Is this good investment?

Question

City Heights, San Diego
Second floor unit of Condominium of 6 unit complex
736 SqFt
Build in 1992
One car garage + one off-street parking space
Rehab cost about $2,500
Rent: around $1,200
HOA fee: $220 (include CAM, Bldg Maintenance, Water, Limited Insurance) 
Property tax: $1,000 
Listing price: $95,000
**This complex was converted into condominium in 2005** 
Newer roof, well maintained outside. Newer A/C, heater, stove.
Newly arrived immigrant communities, not really good area in SD
 
This would be my first investment.
What do you all think? Is it good to buy?

K T · Answer

Thank you both for your advices.
Now I understand how cash flow calculation works. I will pass this deal and keep looking for a better one.

Thank you.

Jon Holdman · Answer

To evaluate the deal, assume 100% financing of the total investment.  To be even better, include closing costs and such, too.  Even if you're putting in a down payment, you could do something else with that cash.  By evaluating the deal assuming a 100% loan, you're paying yourself the same return on your cash on the loan.  If the deal doesn't work using that calculation, then its a loser.

Commercial deals are often evaluated assuming no financing.  That calculation, net operating income divided by purchase price is called the "cap rate".

In both cases, you're taking the financing out of the picture and evaluating the deal independent of how you will pay for it.

Then, you can turn around and do a cash on cash calculation.  Take the total cash flow for a year, divided by your investment.  To me, for real estate, this needs to be a pretty hefty number, like 20%.  Real estate is risky.  Unless you're careful, I think you have a potential for additional downside there in San Diego.  Plus tenants can be a big hassle and cost you lots of money.  Especially in a tenant friendly state like CA.

So, if I use my break even price of $87,685 and your down payment of $30K, and include 2% for closing costs, I come up with a loan amount about $62K.  I'm assuming you'll pay for the rehab and closing costs out of that $30K.  The payment is about $411 for the P&I.  Using 50% for expenses (read the sticky threads in the Rental Property forum), that makes your cash flow about $189 a month.  That's 7.1% cash on cash.  Too low, IMHO.  At $95K, its more like 5%, which is better than CD's, but not much.  So, yeah, you'll have some money coming in, but its really from your down payment and not from the property.

Now, there may be other factors, such as significant potential for appreciation, or new demand from new job growth, that might lead you to want to speculate.  But as a pure rental investment, this one is not very good.

Will Barnard · Answer

K T,

Jon gave you a great explanation on why to calculate your acquisition price + rehab and cosing costs all into the loan due to oportunity costs of that money.

If you like, you can try this calculation to see what return you are actually getting for your down payment:
Analize the deal based on the actual financed amount. The amount of cash flow you get X 12 months then divide that by the total amount of the cash invested (down payment, rehab, clsoing costs). That will give you your COC (cash on Cash) return on the money invested. In this case, it is not good and the deal is not good enough at the ask price as Jon eluded to.

K T · Answer

Hello, Jon. 
Thanks for your response.

When I calculate cash flow, should I use total purchase price plus rehab as loan amount? Do not need to deduct down payment from purchase amount? Sorry for stupid question, but I am new with real estate investment and not really understand yet the rule of cash flow calculation.

I am planning to put $30 down, so I will loan $65K. If I use this number as Payment, there will be positive cash flow. Is this right way to do cash flow calculation?

Jon Holdman · Answer

If you paid no more than about $87.5K, you would be break even.   You would need to be under about $72.5K to make the common goal of $100 a month in true cash flow.

Analysis at $87.5K purchase price:
Rent: $1200
Expenses: $600
NOI: $600
Payment: $600 (payment on $90,185, which is $87,685 purchase plus $2500 rehab, 7%, 30 years)
Cash flow: $0