Would You FHA? $179K 15% Cap 1st Deal

Question

I have no debt, decent income and would be first time home buyer. Would you FHA 5% down? Here are the details. Obviously I did NOT include the 5% down. Any advice would be great.

AP - $179K ($179 @5% 30YR)

GSI - $27,000 ($2,250pm)

Vacancy - $1,350 (5%)

Effective Income - $25,650

Gross Operating Income - $25,650

Total Operating Expenses - $6,926 (Provided by the broker but I will verify)

NOI - $18,725

Debt Service - $11,531

Cash Flow Before Taxes - $7,194

YEAR TWO - $6,000

YEAR THREE - $6,801

YEAR FOUR - $7,645

Simon Campbell · Answer

I believe what throws off some investors is that they forget that the 50% rule includes the slightly intangible vacancy rate. Generally that represents 10% of the 50.  Another 5% of the 50 should be set aside for capital repairs (on the average, more if it is older and hasn't been recently remodeled). If you have a rental that has no owner paid utilities, that could account for another 5% of gross rents. So, I could see how @Eric Bowlin could say his actual expenses are 30% of gross receipts.

Eric Bowlin · Answer

You may own more properties than me... But who cares. My wife and I retired from our day jobs at 26 years old and live very well now off our rental income for the last 4 years and have only grown faster since we started full time.

Why do we discuss our different opinions and approaches if people simply attack and discredit anyone who disagrees. I didn't realize that's how things were here at BP.

Jon Holdman · Answer

Yes, and I could say that I don't believe the 50% rule because in 2013 I had to replace a sewer line on one of my properties and that repair alone costs over 50% of the gross rents for that property for the year.  And I still had taxes, insurance, and repairs from damage from our severe storms in Sept 2013.

I could also say that craps must be a winning game because twice I've started with $200 and walked away with $500.

But I know good and well that these sort of exceptions to the averall average aren't unusual.  And I'll have good years to make up for the bad ones.  And bad times at the craps table that offset any good ones.

So, @Eric Bowlin  if you tell me you have 50 units and you've been running them for 10 years, I'll give some credence to your 30% number.  (I assume because you say "consistently under 30% of rents" that your actual numbers are close to 30% or you would have said "below 20%" or some such.)  I also allocate 14% of the total 50% to property management.  That's 10% of collected rents plus half a months rent once a year to fill a vacancy.  So I would put you at 44%.  Better than average, but in the same ballpark.

Let me add that this is simply a rule of thumb.  Your actual expenses will be what they are.  You can always convince yourself something is worth buying by ratcheting your expense estimates down.  That doesn't mean it will work out once you own it.

Eric Bowlin · Answer

@Jon Holdman I disagree. I completely believe that expenses can be consistently under 30% of rents (excluding a property manager)..I know because I essentially do it on every one of my properties every year. On a property with that rent income, I would expect to net at least 10k a year after debt service.

I look at the 50% rule as a guide for 'worst case scenario' type math. If the deal works at the 50% rule then it works under better circumstances. Just like you might add 10% to a rehab budget as contingency.

But then again, every market is different and maybe in your area it's more accurate.

Jonathan Napper · Answer

oops, that on me. Let me clarify, the brokers documents stated that total as "if not separately metered" but the building IS separately metered.

Marc M. · Answer

That's a conflicting statement. If the units are separately metered, each unit has its own meter. Non-separated total means that there is one meter for the entire building.

Jonathan Napper · Answer

The broker said that, that expense total reflects a NON separately metered total. Each unit has its own meter.

Simon Campbell · Answer

Most rental properties are arranged so that the tenants pay for their own utilities. Paying for utilities as a landlord is often a killer to cash flow. Imagine your heating bill if the tenants are not responsible for paying to keep the place 80 degrees. Ouch!

The 50% rule does not include paying for all utilities. This could be a deal breaker. Might want to look in and see if you can get it separately metered and how long the leases are in place. Additionally, always verify expenses and figure out why they are so high.

Jonathan Napper · Answer

CORRECTION. Expenses are $9,399 per broker documents. Am I the only one who think 34% of GSI is high? The Utilities alone are $5,833.

Simon Campbell · Answer

This property can cash flow $262 per month. You have gross rents of $2,250. Vacancy at 10%, other expenses (not including property management, utilities or the mortgage) at 40% leaves a monthly net income of $1,317.

A mortgage with 5% down, 30 years at 5% with PMI should be $1,055. Leaving $262 per month. An interest rate of 5.5% would leave $209.

You need to verify that the rents are market based. If it is, then your looking at a cap rate of 8.8% and a cash on cash return of 28% which is very good.