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. In this article we will talk briefly about why such "rules" fail and the approach we use to determine the offer price.
The Problem with "Rules"
We frequently hear or read about new investors who bought properties that conformed to various "rules" including the: 1% rule, 2% rule, 20% 65% rule, 80% rule, etc. Even though they follow these rules, they lose money. Some of the reasons these rules do not work include:
- They primarily concern the purchase price and not return
- What you pay 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. This mis-belief has lead to financial disaster for many. Before I get into the the process we follow, I want to dispel this popular fallacy.
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. However, if the property is not market ready, it will rent for less than similar properties. Can you "improve" a property such that it rents for significantly more than similar properties? No. For example, if you installed a $50,000 pool you might get $100 more per month. If you doubt this, do a little homework on one of the real estate sites that has rentals. You will quickly see what I am saying is correct. Once you accept this concept, you are ready to proceed.
Work Backwards From the Rent
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 rehab) 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. While the equation looks simple, it is not directly solvable. In another article I will explain how to solve a real world example using a tool, which I will provide. For now, I will simply provide the answer so we can proceed.
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 limited 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.
In this article I explained a process for determining the maximum price you should offer based on the expenses. This approach does not rely upon "rules" or gurus. I can tell you that this approach works extremely well and is a part of the algorithm we use for selecting candidate investment properties. As I stated, in another article I will provide a software tool and a detailed explanation how you can estimate the maximum price for a real world example.