LOS ANGELES – In this article by the pros at Local Records Office we will be talking about evaluating rental properties. If you know me you know that I love rental property and believe that it should play a role in most people’s long-term wealth goals. Many people struggle with how to run numbers of potential rental acquisitions so I posted a form you can use on our free resources page of our website. The second page of the max offer worksheet walks through how to analyze a deal if you plan to keep it and rent it. In this article I will explain how to use that worksheet.
Evaluating the Right and Smart Way
This is a form that I use but it may not be the best one for you to use in your business. It should, however, be a great start. The reason I say that is because my buying strategy may differ from yours. When I buy a property to hold I have very little concern with speculation on appreciation. In the past I would buy property in nice areas to hold even if I lost money each month in hopes that values in that area would increase. I learned some painful lessons with my flawed strategy. Now I only buy hold properties that will cash flow, period.
It might be a great idea to use hard money to get into a property for little or no money down. Once it is rehabbed and there is a tenant in place you can refinance the hard money into a permanent loan. This form is primarily used for that exact strategy.
Once you have a deal in mind you will need to calculate what your max loan amount can be in order to accomplish the cash flow you need to make the deal work. From there you can work backwards to your offer price. To calculate the max loan, start with the monthly rent. You get this number from a rent analysis that you or a management company you work with will perform. One way to do this is to drive the area and call the entire rental signs to see what other people are asking for rent. Keep in mind that this is not a bulletproof formula for success but it is the way I do it. Sometimes people are asking a higher rent amount than they will actually get.
From the monthly rent you need to determine the net operating income by subtracting the following variables: vacancy, maintenance, taxes and insurance. There are a lot of variations to the variables depending on what type of property you are analyzing. For this discussion we are going to be looking at single-family detached housing.
Vacancy – you are going to think you are better at keeping your units full than you actually are. Be conservative here. I use between 5-10% of gross rent depending on the neighborhood but sometimes that is even low. Worse areas have higher turnover.
Maintenance – This depends greatly on the type of tenant you end up with. If you sell your homes on a rent to own you might think you will have no maintenance, but I promise you will. If it is a normal tenant in a low income area your maintenance can be quite high. Use 5-10% of gross rent for a good tenant on a rent to own and use 10-15% of gross rent for other tenants. It should not be much higher than that on a single family home.
Taxes and Insurance – These are most likely quoted on an annual basis so simply divide by 12 and use that number.
From the NOI you need to subtract your required cash flow to determine what monthly mortgage payment you are willing to pay.
Monthly Rent ________________
– Vacancy __________________
– Maintenance ________________
– Taxes and Insurance (TI) _______________
= NOI ____________________
– Required cash flow ___________________
= Max principal and interest payment _____________________________
In the past, most loans that I would get were interest only loans so I used a formula using the maximum monthly payment to come up with a maximum loan amount. The formula was to annualize the monthly payment by multiplying by 12 and then dividing by the interest rate. That was the easiest way to do the math. Now it is very difficult to get interest only loans so you should be looking at the math using a standard mortgage. The best way I have found to do this is with loan calculating software like this one. To make this work you want to leave the Principal and the balloon fields blank and complete everything else. When you hit the calculate button it will give you the loan amount using the interest rate and monthly payment. Interest rates are changing each day and sometimes several times a day so get an idea from your loan originator what the rates will be and add a little cushion in case rates increase by the time you refinance.
This is where the worksheet stops helping you but you are obviously not done. Print this newsletter and keep it for your reference. From the maximum loan amount subtract closing costs for the refinance, which should not exceed 3% of the loan amount. You can have your loan originator help you with this number. The result of subtracting the closing costs leaves you with the hard money loan amount in which you will be refinancing. Ideally you want your hard money loan to cover as much of the deal as possible so you need to subtract the repairs and the closing costs from this number to come up with the offer price:
Maximum Loan ___________________ (from the worksheet)
– Refinance costs _____________________ 2-3% of refinance loan amount
= Hard money loan _______________________
– Repairs ________________________
– Closing cost to buy _________________________ (4% plus $1,500)
= Offer price ______________________________
The final step is to be sure you can get the hard money loan for the amount you are hoping for. You do this by dividing the hard money loan amount from above by 70%. The value of the property needs to exceed this number for the deal to work. For example, if you were hoping for a loan in the amount of $100,000 the value of the property would need to be $143,000. 100,000 / 70% = 143,000.
Often times the deal is strong from a cash flow perspective but there is not enough value to borrow all the acquisition costs in the hard money loan. If this is the case and you decide to move forward based on cash flow potential you will most likely need a down payment for the hard money loan but will not need any additional cash for your refinance. Contact your hard moneylender for help with the down payment amount.
It is much more difficult to analyze a deal’s cash flow because there are many more variables and often times two loans. If you are not using hard money it is a little easier but you will need to add your down payment amount to the maximum loan amount from your worksheet to come up with the offer price. Although this can be very confusing, I am confident that you can get comfortable looking at deals this way with practice. Although I might not have time to answer everyone please feel free to ask questions. If I get several questions I may include something in next month’s issue with the most popular questions and my responses. Interest rates are ridiculously low making it is a great time to buy rental property.
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