nothing that anyone can tell you in a single response that would provide enough insight for you to go out and start making successful deals...

Try this:

Go read through these forums, read at least a couple books (I recommend starting with "The Millionaire Real Estate Investor"), start asking a lot of *specific* questions, and find a couple successful investors in your area that are willing to help you get your feet wet...

J Scott

1) Hire a property manager (or be prepared to work very hard)

2) Make sure maintenance costs are factored into your analysis/plan for acquiring each property