Work Backwards to Make Money
Many new investors buy a property based on various popular "rules" ( and then discover that they cannot break even let alone make a profit. Some of the reasons these rules do not work include:
- They are primarily concerned with the purchase price and not return
- What is paid for a property has no correlation to what the property will rent for.
- The rules do not take into account costs like insurance, property taxes, management, vacancy, repair, etc.
- The rules falsely imply that there is the option of increasing the rent above market rate if necessary in order to make the property profitable.
You Have Little Control Of the Rent
How much a property will rent for is largely based on two factors:
- The condition of the property
- What similar properties recently rented for
If all the similar properties in the area are renting for approximately $1,000/Mo. your property is going to rent for about $1,000/Mo, unless it is NOT market ready, in which case, it will rent for less. No "improvements" to a property will make it rent for significantly more than similar properties
Below illustrates the problem.
Following one of the many rules or touts of "investors dream", you buy a property. Next, you rehab it and when everything is done, you put it on the market at the rental rate you need to make a profit. Unfortunately, the rent you need is more than the market rent. The result is that the property will sit vacant until you lower the rent to the market rate. When this occurs, you are on your way to losing a lot of money.
Our approach is to start with the market rent and then work backwards to the maximum price. See the image below.
For example, suppose you found a property with the following characteristics:
- Estimated rent: $1,230/Mo. This is what similar properties (after renovations) recently rented for.
- Taxes: $996/Yr or $81/Mo.
- Insurance: $450/Yr or $38/Mo.
- Financing terms: 0% down, 4.5%, 30 year fixed. No such financing is available but the 0% down simplifies the calculation so I choose to use it.
- Property management: 8% or $98/Mo.
- Debt service: Unknown at this time. Debt service is dependent on the purchase price. Note that I only included a few cost items to keep this example simple. In reality, there would be several more.
The formula relating rent with expenses is as follows:
0 = Rent - Debt Service - Taxes - Insurance - Management
Note that Debt Service is a function of price and financing.
Solving this equation determines the price at which the rent equals the sum of expenses.
Plugging in the known values:
0 = 1230 - Debt Service - 81 - 38 - 98
Solving the above for Debt Service:
Debt Service = 1230 - 81 - 38 - 98
Debt Service = 1013
The price that has a monthly debt service of 1013/Mo, is ~$203,450. So, the maximum you could offer for the property in this (overly simplistic) example is $203,450. What if the asking price is $250,000? Find another property! What if the asking price is $190,000, it is worth further investigation.
Another advantage of this approach is the minimum amount of information you need in order to make a go/no-go decision on further investigation. In the example, the only value I had to estimate was the rent which is relatively easily based on recent similar rentals.