Evaluating a Rental Property, Pt 1

This is part one of two.  We'll be looking at the costs that go into evaluating a rental property investment, or figuring out that your old home is not a good one!

For the active investor or accidental landlord, owning a rental property is becoming somewhat of a common thing, but not all deals were made equal! There are townhomes, condos with HOAs, mobile homes, single family homes, etc. Each have their advantages/disadvantages. But at the heart, the numbers are what separates an asset from a liability.

Property management (PM): "But Chris, I'm going to do this myself." Well first off all, your time is worth something, so you better factor in the paycheck you just started working for by managing your own property. What's your exit plan? Unless you want to take toilet calls the rest of your life, you will eventually give up the management to someone else. When you do to sell, your buyer will factor Property Management in. So do yourself a huge favor, don't cut this cost out.

Maintenance (MX): Maintenance varies. Could be as low as 5%, could be as high as 25%. Get a feel for this through the current owner's expense records. Consider the year of the home. Don't forget landscaping and annual costs like termite treatments and powerwashing.

Insurance - Important stuff, protects your investment. Insurance providers vary wildly in their quotes, make sure to get a hard estimate from multiple companies before pulling the trigger.

Taxes - The local governments will take their share. These are usually pretty predictable, and mileage rates are published. Factor it in.

Vacancy: If only we could have 100% occupancy all the time... Every day that a tenant isn't in your home paying rent is lost revenue. If it takes a month to "turn over" after a renter (that's repair, clean, advertise, show, re-lease), thats 30 days you didn't get paid. Vacancy depends on your property manager, your property, and your market. Typical vacancy ranges from 7-12% of your gross rental Income, or GOI. Make sure your number can handle that and you won't be blindsided when you're eating the mortgage every month. HOA: What may look like an easy $100/mo with benefits may turn into thousands when you get tagged for a special assessment to re-pave the parking lot, put up a new fence, or install that fancy security system the homeowners have been dying for. While many of these things may have a positive impact on rents, the important thing to note is that you have very little say about what its spent on, but you will be the one paying for it.

All of the above factor into your Operating Expenses or OE. Subtract that from your take in rent (GOI), and you have your Net Operating Income, or NOI. Hopefully you're in the green, because you haven't even factored in your mortgage yet.

Debt Service: Your mortgage. Rates, term, amortization vary. I love using debt to leverage my investments, and I advise everyone to do the same. There is one important thing to realize though, it's about the value of equity. I hear a lot of people justify negative cash-flow every month, claiming they are building equity in their home by paying the mortgage principle down. STOP. Please stop, stop that ridiculous rationalization. The average mortgage lasts less than 7 years, and in those first 7 years you're paying a minuscule fraction of the principle compared to the money you shovel into the mortgage. And the little equity you do build is typically worthless. You can't do anything with it, you can't buy an equity sandwich, and that equity does nothing except serve as a nice safety pillow for the bank in the event that you default.

Capital Expenditures - Ahh yes, CAPEX. This hidden expense is the most often overlooked, yet most likely to negate all your profits. After 8 years of a solid $100/mo cash flow, you will lost every cent to the replacing a worn $10,000 roof. The same goes for your water heater, HVAC, kitchen appliances, cabinets, countertops, everything. Factor these expenses as a fixed monthly cost. If a roof will last 10 years and costs 10,000, then you simply must divide this cost by the lifetime of the roof, figuring out what expense to factor per month. 10,000/(10*12) = $83. Everything in that home will eventually fall apart, how will you survive the cost? By making sure you've budgeted for it. NOTE: a home warrantee can be a great method to mitigate unexpected CAPEX, just make sure to budget for it (the warrantee company has!).

There are lots of bad deals out there. Retail MLS prices rarely make good investment properties. Your previous home rarely makes a good investment, especially if the rent barely covers the mortgage. Please, if you are paying out of your own pocket to let a tenant live in your home, don't rationalize it, call me and lets fix it, there are ways. Sit down with the numbers and figure it out, and make an informed decision.

Feel like I missed something? Post it in the comments! Next week I'll run through the numbers and share my personal property calculator and the criteria I use to make decisions.