Evaluating rental real estate the basics

 I was asked the other day to help a couple evaluate a property they where considering purchasing. I hesitated a bit only because they need to make their own evaluation. They are the ones who will need to live with any decision made. I offered to give my opinion, but they needed to crunch the numbers themselves.

I did a walk around and a walk through the property with the couple. I verbalized what I normally would have thought as I went along. We also spent some time talking about what their long term plans where and what they wanted to accomplish investing in real estate. Once that was done, we listed some criteria that any property needed to have to meet their investment goals, and their skill set. The following is pretty much what we talked about over coffee that day.

When I first started making real estate investments I wanted safety, little risk and lots of leverage. As I gained experience and had some steady cash flow coming in, I took more risk and purchased higher priced properties. Today I want cash flow, equity at purchase and repairs that can be hired out. When I was in my twenties and thirties, if the pay off was years down the road that was OK! If a property made me $100 positive cash flow and another $100 equity build up each month, I figured at years end I was $2,400 richer. Today I want faster returns and bigger numbers. I want at least a $300 monthly positive cash flow (annually .05 percent of the property's value) and a mortgage not over 66% of the property's value. I still own some of the properties I purchased back when I first started, they are still making me money thirty years later.

Your Goals: You have to have a good idea of where you want to be in five years. Maybe even ten years and twenty years from now. Real estate is not a fast way to riches and it is ill-liquid. Read all the articles on this site and you will find an investing style that applies to you. So set your goals, because it gives you a target to aim at.

When I was 24 years old and just getting started my goal was to make $1000 a month in positive monthly cash flow. It took a few years to get there and in between I was learning as well as building equity. Today in my Gem rental properties company I have a partner, our goal is to make one million dollars a piece in five years. You can read about Gen rentals LLC in the articles section of this web site.

What do you have to work with: The amount of cash, monthly income, equities, skill sets and the help you have available to you will in part set your limitations. If you have a lot of cash there are some great bank owned properties to buy. If you have a lot of cash flow and can sustain losses for a long time, there are a lot of undervalued markets where you can buy houses cheap. The trouble is your rents may not cover the mortgage payments for a few years. If you have little cash but lots of skill and time you can buy fixer uppers on the cheap. If you are a contractor you might work with lenders to finish their unfinished repossessed homes. If you own property but are short on cash you can leverage what you own to get cash to put into more properties. The possibilities are as varied as people's circumstances and the properties available. As you read the articles on this web site you will get more ideas.

Mortgages: Loans are harder to get now. On the other hand rates are low. When I buy a rental property I try to keep the amount borrowed at 66% of the property's value. This is because I will be able to make the mortgage payments even if I have a sustained 25% vacancy factor. I have never had that high a vacancy so it is really my peace of mind insurance rule. When I was young I would by a house if the seller would finance it with $1,000 down. Today I put down 66% or (as most often happens) I find properties undervalued by that amount and pay down as little as I can. After I fix up a property or reposition the property (see the syndication articles) I will have increased the value and thus the equity. I can then refinance based on the new value and take out money to accumulate more properties. If you want to make large amounts of money investing in rental properties you need to acquire larger properties, or more properties. If you are blessed and can do this without borrowing then more power to you.

Repairs: When I was a tad younger I did my own repair work. You learn a lot doing that and you build sweat equity. Today I hire everything done. When I evaluate property I deduct from the estimated value of the property in pristine condition the cost of repairs at contractors rates. I then sub contract the repairs myself and make the 30% markup that a contractor would get. I must be able to buy the property at it's economic value, less all repair cost and all updating cost. I always keep in mind my two goals. One; a positive cash flow of $200 a month per rental unit or $300 for a single family house. Second; equity of 33% of the value, either from cash paid down or from equity enhancements such as repairs. The next rule is a loan of no more then 66% of the property's value.

One more thing about repairs. If you do not know what you are looking at get an experts opinion. Not a handyman looking for work. Call a contractor, or several if need be. If you get this wrong it can be expensive.

Value: Three methods of valuation, replacement value, comparable value, or net cash flow value. You are in the rental business that means you want net monthly cash flow. The value of the property to any future buyer will be based on the net cash flow the property produces. If a buyer wants a 10% annual return on his invested capital he will pay $100,000 for every $10,000 in yearly net income. (net operating income divided by cap rate = Value)

Net Income: The properties annual rental income less all expenses; property taxes, repairs, utilities, vacancy factor, management fee etc. You want to get to the number that represents what is left to pay the mortgage with and make a profit. This is the number I use to determine the value of the property. (net operating income divided by total cost of property = % return on investment)

Cash Flow: There are two. Net cash flow form operations but before mortgage payments. Also called net income. If that number covers the mortgage payment you have a positive cash flow. If it does not, you have negative cash flow and will have to make up the difference.

The second cash flow number is the cash flow after making the mortgage payment, or the spendable cash flow. Take the annual net income and subtract the mortgage payments and you get net spendable cash flow. Take this number and divide it by the cash you put into the deal and you get cash on cash (%) return on investment. See Gem rental articles for examples of these formulas in action.

Evaluating property is a complicated subject. There are plenty of experts to advice you. Starting with your real estate professional, your local investment club, this web site and many other sources. Just reading all of the articles on this site will give you enough information to do your first deal. Getting past that first deal is important to give you the confidence to get rich renting properties. The real profits will come from gaining more and more knowledge and experience.