Residential rentals: how much cash flow do you require?

Question

How much cash flow do most of you require before you'd consider the purchase of a residential rental property?

I've been modeling $100/mo per unit when analyzing properties (using the 50% rule). Is that too aggressive for a newbie?

It's interesting to browse the MLS and laugh at some of the asking prices out there.

Jon Holdman · Answer

For one thing, I want to invest near where I live.  Maybe as I get more experienced, I'll be more willing to invest at a distance.  But, for now, I want to be able to look at the houses, be in on the inspections, and handle the property management.  So, that limits my choices.

My intention at the moment is to buy and hold.  Not that I'm opposed to doing fix and flips.  But, I think the market in this area will improve in the coming years.  So, I'd rather hold on to something for the long term.

I've looked around at various areas for which ones make sense for rentals.  I've found an area where prices and rents have a pretty good ratio.  Not up to the 2% you can find in some areas, but high enough to have positive cash flow even with true expenses and current rents.

I know that vacancy rates are much lower than they were previously.  A few years ago, vacancies we up around 12%.  Now they're more like 5%.  I've heard various numbers from various sources.  The most recent was a piece on the local NPR station talking about how difficult it was getting to find rental housing.  I can look on craigs list, look in the local paper, and drive the area looking for "for rent" signs.  Given the number of houses in this area, and the small number of advertised rentals, I have pretty good evidence of lows vacancies.

In this area, there is a lot of new development.  Until recently, this was a pretty seedy area.  But a number of hospitals are moving in.  Very nice ($500K+ houses are being built nearby.  There's a major street in this area where the city has taken possession of long stretches with plans to redevelop it.  That's already started in some parts.  All the "fast casual" chains like Chipotle, Spicy Pickle, etc., are starting to move in nearby.

There are lots and lots of foreclosures in this area.  Recent calculation have 70% of recent sales involving foreclosure.  And those houses are dumpy and need work.  At the same time, houses in good repair are being bought by retail buyers.  I received an appraisal today on a house I have under contract.  The appraiser noted the market in this are has split into two segments.  A larger one of investors buying foreclosures and a smaller segment of retail buyers buying move-in ready houses.  I'm going after REOs, and I've been outbid numerous times.  All that tells me that if I'm guessing wrong, I'm not the only one.

There have been some other posts that talk about evaluating local economies.  Try the search function and you can probably find some of those.

Jon

Matthew Mucker · Answer

TWatson, I'm going to have to borrow 100%, so cash-on-cash probably isn't going to be an effective metric for me. (I will buy the book, though.)

Jon, that's some sage advice there. You know, I've lived in this area for 20 years now, and I have no idea how to gauge the local economy. Any pointers?

I'm in the Dallas/Ft. Worth area. I believe our economy is actually doing quite well. Our area hasn't been hit with the real estate appreciation and crash that has hit much of the country.

I'm still faced with setting a criteria for myself for what would make a transaction a 'good' transaction. I've put together a spreadsheet to figure NOI and cash flow, with two mortgages, and to find the gross rents needed to reach a certain cash flow. I just don't know what my target number should be.

So let me once again turn my question around... what do you folks use as your metric for determining what's an acceptable deal?

EDIT: just for a sanity check, the assumptions I'm currently modeling are a 1st mortgage of 80% at 7% for 30 years, second mortgage at 10% for 15 years, and operating expenses of 50% of gross rents.

Edwin Brown · Answer

Cashflow per unit does not take into account how much you had to put out to get there. 100/unit is great for a 30k house, not so good for a 250,000 property.

Jon Holdman · Answer

What do you mean by "too aggressive"?  You mean, is that too much to want?  Should you be willing to accept less?

Consider that as a new investor, you're likely to make mistakes a more experienced investor would avoid (or, more likely, already made.) So, you need more breathing room, not less.

You do have to consider the environment where you're investing and your goals.  In a flat economy and abundant rentals, you want plenty of cash flow.  In my farm area, we have new jobs coming in, vacancy rates falling and rents rising.  So I'm willing to do a little lower, betting (and it is betting) on future movement in my direction.

Jon