How to Evaluate Properties Like Everyone Else is Doing
- November 10, 2018
- Posted by: Jim Pellerin
- Categories: Analyze, Buy, Rent and Hold
In this presentation I’m gonna show you how to analyze a property for a buy rent and hold investment. Keep in mind that there are many different types of investment approaches or investment strategies. But today we’re strictly talking about buy rent and hold.
So here’s the process that a lot of people normally follow. First of all, they’ll go out and they’ll meet with and talk to a lot of Realtors. They’ll get out there. They’ll do a lot of driving around. They end up visiting a lot of Fixer Upper’s. They get there and either it’s for sale or it’s already sold and then they’ll have to shop around and look for more.
They look at the properties and see if they like them.
Now you noticed at this point that they haven’t done any kind of financial analysis. Then what normally happens is, they’ll go back and then they’ll start crunching the numbers. So what their approach is … they go out, look for a property, if they like the property then they’ll do the financial assessment. Infact, I get a lot of sellers very upset with me that I don’t want to see the property before I did the finances on them?
So, a lot of investors spend a lot of time with what’s called driving for dollars or at least that’s what a lot of the trainer’s tell their students to do. To go out and drive the neighborhood. If you find a property, that’s good.
I’m not suggesting that they tell them to do that all the time, but certainly I’ve heard it a number of times. I’m sure you can find a deal here and there but there is an easier way. So obviously there’s a limitation on what type of property you do want to buy?
The other problem that happens is when you’re doing a whole bunch of analysis or you’re doing a whole bunch of evaluations against many properties you tend to start getting lazy and your analysis gets weak. So the deal looks better than it actually is. The other thing you’ll run into is that you’re trying to make a deal work because you’re spending so much time analyzing these properties. You start thinking … well maybe if I reduce the cost, you know, or there’s no way I’m going to have 5% vacancy. There’s no way that the utilities are gonna cost that much or I’m gonna do all the maintenance myself.
So some expenses end up being left out and some expenses are estimated on the low side. So instead of 5% for maintenance, maybe they’ll put 3% or 2%. And I’m sure those expenses can vary but it depends on the condition of the property.
So they’re really trying to figure out how to make the deal work, which is not necessarily a good thing. So let’s do a simple analysis. So what we’re going to do is we’re going to look at a sample property here.
So this sample property is for sale for $320,000, but it can be purchased for $300,000. The monthly rents are $1,700, which is really the top rent for this property in this market in this location. In this example the annual taxes are about $3,000 and the insurance for this property is going to be about $300.
As mentioned, the purchase price for the property is $300,000. In this case, we’re putting 20% down so that means $60,000 which leaves a mortgage of $240,000. Our closing costs in this area for this location is about 2%. That includes things like land transfer tax, title search, legal fees, inspection, appraisal and things like that. So it’s about $6,000. So you add those two together and you get a total investment required of about $66,000.
I already told you that the rents are only going to be about $1,700 and that’s max right now. So $1,700 x 12 = $20,400 annual rent
Now let’s look at annual expenses.
I figured the mortgage payment at 3.5% and some people are saying well they can get a lower rate. But, just to be on the safe side and depending on where you are with your investment portfolio 3.5% is good. That means we have a mortgage payment of $1,200 a month. $1,200 x 12= $14,400.
Taxes, are about $3,000 and insurance was about $600, maintenance we’re estimating here is about 5% which is about another $1,000 and eighty. So your net income is $1,320. What I did was added up all these expenses and subtract them from the rents and I came up with $1,320, which really puts your return on your investment at only 2%
Now, that is almost $100 a month cash flow, which isn’t too bad if you’re looking at a long term here and really
buy rent and hold or rental properties is a long term gain. It’s not something you should be doing in the short term if you’re trying to make money or if you’re trying to replace your day job because it’s just not going to happen.
There are other investment strategies that could help you if you’re looking for quick cash or medium-term cash, but really buy rent and hold is a long-term play and, depending on how you strategize it, most people look at it as at least a 10-year play.
By the way, that 2% return is based on the net income divided by this total investment
So now let’s look at the principle pay down. So over the the one year you’ve paid about $6,000 down on your mortgage and, with the appreciation, let’s say it was $3%, you’ve made another $9,000 which is a total of $15,000. Add that to the original $1,320 and you’re coming up with $16,320. Now, that’s a good return of 24.7%. But again, it’s an internal rate of return which isn’t realized until you sell the property. Obviously, over the period of time, let’s say ten years, you’re gonna have other expenses like a more a roof replacement, new windows, furnaces … major expenses where you may have to pull some of that equity out to pay for those expenses.
So anyway, that’s a simple analysis and it’s usually what most people do.
But there’s one minor problem with that analysis … some expenses were not accounted for. And I’m just gonna highlight two here. There was no vacancy allowance and there was no management fees. Now some people argue .. “well, I’m going to manage the property myself”. That’s fine. As long as you never want to retire from managing these properties, especially if you get into big numbers like 10, 20 30, 40 or more. I know people with 300 properties. So really it depends on how much you want to scale this business?
Okay, so let’s look at it from a different perspective. So now what we’ve done is we’ve modified the analysis and we’ve now include a management fee of 5% which is another $1,080 so you could be paying yourself about $100 a month to manage this property? Vacancy would be another $1,000 a year. So, over the course of a year, you’re expecting potentially one vacancy. Or maybe over three years you have a two month vacancy.But really you need to put in some kind of vacancy and some kind of management estimation.
Now if you take all these estimates or all these expenses and subtract them from your rents of $20,400 now you’re actually losing money. About $75 a month. Now, I don’t know about you, but I don’t like to be pulling money out of my pocket every month to subsidize my real estate investment. So you’re now losing 1.5%. And sure if you look take into the account the printcipal paydown and the appreciation you’ve only made fourteen thousand because you had to subtract the $840 that you lost. You’re still making 21.4%. You can look at it that you’re pulling $840 out of your pocket every year to really
invest in this long-term investment that’s going to give me 21%.
The point is that you want to make sure you add in all your expenses and that you’re prepared to make up for that negative cash flow. If you come back to the original point here is that people are trying to make deals work because they’re so busy
evaluating properties by running around and spending a lot of time in the road rather than doing a whole bunch of analysis first. You don’t want any surprises
So … when evaluating properties, you don’t want to cut corners. You want to make sure that you identify all of the expenses. I would rather spread to spend more time evaluating the right properties. Then I only have to go look at the properties where the financials make sense.