Rental Property – The Financial Side (Part 2)

In part 1 of this series I explained the background of the rental property I am considering buying with my family. If you haven’t had a chance to read it catch up here.

So now that my parents and I had a chance to see the townhouse and what would need to be done to the property it was time to figure out how to make a decision. Let’s start with the numbers!

There are many numbers that are important when making a decision on buying a rental property. The first one that we calculated was how much we would offer for the townhouse. It was listed at $73,500 which may not seem like a lot but would probably be about 5,000 under market value IF it was in great shape and ready to rent out. As you remember from Part 1 it wasn’t, so we definitely would not be offering anywhere near that amount.

We knew we had to replace one, if not two, sliding glass doors, all of the flooring in the entire unit (around 1200 sq ft), the kitchen cabinets, the kitchen counters, a few light fixtures, the interior doors, some parts of the one and a half bathrooms and the roof. We also would have to buy a refrigerator, a washer and a dryer. We figured all of this would cost $20,000 to $30,000 to do most of the work ourselves while hiring a contractor to replace the roof, tile the downstairs and re-carpet the upstairs.

Another factor is the townhouse is a short sale that has been on and off the market for a year or two. The lender finally gave notice that the bank will be proceeding with a foreclosure if they don’t sell it as a short sale within the next 30-60 days. With all of this information in our hands we decided that we would probably make an offer of around $50,000.

Now that we know what our offer price would be we can calculate the monthly numbers. I contacted my mortgage broker and she said we could likely get a 4.375% 30 year fixed loan. We would have to put down 25% because it was an investment property and there would be a .75% origination fee. We would also have to pay closing costs that would probably run $2,000 to $4,000. This would make the mortgage part of the mortgage payment $187.23. Awesome huh? But then you have to figure in insurance and taxes.

My parents own a similar townhouse so we know our yearly insurance and taxes would come out to about $2,000 a year, or $167 a month. Insurance is expensive because the townhouse is three blocks from the Gulf of Mexico and we’re forced to buy insurance from a state backed agency (but that is a whole other post for another day). That brings the whole mortgage payment up to about $355. We also figured a safety buffer of $150 a month for repairs, maintenance and vacancies bringing our total monthly cost to $505 a month.

Next, we took a walk around the neighborhood to see what was for rent that would be similar to our townhouse. We found a few rentals and also pulled some comps online. After a lot of research we decided we knew we could get $700 a month and could potentially get up to $800 a month for rent. This would leave us with a net monthly cash flow (after our reserve) of $195 to $295. Keep in mind that my parents and I would be splitting both the costs and revenue so you would have to factor those numbers to get each of our shares of the cash.

Last week I also mentioned that I read a couple books. The most useful one was The Complete Guide to Your First Rental Property By Teri B Clark (also available in Kindle edition). The book discusses what to expect while investing in your first rental property, how to go about it, the numbers behind the deals and more. The book was published before the housing bubble burst though so you have to take it with a grain of salt. I borrowed this book from the library and suggest you do the same if you are interested. However, if you want to buy it I have linked to it above.

The book mentions a few calculations as far as numbers go to determine whether a property is worth it. The first is the Capitalization Rate (or Cap Rate). To do this you divide the Annual Net Operating Income by the Purchase Price. They say a Cap Rate below 8% will end up costing you money instead of making you money. The book seems to interchange Net Income (income after expenses) and Gross Income (total income with no expenses taken out) in their examples so I’m not sure which to use. It also doesn’t seem to take into account immediate upgrades. I would factor them into the sales price but remember that you will likely be paying cash for these so have the money up front. If you have any insight on this please let me know and I will update accordingly.

The next method the book mentions is Gross Rent Multiplier method. This is the sales price divided by the monthly net income. You then multiply by the annual gross rent and compare it to the sales price. If it is higher than the sales price then the property is worth more than you are paying for it, according to the book.

Another method is the simple Return On Investment (ROI). Add up all of your expenses and then determine what percentage return on investment you want. Multiple the total expenses by the return and then add that to your expenses to get the rent you would have to charge to get your desired ROI. If the rent is too high for the area it probably isn’t a good investment. If the market rent is higher you may get a larger ROI.

We ran through the all the numbers multiple times and next week you will find out our decision.

Just as a reminder, I am DEFINITELY not a real estate professional so please do not rely on anything in this article to make your own decisions. Seek guidance from a true professional.

Have you ever thought about buying a rental property or already have one? If so, let me know how your experiences with rental properties have gone!

In part 3 of this series, which will be posted on next Wednesday (5/16/2012), I will reveal whether we decided to purchase the rental property or not and why we made our decision. Stay Tuned!

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About Lance Cothern

Lance Cothern, a Certified Public Accountant (CPA) licensed in the Commonwealth of Virginia, is the founder of Money Manifesto. You can read more about him here or connect with him on Facebook, Twitter, Google+ or Pinterest.

Comments

  1. Fun post! We are looking at buying a duplex to live in for a few years which will eventually become a rental home. It would be a big sacrifice for us because we really love our house and it’s quite spacious…however, it’d be nice to reduce our overall debt and monthly payment and allow us to get really aggressive with becoming debt free!

  2. I’ve owned a single family rental home for 10 years. It’s been a pretty good experience over all. My one word of advice is to only do it if you can manage it without having any cash flow…and if you have a separate emergency fund. Why? Because stuff always comes up! Also, you need to assume that you’ll be vacant at least one and maybe two months a year. This may never happen, but it is good to plan ahead for when it does. I’ve had 3-4 month gaps sometimes between tenants because it took me quite a while to get stuff fixed up after a tenant, and to find a qualified renter.

  3. It’s fun to read how you work through the numbers and logic. Some great real estate deals to be had these days, at least compared to 5 years ago.

    Regarding the insurance: Is private insurance simply not available due to hurricane risk, or why are you ‘forced’ to buy from a state-backed agency?

  4. Very useful stuff. I’m like you: interested but learning. I’ll be interested to see your decision.

  5. @Jason – Sounds like a good deal if you can enjoy living in it. If you don’t enjoy it it may not be worth it.

    @Rich – All great points. We took most all of that into account when making our decision which will be revealed next Wednesday 🙂

    @Kurt – Word of Mouth on the Florida insurance is that the legislator passed some law to where insurers would basically lose money if they insured certain areas (aka any close to waterfront areas in Florida due to hurricanes). Basically the ONLY agency that will insure for hurricane loss is the state backed agency which is underfunded and if there were multiple major hurricanes in a season may go defunct, but I am required to have it as long as I have a mortgage. The only way you can get insurance from the agency is if no one else provides insurance to you or if their insurance rates are over a certain % higher (pretty high I think) than the state agency. I do have regular homeowners for hazards (fire/theft etc) but most normal insurers won’t even insure that in Florida. Hopefully it changes one day but I doubt it.

    @John – It was a huge learning experience and I’m excited to reveal our decision next Wednesday 🙂

  6. I have been wanting to expand into rental properties too but we aren’t quite there financially yet. We need to stabilize a few more things first. Good luck with everything and I am excited to hear what happens.

  7. I’ve been wanting to buy a rental property, but I do here mixed feelings on the subject. It goes great for some people and i nightmare for others. I am interested to see what decision you make.

  8. Did you include any HOA dues to your monthly expenses?

  9. Janette says:

    How can a town house not have HOAs? Who cares for the roof or lawns? It does share common walls?

    • Great question Janette. This is a row of five townhouses. In between each townhouse is a fire barrier wall that extends above the roof line so each roof is separate. I believe it is something like solid concrete but I am not sure. There is no front lawn, only two parking spots in front of the townhouse and each concrete pad is divided by a small wood strip. There are back yards but each back yard is fenced in an each townhouse is responsible for the maintenance of their own lawn. We do share septic tanks, 3 on one tank 2 on the other, but agreements have been signed to share the cost of the septic between whoever is on that septic tank should it need any maintenance/repair.

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