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How to Analyze a Buy & Hold Real Estate Investment Property

posted Apr 8, 2016, 10:07 AM by Joshua Durrin   [ updated Apr 8, 2016, 10:11 AM ]

Listing price is no indication of performance, though finding a below market property is one of the first things people look for when looking to “invest” in real estate.  Well, let’s take a look at a real life example that appeared to have potential on the surface but after closer inspection turned out to be another over-inflated property. 

One of our birddogs with “Boots on the Ground” turned us onto a listing they came across that at first glance appeared to have some potential.  It was a duplex with a listing price of $165,000 that brought in $775 a month for the larger 2-bedroom unit and $575 a month for the smaller one-bedroom unit.  Given the area it was in, those were pretty close to market rates for rent.  Right off the bat, though, to assess this purchase price quickly, I applied our 1% rule and looked for a ratio of monthly rent to purchase price of about 1%.  2% is really the target as a rule of thumb, but investors all over the nation admit that that ratio is rather difficult to find, particularly in CA.  So, 1% is considered reasonable among most CA investors. 

The gross rents, amounting to $1350 monthly, divided by the $165,000 purchase price puts us at a 0.82%.  That’s actually not too bad.  However, it’s not the 1% I’d look for in this area.  Plus, having spoken with the agent, he mentioned that the unit was in decent condition and had a roof that likely will need replacement in 5-7 years.  So the property was close to turn-key, but not entirely.  I needed to squeeze a few more tenths out of the purchase given its condition. 

Without pictures of the interior or inspections, however, I could only guesstimate what the costs would be based on conversations with the agent.  Let’s assume that the renters will stay put for the time being but budget in some turn-over costs within the next 3 years of about $3000 per unit plus the cost of the roof over the next 5 years (about $4000) for a total of about $1800/year in capital expense costs, or $150/mn.  I’m likely going to realize at least one month of vacancy over the next year in at least one unit as well.  Let’s assume the larger unit goes vacant for the sake of being conservative thus adding $775 per 12 per month span, or $65/month in vacancy expenses.  Taxes I estimated to be around $160/mn and insurance about $100/mn.  Water, sewer, and sometimes garbage are often paid by the landlord and I could only guesstimate that to be about $50/mn on average at this point as well.  I’ll set a maintenance budget of around $50/mn and plan for a property management fee of about $100/mn so that I don’t invest my way into a new full time job accidentally. 

With the costs of ownership approximated, to own this property I’m looking at a cost before mortgage expenses of $675 per month.  That falls in line reasonably with the 50% rule for rental properties where costs are typically 50% of the rental income you receive.  That leaves me with $675 a month in “profit.”  Now, were I to pay cash for the property outright, I’d have all of that as monthly income.  However, that may not be the best use of my money.  I have to look at a few other metrics to determine if paying all cash is the best investment option for me. 

The objective for me is to make my money work it’s hardest.  An infinite return on investment is the best return, agreed?  Well, to do that, I’d have to make money while not putting any money down… which is possible… meaning that my cost basis was $0.  Any growth having put $0 into the investment is infinite (the ratio is actually undefined mathematically, but that’s getting a bit too nerdy for our purposes here).  At the opposite end of the spectrum, if I to pay all cash for the property and minimize expenses I would also be enabling all of the income to go toward boosting my rate of return.  This can only be an infinite return if the income is infinite… which is not actually possible.  For the practical scenario, if I paid the asking price of $165,000 (excluding closing costs) to make $675 per month, or $8,100 annually, I’d yield a cash-on-cash return of less than 5%.  Well, that return stinks quite honestly.  I’d rather leave my money in the stock market and bank on the average annual return of 8-12% per year depending on the information sources you use as a reference. 

Alternatively, if I keep my cash dollars invested to a minimum, I increase my potential cash-on-cash rate of return.  For this property, if I seek to put the minimum down while still having the tenants pay off the mortgage for me, I reduce my cost basis and effectively maximize my rate of return for the dollars I invest thereby making them work the hardest for me.  In this case, let’s say I put down $16,500, 10% of the asking price.  Doing so, that price leaves me in a negative cash flow position by about $155 per month after paying all expenses and my mortgage costs.  So, it doesn’t make good investing sense to purchase this property at asking and still call it an investment property.  It’d be more of a “liability property” at that purchase price. 

I seek anywhere from $100-$300 per door per month on a buy-n-hold property.  Given the seller’s market we’re in currently, I’ve had to target the lower end of that spectrum.  Since this is a duplex, I assumed $200 per month in cashflow for this to be a good investment deal for me.  That means I have to find a way to reduce the monthly expenses so that the investment returns $200 net profit per month.   Recalling that our max potential income per month is $675 (without reducing ownership expenses somehow… and be careful of doing eraser math here), a mortgage amortized over 30 years with a payment of $475 per month amounts to about $88,000 at today’s interest rates.  Thus, my monthly cashflow goal is accomplished if I can leverage $88,000 of the total purchase price. 

To get to an $88,000 mortgage, I have to come up with the difference from that baseline to what the seller will accept.  Looking at my goal of maximizing my cash-on-cash return, ideally I’d put about 10% down, the going rate for conventional mortgages on investment properties these days.  Using 10% down, that means my purchase price would be $98,000 in this case and my cash-on-cash return would be 24%, or $200 per month annualized relative to my $10,000 down-payment. 

Now we’re talking! A 24% realized rate of return is pretty great!  However, it still isn’t my maximum allowable offer.  I still have some wiggle room to negotiate if I stick to my metrics.  In my case, I want my dollars invested to beat the stock market.  With the market earning 8-12% annually over the last 100 years, I’ve set my minimum cash-on-cash return goal to 15%.  The 10% down-payment gets me 24%.  So, I can actually afford to pay a higher down-payment to sweeten my offer for the seller if I need to and still accomplish my investment goals.  I do still, however, need to stick to an $88,000 mortgage regardless in order to cash-flow monthly. 

To get to my maximum allowable offer I figure out how much cash I can invest while still achieving 15% with $2400 in annual earnings.  Dividing $2400 by 0.15 gets me to $16,000, meaning that I can put as much as $16,000 down and leverage $88,000 for a total purchase price of $104,000 (less purchasing costs).  That’s $6,000 higher than the minimum down payment option and allows me some more negotiating room when approaching this seller. 

Bear in mind also that there are three contributions to my true return on investment for this type of property.  The first is the actual cash-flow per month which is really the return I use to assess the purchase price as that's the liquid portion of the return, the portion I realize each month.  However, having a rental also means that someone is paying your debt down.  For this scenario it would be approximately $900 of the principle balance paid down over the course of the first year.  Thirdly, we benefit from market appreciation.  Using a conservative annual estimate, we could expect an annualized appreciation in the property value of about 4-7% year over year, or $5,200 in the first year.  The appreciation is specific to each market, mind you.  However, for me it’s important that I use a long term historical average, not the growth from last year, as this a buy & HOLD property I’m evaluating.  Also, while I don’t bank on appreciation, I can and do use it to assess the true return on investment.  In this case, summing the portions of cash-flow, debt pay-down, and appreciation results in $8,500 in true gain in the first year.  Thus, our true rate of return (including non-liquid gains) is $8,500 divided by our initial $16,000 investment, or 53%!!!  Now that’s the mark of having your money work for you instead of you working for your money! 

Unfortunately, the market where this property is located is a bit hotter for sales than the rental opportunity supports for our liking.  I presented the listing agent with the offer but it wasn’t accepted.  It was crucial for me, however, to maintain a positive relationship with the listing agent for when things change in the future.  I’ll continue to follow up with the listing agent periodically now that they know my criteria.  In this business, especially at this time in the market cycle, it is very rare to land anything on first contact.  So, while we weren’t able to land the property here, we were able to build a relationship with another professional in the industry and position ourselves very well for the next dip of the market cycle.

Well, what say you? 
What are some of the metrics you’re applying in your market and how successful have you been in your market?