Question for Landlords
Specialist · Jacksonville, FL · Member since 2008 · 140 posts · 14 votes
I am curious to know what do you consider as a good deal? What type of property a wholesaler would have to bring you for it to be a no brainer to buy the property. I know each market is different but like wholesalers I'm sure there is a formula when buying rental property.
For me, it's a minimum $200 per month cash flow and minimum 20% cash-on-cash return. I also want to see that there is equity so that I could resell the property for a profit in the short-term if I decided to.
For me, it's a minimum $200 per month cash flow and minimum 20% cash-on-cash return. I also want to see that there is equity so that I could resell the property for a profit in the short-term if I decided to.
Thanks J for the response. Now when you say resell in the short term do you mean like 3yrs?
Hi E.
"Landlords" (rental property investors) only need to use simple math when it comes to rental property:
Revenue – Costs = Income
If the property is not on the “Income†side of this equation, then as a "Landlord" that invests in rental property only, they should walk away. There is no other test needed. “Real†numbers and a calculator. Only tools required.
Again, I am only speaking of the Landlord that buys to produce income and has no intention to sell the property in the near future. Therefore, it is not about appreciation or the desire to dump the property for a gain, but rather nurturing an income producing investment.
Buying rental property is about buying in the "now". If the “now†numbers do not work based on the above simple math, then walk away because it is nothing more that another piece of property with "blue-sky" hopes, not necessarily an "income" producing investment a Landlord would want.
In the context of this post, when we are talking about "no brainer" investments, your (Dave O) algorithm is too simple and not quite complete for me. CR = Contract rent, BASIS = Contract Price + Capitalized Fixup. The 'no brainer' deal for me is:
(CR/2) - (CR*0.25) - BASIS/200 - BASIS/27.5/12 > 0
This no brainer assumes we account for long term expenses (first part CR/2), really bad vacancy, rough interest expense (BASIS/200) at current commercial rates, and monthly depreciation expense (BASIS/27.5/12). Typically I don't worry about fixup expenses on most properties. If they are big rehabs (or adding a bathroom, etc.), we'll add to basis.
So we closed on a SFR for $37K, rented at $850/month. No brainer? Almost. Plug in and the result was -$51. But change vacancy to a more realistic 12% (6 weeks a year) and the number is $60. In this case, almost is/was close enough since our reserves were lower than average. Of course, actual number may outperform the estimates... most of the time this is true since vacancy is usually much better than the model.
Hi Chris,
I am sure there are multiple complex "algorithms" a landlord can use to make themselves feel good or bad about investing in a specific rental property. However, I would argue that an out-of-pocket monthly cost is a "monthly cost". Likewise, monthly rent is "monthly rent". If your month is more costs than rent, then you are (negative) out-of-pocket for that month and you are not producing income into your bank account (or covering your costs).
I find it interesting that you do not count "fixup expenses". As a landlord, if I have to spend one penny on anything to do with a property, I count it. I consider it out-of-pocket operating expenses or costs. If my rents do not cover those costs (factoring in vacancies), then I have a losing income producing investment for that month. Reminds me of a business saying: "Watch the pennies and the dollars will watch themselves."
Granted, you can throw in annual depreciation and take it to the front of the IRS Form 1040 and attempt to reduce your income tax liability (providing you qualify), but this does not positively or negatively impact your monthly operations of an income producing rental property.
The math is simple and is based on how many times you open your wallet and how much you deposit into your account on a monthly basis. This is all about the "now" numbers. If not, then you are not a landlord, but rather a real estate investor waiting (or hoping) on some other payoff down the road with the piece of property you have invested in.
Revenue – Costs = Income
....
There is no other test needed.
I disagree that there is no other test needed. There are two reasons I disagree:
1. I'm guessing that you can get pretty much any property to be "income positive" based on your formula, even if it means paying all cash for the property.
But, that doesn't make it a good investment. For example, if you spend $200K to buy a property for cash, and it produces $100 per year in positive cash flow (income), it meets your formula. But is that a good deal? Getting $100/year for a $200K investment?
I don't think so.
2. Your formula might be good for someone with infinite amounts of cash, but I don't know anyone with an infinite amount of cash.
Based on your formula, if 50 properties came along that all earned $1 per year in positive cash flow (income), you would say, "I'll buy it." But, in reality, that would likely eat up all your capital, which wouldn't allow you to purchase those properties that return a LOT more than $1/year.
In other words, your single simple formula doesn't allow a landlord to compare investments when he has limited funds but multiple investments to choose from.
While your formula is not incorrect (assuming you're really accounting for ALL costs), it's certainly not the only formula needed to maximize a portfolio in the real world.
This doesn't even include the non-financial aspects of rental property. Do you really want to own a property in a war-zone just because it generates $10/year in income? What about buying a 150 year old property that needs $100K in rehab, but will return $10/year in income when you're done (it meets your formula!)?
"I find it interesting that you do not count "fixup expenses". As a landlord, if I have to spend one penny on anything to do with a property, I count it." For anyone reading this site for more than a day, you'll know that these expenses are part of the 50% of Contract Rent part of the formula. In the context of my post, I don't count anything extra for fixup expense in a new property acquisition. Any "big" fixup or modification (read my post) will be capitalized, not expensed.
My math is simple, not complex. It accounts for scenarios your formula doesn't. Your formula doesn't account for reserves or capitalized costs or even financing costs... all of which are part of the equation, IMO.
To add to what Chris Martin just wrote, those who are familiar with the 50% rule of thumb will know that vacancy allowance has also been included in that 50% expense, as described in other BP threads. So Chris is really creating a healthy cushion for vacancy with that additional 25% loss of rent that he has in that formula above. And the math in that formula is simple - you could easily do it in a spreadsheet.
The other points made by JScott should also be considered important - including the ability to sell quickly in the market in the event of some cash-crunch. You know investors want to be "all in" for under 70% of ARV, so you have to be buying with that in mind to have the cushion needed for resale (to an investor). Even an over-priced property can cash flow positive in some areas (think places like Detroit where you can buy for comparatively smaller amounts), but because it was purchased above market it will be tough to sell without a loss.
Hi J & Chris,
Great discussion. Please understand that "costs" are costs, to include anything you open your wallet to. If you want to consider reserves a cost, go for it and factor it in. However, until I write a check against it, it is still not money spent although it is set aside from an accounting perspective. As for depreciation, you still layout the initial costs and then you write it off over a short schedule to gain a tax advantage. In this case, use the actual tax savings as your offset and add it to the revenue.
For the person that pays cash for a property, that is a "cost" that you want back through either the rents or an eventual sale so you need to bake it into the equation as a cost.
Using J's example, on $100 per year cash flow, it would take you many years to get your $200,000 back. Not a good investment unless you are one patient investor and throwing $200k around means nothing (by the way J., you can apply this to all your examples regarding cash). I do not know about you, but I always want my cash back and definitely consider cash as a cost that has to be recovered.
As for the "location" part, if the property is in a war zone, out in the country, next to a power plant, brick versus vinyl siding, etc., you will never get to the math equation because you will never consider the property anyway, so this is irrelevant to the simple formula.
Lastly, the threshold for an acceptable positive cash flow amount depends on the landlord. If you need it to live on, probably not. If you make enough with a W-2 job, then maybe you are happy breaking even and letting the tenant pay for your investment as long as you do not have to dig into your pocket.
Again, great discussion.
My first check is market rent / .03 (I've seen .02 used here but that just isn't enough for me). If there is a chance I can get it for that price or less, I'll then look at rent-ready repairs and subtract them. Chris M.'s formula is very conservative and I like that, I'll add it to my checks. So far, I haven't purchased anything that is worse than (market rent / .032) - repairs but I have had to be very patient.
[Edit] I should maybe add that we are doing 0 down financing (6%, 7 yr) and paying for repairs out of pocket
Chris R., yes conservative since the OP was talking about a "no brainer" type deal. In my investing area if the numbers work, I'm there. The property "type" doesn't matter to me that much. And I assume full financing even if I can't get it. If the deal is really good I have been able to. My simple model catches some of what Dave O alluded to regarding "location" since "impaired" property (war zone properties, older units with functional obsolescence, bad location, etc.) rent for less (or much less), have higher vacancy, higher capitalized costs... even though they are "cheap" from an acquisition contract price, they might not be a good buy for me. That's one reason why older neighborhoods sometimes have a wide range in closed sales prices.
So to answer E. BEAUVAIS, the markets are clearly different and each individual landlord's formula may be different. My view is a good wholesaler will be able to capture this critical information from their buyers and use it to present the ideal properties to a choice subset of their list.