Purchase price to rent ratio

[David B.]

I have been wanting to purchase our first rentel property .

The neighborhoods where i would like to purchase the price far out weighs the rent commimg in.

rough numbers. Asking prices. Not done enough detail research to see what the homes actually go far plus how long set on market.

i drove around today. Found 3 for sale. 

147k 3 bed 1.5 bath

185k 4 bed 2 bath

155k 3 bed 1.5 bath.

neighborhood brings around 900 month on average. Highest i have ever seen listed $1100 which was a bigger house.

will the rent to purchase ratio correct its self in due time.

i try use the 4 square method to determine good purchase or not.

but most of the time im looking for 10% yeld or better or im wasteing my time keep money in stock market.

any tips or advice on how to handle high purchase price and low rents.

[Nathan Gesner]

First and foremost, you really need to get an understanding of "good" cash flow. Many on Biggerpockets think that cash flow is anything above the cost of the mortgage. If they have a mortgage of $800 and rents for $1000, then they claim they have $200 cash flow. That's not correct.

How to calculate cash flow

You then have to study your market to understand what kind of deal is required to produce a good cash flow return. In my market, a 3bed/2bath home will cost $250,000 or more and rents for $1,500 a month. If I put 20% down on the purchase, my mortgage, taxes, and insurance will be about $1,200 a month. Then I set aside 10% for property management, 10% for maintenance, 10% for capex, and 10% for vacancy. I need to set aside $600 a month but I only have $400 available. I consider that a bad purchase.

So what do you do? Buy properties below market or shop another market. For example, I bought an investment two months ago for $230,000 that appraised for $290,000. Because I got it below market, I can use the cash flow method described in the article above and still cash flow about $200 a month. If I bought the home at market rate, I wouldn't be close.

Also consider that there are various ways to earn money with a property. You'll never find anything that cash flows in San Diego, but you can make a killing on appreciation if you time the purchase right. In my experience, markets either cash flow or they appreciate; they don't often do both. That's why you can find crazy cash flow in Cleveland but the houses are still $50,000  which is hardly above where they were five years ago.

Once you really know your market well and what it takes to cash flow, then you can develop a rule-of-thumb to quickly determine whether a property is worth investigating. I use the 1% rule: if a property rents for 1% of the purchase price, then I know it's likely a good deal. So a $100,000 home should rent for $1,000 a month. I've done the math enough times to know that is generally true in my market. It's not always true, but it's close enough that I know the property is worth investigating further to verify. In some markets, they aim for 1.5% or 2%. Others may be 0.8%. It all depends on your goals and the market your working in.

I have purchased properties (or helped investors purchase them) quickly because I know the numbers and the market. You have to put in the hours and do the calculations. After you've crunched the numbers on 100+ properties, you will gain the ability to crunch the numbers on a napkin or in your head, at least initially. You'll still want to investigate further but it really helps narrow the field and prevent you from wasting time on things that won't work.