I am looking at some inexpensive condos in a lower-income area offered for $54,500. With lending being what it is these days, I am thinking of going in with a $20k down payment for a $34,500 mortgage. My spreadsheet indicates $60/month positive cashflow.
What are people getting for 30-yr fixed rates from major or local banks on properties with this kind of LTV? (about 65%)
A 50% rule evaluation would look like this:
Rent: $550
Expenses: $275
NOI: $275
Payment: $363 (7%, 30 years, $54500)
Monthly before tax cash flow: -$88
So, this doesn't pass the 50% rule sniff test. Its even a loser with my more optimistic 40% rule, since I manage them myself for free.
Trouble is your expenses (P&I is not an expense) add up to $294 and you've neglected maintenance and vacancy. HOA fees are investment killers, its killing this one. Once you account for vacancy and maintenance (this is caused by tenants), and optimistically estimating 15% total for these two, your expenses are $376. That leaves NOI of only $174. Even considering your down payment, which reduces your payment to the $230 you state, this thing is costing you $56 a month.
You can put $20K into a CD and actually make $50 a month with zero risk, guaranteed by the US government. That would put you over $100 a month ahead of sinking your money into this money pit.
The HOA fees alone are 24% of the rent. This will never work as a rental. Given the $376 in expenses, I put $26K as right at break even. To be making $100 a month, $11K looks like the right price.
Just say no to this horrible investment.
probably around 7%.
i should note that the $60 positive cashflow is not much.
post the numbers here and we can analyze the deal a bit.
how many condos are you looking at? projected rent? condo fees?
i am hoping that at the very least, your estimation of $60 a month is factoring the full purchase price and not just the loan amount (as that is just creating false cashflow).
Josh, I guessed 7%. Thanks for challenging my numbers. I went through my spreadsheet with a fine-tooth comb, and found out this may be closer to $27/month than $60 before tax.
Here are the numbers:
Purchase Price: $54,500 (though I think I can do better than this)
Depreciable Basis: 46,870
Down Payment: $20,000
Monthly P+I: $230
Monthly Insurance: $21
HOA: $130
Monthly Tax: $67
Monthly Mgmt Fee: $55
Monthly Capital Improvements: $21
Total Expenses: $523
Market Rent: $550
Annual Pre-Tax Positive Cash Flow: $317
Annual After-Tax Positive Cash Flow: $1013
I have read someone else on this board aim for $100 cash flow per door. I kept lowering the purchase price until I hit $43,000, which yielded $102.95 cash flow before tax. Incidentally the 2009 tax value for the county is listed as $42,321.
Let me re-phrase my question. At what price would you buy this unit, assuming the income potential is calculated correctly? (I have asked the property manager for the market rate)
Any more deal advice is welcome, and also if going down to $43k with a nearly 50% down payment would yield a better rate than 7%.
maybe i'm calculating this incorrectly (one of the 50% pros will solidify), but in order to obtain $100 cashflow on this property,i'm calculating a purchase price of about $26,500.
30 year p&i for $26,500 @ 7% = 176.31
50% of rent (550) = 275.
275 - 100 (cash flow)= 175
so if my number are correct, it would be a little less than $100 in cashflow for a 26,500 purchase price.
in your numbers, your p&i payment of $230 is for $34500. to get a true #, you must NOT subtract the 20k downpayment and figure the full purchase price for calculating. reason for this is that if not, you are paying for cashflow.
if i pay cash for a 50k house and rent it for 1000, my cashflow isn't 500 (per the 50% rule). we have to factor that the 50k i put down may have been earning something more(or less) if used outside of this transaction.
The reason for this is "opportunity cost" as Josh is attempting to explain to you. You must factor in the entire purchase amount including rpairs and not reduce it by your down payment. Placing more money down on a deal does not make the deal better.
It is either a good deal or it is not. By your numbers, this is not a good deal. At the full purchase price, you are paying about 1% of the rent to purchase price ratio. That is a recipe for a cash loss each month.
For rental rates at the $550 level, you need to be at 2% rent to price ratio which would be a total price you can pay of $27,500
I'm very familiar with the notion of opportunity cost. In this situation, though, isn't putting down the full purchase price double counting the $34,500?
Here's what I mean. I put down 20k out of my pocket. The $230 a month is my cost to obtain $34,500 that is Other People's Money (OPM). I don't experience a cost of an extra $34,500 when I put down the $20k. I only experience that cost as a $230 expense each month on an ongoing basis.
At the $43k price, I am clearing $102.95 a month in BTCF or $1235 per year. 1235/20,000 = 6.175% return.
Obviously it's a much better deal at $27,000, but I don't see how you can count the $34,500 and still count the monthly P+I payment.
Either it's the down payment as the denominator for ROI, or it's the 54,500 and you ignore the cost of the P+I payment. Do the latter and your monthly profit moves to $333. Multiply by 12 and divide by $54,000 and you get 7.4%.
The former approach is found in the Investing in Real Estate book by McLean and Alread on page 85.
The latter does not make sense to me because it ignores the time value of money implicit in borrowing.
Can I put $20k in a mutual fund and get better than 6.175% for the same amount of risk? That's the big question.
A 50% rule evaluation would look like this:
Rent: $550
Expenses: $275
NOI: $275
Payment: $363 (7%, 30 years, $54500)
Monthly before tax cash flow: -$88
So, this doesn't pass the 50% rule sniff test. Its even a loser with my more optimistic 40% rule, since I manage them myself for free.
Trouble is your expenses (P&I is not an expense) add up to $294 and you've neglected maintenance and vacancy. HOA fees are investment killers, its killing this one. Once you account for vacancy and maintenance (this is caused by tenants), and optimistically estimating 15% total for these two, your expenses are $376. That leaves NOI of only $174. Even considering your down payment, which reduces your payment to the $230 you state, this thing is costing you $56 a month.
You can put $20K into a CD and actually make $50 a month with zero risk, guaranteed by the US government. That would put you over $100 a month ahead of sinking your money into this money pit.
The HOA fees alone are 24% of the rent. This will never work as a rental. Given the $376 in expenses, I put $26K as right at break even. To be making $100 a month, $11K looks like the right price.
Just say no to this horrible investment.
Although John, Josh, and Will have done a really nice job of analyzing this deal... Adding another point is condos, as a general rule, are terrible long term investments even if they cash flow. They are usually the last to go up in value and the first to go down. Except in a case where the location is exceptional like beachfront or a destination city like New York, Chicago, Miami, your simply going to reduce your upside with repect to apprecation.
Investment in location and dirt will pay higher returns over the long term.
The other shoe waiting to drop in condos is a special assessment. A friend of mine kept his condo for a rental after he moved to another state. Since he no longer lived there he did not attend the board meetings (he had been president) and was not there when they voted to vinyl side the buildings. They must have taken the highest bid they could find because it cost him an extra 9K that year.
My daughter rents a condo for $2700 a month. The project is made up of an HOA with heavy ownervs.investor ratio. Their restrictions are getting worse. They proposed that the investors run their leases by the board for approval. Who needs it? You can't even hold an open house or put a sign in the window at these places. Bunch of snobs.
Jon,
I hear your point on potentially underestimating the cost of maintenance. But here's where I wonder about the 50% rule, and I struggle to accept it.
If the 50% rule says expenses are half of rent, then as rents get higher, so do expenses. Or, put another way, wealthier renters cause more damage?
This seems counter-intuitive to me unless you're renting a home to a hard-partying rockstar.
In my mind, most higher income folks who can afford a big rent payment may have owned property before, or are at least familiar with the notion of maintaining an asset.
Of course, maybe the 50% rule's tie to rent is actually the mortgage payment on a place, in which case then the tie to rent value makes sense. (more expensive homes should rent for more money)
I'm presently not a landlord, so I can't speak from experience, but I still find the 50% rule a bit rough for making decisions.
If there's a way to break the 50% rule into a X% debt payment rule and a Y% operations/maintenance rule, I'd have more confidence in it.
Any thoughts?
Also, Jon, do you calculate ROI using Josh's method on your properties? Or another approach?
Thanks!
There are several long threads in the Rental property forum about the 50% rule. They're sticky, so they're right at the top. Give those a read. Counter intuitive or not, every time anyone's come up with real data its been borne out. Many have argued against this rule of thumb. Yet any time actual data has been provided its been shown to be correct.
In your case, though, it doesn't work. Your stated expenses add up to $294. That's 53% right there. Add in for maintenance and vacancy, both of which you WILL have, guaranteed, and you're much higher than 50%.
I've looked at property data for apartment buildings where its been much worse. 70-80% in a badly managed or bady maintained building is entirely possible. The 50% rule should be considered a minimum. That's what you'll get if you do a good job. Note that there's no upper bound. 125%, 150% or more is entirely possible.
The 50% rule does not include the debt payment. That is just the P&I part of the payment. The 50% rule does include the taxes and insurance.
The 50% rule will serve you far better than trying to say maintenance is so much, vacancy is so much, etc. Some items are predictable, some are wildly unpredictable. If you have 50 units for 10 years, this rule of thumb will be accurate. If you have one property for one year it will be wildly inaccurate thanks to these large, but unpredictable items. All the HOA has to do is decide they need new roofs and assess each owner $2000 to pay for them. That will consume eight years of your "cash flow".
There are no "wealthier renters". There are only a very few rentals with multi-thousand dollar rents. Some areas, like NYC, command higher rents. Some areas, like the bay area and LA have very high home prices but the rents aren't nearly as high.
I would calculate cash on cash return by taking your total cash flow for the first year and dividing by the total cash invested. I wouldn't really call that ROI, which is a vague term. The numbers you show give $27 a month in cash flow or $276 a year. Assuming that includes closing costs, that makes your cash on cash return 1.4%, much worse than even CDs. In reality, its not nearly that good because you've left out maintenance and vacancies. A two week vacancy will wipe out your entire year's cash flow.
I certainly wouldn't figure any tax benefits. Under some very limited circumstances you may be able to use the passive loss from a bad deal to offset other income. People pushing bad deals often have a complex spreadsheet showing how the losses turn into gains. Realistically, you'll be able to use the tax benefits to shelter the rental income.
Depreciation is the worst. Look, people say, you get to deduct this but you don't spend anything. Free money from the government. What they neglect to mention is that you have to pay it back! That's right. When you sell, you'll discover the "basis", i.e., the amount you subtract from the net sales price, has been reduced by the amount of depreciation you took or could have taken if you didn't. So, if you paid $50K, sold it for $75K, and took (or could have taken), $15K in depreciation, your gain is not $25K but $40K. Then, you have to pay "depreciation recapture tax" on the amount of gain up to the depreciation taken or that could have been taken. So, you'll pay depreciation recapture tax on the first $15K in gain, and capital gains tax on the remaining $25K. Depreciation recapture is your ordinary tax rate, but is currently capped at 25%. Who knows what that will be in the future.
Tax benefits are gravy, and are usually much less significant than you would be led to believe by folks with a vested interest in seeing you buy a property.
Jon, thanks for the clear response covering this situation. I agree with your conclusion: not a good investment.
Consider also the price volatility discussed in this post. To make this work, the price has to drop by about 50%. What happens when "P M" needs to sell the property and interest rates are higher? Will P M need to drop the price to get the deal to work for the next buyer?
P M, put your money on Godiva's Chocolate in the 3rd.
That is great info. Thank you Jon. I had no idea there was a recapture tax on the depreciation. I understand how 1031 is "deferred", but I always assumed that "depreciation" was a literally a figure wiped clean. :/ Better to know now than later. Kind of like Santa.
It is a good deal if you can get the property for maximum $26,500. But add in the HOA fees, man, that could even impact these figures.
Are there any threads on the impact of HOA fees on cash flow? Having never death with them, I have no idea how that could play into the expense category. Does your HOA fee cover ALL expenses (past, present, future?)
Anyway, I think you get the idea.
HA! Touche, Kevin. Your recommendation is appreciated, but I'm doing better with monthly dividends from PGH right now. (Very low P/E ratio) I use that and CDs as comparative investments.
The depreciation recovery was a facet I was not aware of. Indeed, that is an important factor. Thanks for filling me in.
This thread is encouraging me to look at more single family opportunities in the area in lower income neighborhoods with limited amounts of violent crime.