BiggerPockets

All,
First post for me but from what I have read thus far, this forum is great.

I live and work in Massachusetts in the Financial Service industry and have amounted a small (>100k) in cash over the last couple of years. Over the past three years, I have been wanting to purchase a 3 family home as an investment. I do not plan on living in the building, but renting the all three units. Im not in a huge rush to purchase, but with the decline in the overall real estate market, I am starting to see multi family's for prices they haven't been at in 5 or so years.

The short of it is, I am looking for advice on purchasing multi family's for a long term investment. I have the financing all in line so Im looking more advice on what to look for in a multi-family, where one could run into issues (zoning, repairs, etc) and what is a good annual rate of return on the rents vs expenses.

All and any advice would be appreciated.

Thanks for the advice. I am looking in eastern mass and have been seeing multi prices drop significantly. I am currently running monthly numbers using the mortgage payment, insurance and taxes like you said. One thing I am struggling with is incidental repair figures. Obviously this number is a variable figure, but what do you feel is a good number to use in terms of a minimum on an annual basis.

I guess what I am saying is can you for sure know you will spend 3K (just a example) a year in fixes/improvements.

How do you feel about section 8 housing. Have you had good luck with it. I know something about it because my brother owns rentals in Georgia, but Im not 100% familiar with the program. Could you elaborate a little. Did you buy your buildings already section 8 approved or did you make them section 8. If so, what was the process?

Thanks again

JK,
Assume that all expenses, not including your mortgage payment, will be at least 50% of the rent. In a well managed, well maintained property you can keep them to 50%. They can be much higher, even over 100%.

Don't try to itemize them out, because they can be very irregular. If you have a 100 unit complex, then the large number of units will tend to smooth the expenses out. With a three unit (triplex), the expenses will be much lumpier. At some point, you will have to spend for major items like boilers or roofs. Many years you will not. But, if you budget 10% for maintenance, and you don't spend it, you better be socking it away for the years when you do. With 100 units, one's always going to be in the middle of an eviction, another's going to be trashed, or whatever the proper numbers are. With three, you may go several years without an eviction or a tenant who makes a mess. But, when you hit these problems, they will really hurt.

Find a place where you can make money if you assume expenses are 50% or whatever the current owner can document (whichever is higher) AND 100% financing.

If you manage the property yourself, assume about 10% of gross scheduled rents for management fees back into your pocket. Note that money is for being a property manager and not on the investment itself. Absolutely nothing wrong with that, but you will earn that money.

While I agree that jgfichte that waiting and analyzing for too long is bad, jumping headlong into a bad deal is even worse. Lost opportunities are easier made up than lost money.

Assume no appreciation. The appreciation we've seen over the last eight years has no historic precedent [ref: Case-Shiller], and is likely to have to be worked out of the system before we start seeing appreciation again. Find properties that make money right now.

Jon

Thanks for the great tips. One question I have in regards to the expenses. When you say all expenses, excluding mortgage payment will be at least 50% of the rent, are you including the taxes and insurance in this number or is the 50% on top of the insurance and tax. While I understand these are expenses, in my previous postings I was already accounting for these outside of my maintenance expenses.

Thanks again

Great tips. Thanks. This is exactly the info I am looking for.

Guys,
Thanks again for these tips. I am working running these numbers using the 50% expense number and the properties I was looking are dont look as good as I thought.

Being that my brother has rentals in Georgia, I understood the importance of having cash to pay when the property is damaged or needs normal repair.

Because of the listing requirements in Mass, I am able to get last years tax payment and I also ask the realtors for last years insurance, so I am taking the monthly rent, cut it in half (50%) and then subtract my monthly insurance and tax bill and am now using that as my " Misc" monthly expense. So as an example, my rent is $3000, so my total expense is $1500. I subtract a payment for tax of $400 and $200 for insurance, My misc expense line item on a monthly basis will be $900.

One question I have is what is a comfortable number for a profit I should be looking for after my expenses. The properties I am looking at right now are slightly in the red on a monthly basis using this formula. Now being that I am in the Financial industry (and have common sense) I understand that you never want to be in the red. With that being said, I also know that the montly expense may or may not be used. I am assuming, based on your past posts, that I should just assume that even though I dont use it in month one, to be safe, assume that I will use month 1 and month 2s expense allowance in month two (if that makes sense).

Maybe I am imprudent or too aggressive, but I feel that planning for every possible eventuality and saving for it limits my growth.

Yes, I understand, if you have a 100unit complex and you need a new roof or boiler you are talking big $$$. Maybe 200k for a roof. With residential multis I funnel my cash into new projects to build my total net worth. I have some saved, but I usually approach problems as they happen. I typically spend 2k/yr on unexpected expenses per building. If a roof or boiler is going, I'm not surprised. I can tell you already that I will need a new roof on one of my building in the next 2-5 yrs. I'm already planning for it. I had an eviction this summer that cost me 5k in rents/legal. Again, these are, on the whole, small figures. I roll with it. Are these real expenses, yes. How often do they happen? That was my first eviction across 14 units in 5 yrs.

I don't think it would be easy to find a 3-family in a reasonable neighborhood that fits the stats you've offered this guy. I say this not only as an active investor, but as a licensed Realtor. It would be near impossible to find a good 3-family in my area for under 250K. And that's one that need some serious fixin'. Most sell for closer to 325-350K. A mortgage on 250K is easily 2k. With an expected 3k a month income you are paying 2k to mortgage and only 1k left for other expenses. Again, there is not your suggested 50% remainder. By your own formula, you could NEVER EVER buy mulifamilies in Connecticut, unless of course you are willing to suffer gun-shot wounds as another uncalculated expense ;).
And even in the ghetto, I'm not sure your number would work.

...my whole life until I moved to NH summer '06. It sure seemed to me like property values were nowhere near positive cash flow, even after the huge drop.

Where are you looking?

Wow! There is so much bad information in these last few posts, I don't know where to start.

First, let's start with a few basic definitions.

Operating expenses are all those day to day expenses incurred in running a business, excluding debt service. For a rental property business, they include taxes, insurance, management, maintenance, advertising, office supplies, entity maintenance, legal fees, evictions, setout fees, damage done by tenants (in excess of the security deposit), lawsuits, capital expenses (not technically an operating expense), etc, etc, etc (I could go on and on).

Cash flow for rentals is determined by subtracting the operating expenses and the debt service from the gross rents.

The NUMBER 1 reason that newbies fail is that they don't understand operating expenses and therefore have a negative cash flow.

Let's look at a few things that were said in the previous posts:

so I am taking the monthly rent, cut it in half (50%) and then subtract my monthly insurance and tax bill and am now using that as my " Misc" monthly expense. So as an example, my rent is $3000, so my total expense is $1500. I subtract a payment for tax of $400 and $200 for insurance, My misc expense line item on a monthly basis will be $900.

This is wrong. To determine your cash flow, simply subtract the mortgage payment (principal and interest only) from 1/2 of the gross rent. Taxes and insurance are part of the 50% operating expenses.

With residential multis I funnel my cash into new projects to build my total net worth.

Net worth is good, but it won't pay the bills or keep you in business. Cash flow is what keeps a business IN BUSINESS.

I have some saved, but I usually approach problems as they happen. I typically spend 2k/yr on unexpected expenses per building.

In other words, these items are off-budget for you. Therefore, any expense number you claim is inaccurate.

I can tell you already that I will need a new roof on one of my building in the next 2-5 yrs. I'm already planning for it. I had an eviction this summer that cost me 5k in rents/legal. Again, these are, on the whole, small figures. I roll with it. Are these real expenses, yes. How often do they happen? That was my first eviction across 14 units in 5 yrs.

How often do they happen? Every day if you have a large portfolio. What you are doing is what causes many newbies to fail. You're ignoring the real expenses and just paying them out of pocket. You can do that when you have a small portfolio, but you can't do that with a larger one. What happens when you are unlucky and a bunch of things happen at once. If you had real cash flow, you could absorb it. With pretend cash flow, you're out of business. I see it all the time when I'm buying properties from failed landlords.

anyways, the 50% rule they describe here seems too high for me also...i dont believe you will find any of those type of properties in mass even in dorchester, lawerence or fitchburg...maybe fitchburg or springfield

So, what you're saying is that if you can't find a property that will cash flow, buy one that loses money? You see, it doesn't matter where you live. You either make money or you lose money. The math doesn't change because you live in dorchester, lawerence, or fitchburg.

im under agreement on a 3 decker w/ a cap rate of about 12%...pretty good in my eyes...my cash flow estimates are about $1500 per month...now thats w/ me doing all the work, which i will do...that is with no maintance nor property management...

If you're not including management or maintenance or other operating expenses, then you certainly don't have a $1,500 per month cash flow. See the cash flow definition above. What you're really saying is that you're doing the management and maintenance and that you work for free! (your time is worth nothing) In addition, there must not be any materials when you do maintenance. What about all those other operating expenses that I listed above? Did you include those.

All real estate is local. Yes, truism are often true. A rule of thumb that works in one area may not work in another.

Ignoring the operating expenses doesn't work any better in New England than it does in California or anywhere else.

Good Luck,

Mike

jgfichte,

I did not attribute anything to you. In fact, I didn't even mention you. As I said at the beginning of my post, there was a bunch of bad information (much of it blatantly incorrect) in the previous several posts, and I commented on parts of several posts.

I have now gone back and looked at the parts that were attributable to you and it is crystal clear that you don't understand operating expenses. You claim that you have never had a building with an unprofitable year, but you are not including all the expenses, so any cash flow you calculate would be bogus.

You say the math doesn't change, but if you ask any seasoned commercial investor or broker, I think they will tell you it does. The math does change. " A" class NNN buildings likely sell at a far lower cap rates than C class.

Now you're trying to change the subject. We were talking about small residential rentals in this thread, not " A" class NNN buildings. No, the math doesn't change. Math is the same in Ohio, California, and yes, even Connecticut.

My suggestion is that the 50% rule, while ideal, is not realistic in certain parts of the country. Rather than never invest, I'm suggesting one be more flexible on the 50% rule. One can get by with less, still profit handsomely, and be reasonably safe.

What does that mean, " is not realistic" . Does that mean that since facing reality in a given location makes it difficult to find a property that will cash flow, you just pretend some of the expenses don't exist or are off budget? Does that mean, that you buy properties that will lose money since you can't find one that will cash flow? How can you be more flexible with EXPENSES? That doesn't even make sense. How can one get by with less? Do you just not pay the taxes? The insurance? Don't evict deadbeat tenants? You have a get-out-of-lawsuits free card? What does that mean?

Some make money from cash-flow, some from flips, some from appreciation.

That's true. However, we're not talking about flips. We're talking about rentals. Are you suggesting that people accept a negative cash flow in hopes of appreciation in a declining market?

What I also know is that different areas have different expected cap-rates. Do you disagree?

In reality, there are no meaningful cap rates for small residential rentals. You are a perfect example of what I mean. You are a realtor and have been investing for several years, yet you are not calculating the real expenses for your rentals. Without proper expense data, there can be no accurate NOI. When people bring up cap rates, I always ask where they got the expense numbers to calculate the NOI. It doesn't exist for small residential rentals. The truth is that the vast majority of newbies fail and most residential rentals are owned by individuals. As you are well aware, there is a tremendous turnover in rentals. Therefore, even if you had an accurate cap rate for houses and small multis in an area, all it would tell you is what the losers paid for their property. If you want to follow in their footsteps, then buy at the market cap!

The future is always a wild-card . . . and the 50% rule is as arbitrary as any other.

That is simply wrong. The 50% rule is nothing more than the fact that throughout the United States, operating expenses run 45% to 50% of gross rents. This is well established data based on hundreds of thousands of rentals and is anything but arbitrary. You can find this data at any of the large landlord/apartment associations. Moreover, this 50% rule assumes that the landlord is doing everything right. Newbies often don't do things right and their operating expenses can be MUCH higher than 50%. The 45% to 50% figure is not a conservative number, it is the " average over time" number. A conservative number would be significantly higher.

Mike