Does this seem to good to be true?

Question

Hello BP.  I have been interested in REI for a while now and believe I am finally ready to take the plunge.  I have been prying here and finally am making my own post.  I will add a picture and more info to my account shortly.  I just haven't had time yet, being consumed with work.

I have found a town home for 63K.  The highest I will pay is 60K, but plan on offering 50K.  Have seen the home and there is no obvious damage.  Plan on having a contractor/inspector look as well, but there is no forecast damage.  Constructed in 1997.  Avg rent in the subdivision is $650-$850.

Running my numbers at worst offer paying 60K looks like this.  Lender wants 25% down.  $15,000 down, $45,000 financed at 4.125% = $218 monthly mortgage.  Estimated insurance and taxes is $200 monthly.  Charging monthly rental of $650 - $418 monthly liability results in $232 cash flow.

The numbers how I understand them are:

Cap Rate: $7,800 / $60,000 = 13%
Cash on Cash return: $5,400 / $15,000 = 36%

If I run everything at $850, it's even more realistic seeming.

Cap Rate: $10,200 / $60,000 = 17%
Cash on Cash return: $7,800 / $15,000 = 52%

Am I looking at everything correctly or did I make a mistake somewhere?

Carlos

James H. · Answer

You are not using hard numbers. You are just itemizing your predictions of expenses. But on what basis? At least the 50% rule is based on historical data. What are your estimates based on?

The bank won't care about your made up "hard numbers". They will typically take 0.75 times the rent and subtract the PITI from that to determine what they will use to determine if you are making money or not. Then they will look at your Schedule E from tax filings to see what the real numbers were that you reported to the IRS.

FWIW, 650/month for a 60K property is not a good deal. 850/month for 60K property is decent (by my standards if not by all), but still not awesome. You need to be very careful in this price range as 50/month difference in rent may mean the difference between profitability, break-even and loss. In fact, I would think very seriously about driving them to 55K as a firm final offer. If you pay 60K, you need to get concessions from the seller like closing costs, cash allowances - something of value.

Steve Babiak · Answer

Then as I posted earlier, you have to use that lower number for all analysis, and when you get a tenant at that higher number it is your bonus.  Normally rent variation based on start time of lease is minimal; I might give a lower rent to fill vacancy in winter for example, but otherwise i try to get a fari market rent (not always max market rent).

But since you know when the hot season is, you want to time your lease renewal in that area to be during that hot time of the year, so you might end up with a lease for some number of months that isn't a multiple of 12 to do that.  Keep that in mind when you are showing during the slow season, so that the tenant prospects are aware of the lease being a bit shorter (or maybe a bit longer) than 12 months that they might be accustomed to.

Carlos Garza · Answer

John Winston
Thanks for the info.  I knew that I would need money for maint and repairs, but was unsure of what kind of numbers to use.  Thanks for the info.

Kyle B.
I see, I made a mistake when I did the COC.  I misread the calculations from The Basics of Real Estate Investment Deal Analysis Sticky.  I see now that my cash flow is NOI-debt (the loan).  I still see good in >18% though.

Brian Hoyt
Thanks for the info Brian.  I have looked up the 50% rule previously and it makes sense.  I just wanted hard numbers to work with so that I could actually see a scenario and the return rates.  I do think that the 50% rule is definitely easier, but I assume that a lender would rather see the numbers played out instead of a rough estimate.  Or do lenders even look at your numbers?

John K.
Thanks.  I thought it looked good as well.

Sorab Gakhar
You got me.  I knew I was missing something.  Found out HOA is 105.  That basically ruins it for me.  At my worst numbers that basically halves my cash flow so I do not see the reason to go through with it.  I know it would still put me positive $100 a month, but I am not in a hurry.  I would rather keep looking for the better deal than settle for the workable, but not preferable one.

Steve Babiak
The rent estimate is because the market is greatly influenced throughout the year.  It is a military town that has an influx of activity during the summer when the military generally PCS's everyone and then the rest of the year which is steady but not over powering.  During the PCS time of the year, rentals will quickly fill at almost any rate asked because nobody wants to get stuck with the undesirables and as long as it is below the Housing Allowance for the area, most younger military members don't care.  They get the housing for free, and spend it just as freely.  It backs down during the rest of the year though so the rents have to be more competitive.  I have known people in this subdivision though with the exact same floor plan and square footage paying both my high and low numbers with the only difference being the start date of the lease.

Steve Babiak · Answer

You need to get a much better rent estimate.  $650 to $850 is $750 plus or minus $100; $100 is 13% of $750, so you have like a 26% delta there.  Otherwise just call it $650 for analysis purposes and if you get more you'll feel like you're getting a bonus / reward.

Sorab G. · Answer

Carlos, quick question, does the townhome have an HOA and if so, how much?  Now factor that into your equation.

John K. · Answer

I just ran the numbers through my model, looks like 36% returns "Cash on Cash" returns with only expenses as $40/month for insurance and $20/month for Misc repairs (just worse case scenario  everything always!).

Also, with vacancy for one month every two years, your worst case is 32% return on bad years.

Numbers look great!

James H. · Answer

If you can get 850 for 60K, then it is pretty good

Search 50% rule here in BP and throw those other numbers you are using out the door.

You would cash flow, after all expenses using the 50% rule, about 200-250/month. Prettty solid.

Kyle B. · Answer

Carlos Garza I think you are leaving out a few assumptions. For your cash-on-cash return calculation, the $7,800 figure does not include the cost of debt, taxes & insurance, and other misc. expenses.

So even though you are getting $7,800 annually in rental income, as you calculated below, your cash flow is only $2,784 ($232 x 12 months). I think you would want to base your rate of return off this number - which would come out to 18.6% (still not bad).

Also, you will need to include an estimate for other expenses outside of the monthly cost of debt, taxes, and insurance. My guess is it would be lower for a town house, but a lot of people on BP go by the 50% rule - that is, 50% of your rental income will be required for upkeep and maintenance of the property.

At this point, I'll let a more experienced poster chime in and verifty all the points I'm making are accurate.

Kyle

John W. · Answer

Carlos Garza

i apologize, i told you worng. i uses 5% of rent for vacancy. 650 for rent would mean 32.50 a month. repairs and manitenance, i use 2% of value. which $60k value is $120 a month. i hope this helps.

John W. · Answer

Carlos Garza

welcome to BP. 
One thing you are missing are expenses for 1)vacancy. this is an estimate. I estimate 5% of value in your case would be 250 a month. this says that 5% of the time someone will not be in the townhome. 2) also repairs and maintenance. I use 2% of value. in your case, 100 a month. these are estimates, but will come up at some point.

John