Sometimes even savvy investors fall in love with a property, but before you commit to purchasing, please please please do a property analysis to help you make an informed decision. There are two basic ways to make money with rental properties: 1) cash flow and 2) building equity. Most real estate investors focus on cash flow, but if you are committed to long term investing, you should also look at how equity will build over time.
Many new real estate investors (REIs) only look at the projected mortgage versus the rental rates for their area. This can be a costly mistake. There are many factors REIs should consider before deciding to purchase a property. What is current mortgage rate for an investment property? (As of the date of this post, I am told it is approx. 5.725%.) How much cash will you need as a down payment? (Again, as of this post, most mortgages for investment properties require 20% down.) What are the property taxes for an investment property? Depending on where you live these can vary drastically from owner occupied to investment properties. What does mortgage insurance cost for rental properties? How much should you set aside monthly for Maintenance (broken water faucet) and Capital Expenditures, aka CapEx, (new roof or new HVAC)? These will vary depending on the age of the home, but typically run between 5-10%. How much are the property management fees (if you are not self-managing)? These also vary by company but generally fall between 8-12% of the rent per month. And finally, are you accounting for vacancies? We normally recommend a 5-7% vacancy rate depending on the history and location of the property.
As you can see already a lot more goes into REI accounting than just the rent minus the mortgage equals the profit. Let’s look at a fictional house that is on the market for $105,000. It is in an area where the monthly rental income is $1,350. We will make assumptions as indicated in the paragraph above: Purchasing as an investment property with a 5.725% rate, 20% down, and you are planning to do some minor upgrades (paint, light fixtures, etc.) for $5,000. So with down payment, estimated closing costs and minor repair costs, you are looking at $30,000 total cash needed, which brings your loan amount to $84,000 for a 30 year fixed rate loan.
For simplicity sake, we will estimate the following monthly expenses: Mortgage ($488.87), Insurance ($83.00), Property Taxes ($166.00), Maintenance at 5% ($67.50), CapEx at 5% ($67.50), vacancy at 5% ($67.50) and we found a really cool new property manager who is offering 8% to all clients who sign management agreements during their first year of business ($108.00.) Your rent is $1350 and adding up all the expenses, the total monthly expenses are $1048.37, which leaves you with $301.63 per month in cash flow. Most seasoned REIs will tell you they want to see at LEAST $200 in cash flow per month on a property. So after conducting the rental property analysis, this looks like a solid cash flowing property.
What makes this fictitious (but completely plausible) $105,000 single family home an even more attractive to me is the equity gained over time. Assuming 2% property value increase (which in all reality is closer to 3% in our current housing market), this home will be worth $394,839 at the end of the 30-yr mortgage getting you a solid annualized total return of 9% if you sell the paid off property. An average 401K return is 5% to 8%, so to me, this looks like a solid long-term investment as well.
As you embark on your real estate investment journey, we would love to be of service to you. Racine Properties, LLC provides FREE Real Estate Analysis on properties you are interested in purchasing. As you will see in future posts, we believe it takes a TEAM to create successful real estate portfolios. We’d love to be a part of YOUR team!