Let me ask you a question: how long does it take you to pick out your clothes in the morning?
I bet it takes longer than most people will spend doing the math on their next real estate investments. I just don’t get it. People think the best deals are done on “intuition” and just buy something because it feels right.
Ugh. Please people!
I’ve said it before numerous times: If you don’t have the right math going into a deal, you’ll never get the right profit coming out of it. (Tweet This!) That deal you thought was incredible will turn out to be a thorn in your side for years to come and you’ll join the ranks of the millions who have “tried” real estate only to fail.
This is why I harp so often on getting a firm understanding of the math when buying an investment property.
I don’t care if you are buying your first or 100th property – you need to understand and do the math.
That is my ultimate goal with this post: to help you learn to analyze a real estate deal so you can make the best investment possible.
Below I’m going to walk you through the math I use to analyze a rental property, step by step. Please, if there is one post this year you read carefully and don’t skim: let it be this post!
(Oh yeah – hey you! To accompany this blog post, I created a free PDF poster you can download right now and print out. It’s called “The 10 Bigger Mistakes Investors Make When Analyzing Rental Properties” and will help you avoid the mistakes that so many investors make when analyzing deals. Don’t buy a bad deal! Avoid these 10 mistakes and get a great investment property! To get the PDF, just click the button below:)
Click Here to Get the Free PDF Poster!
How to Analyze a Rental Property
There are several primary factors I look at when analyzing a rental property, but the two most important are:
Cash flow and
Appreciation.
Cash flow is simply the money left after all the bills have been paid.
Appreciation is the equity gained as the property value increases.
There are not a lot of great ways to estimate future appreciation without a crystal ball, so I generally choose to focus on the cash flow. After all, I am a buy and hold investor and I assume any appreciation is “icing on the cake” and not the goal.
So I’m going to focus this section on analyzing cash flow. Let’s get started.
What is Cash Flow?
So, as I mentioned earlier, cash flow is the money left over after all the bills have been paid. This is a simple enough definition, but it gets a lot of people in trouble. You see, technically, cash flow is:
Income – Expenses = Cash Flow.
Okay, great. HOWEVER… where people tend to screw things up is the definitions. You see, income may include more than just the rent, and expenses will include more than just the mortgage.
Let me give you a BAD example of calculating cash flow. You might say, “The mortgage is $800 per month and the property will rent for $1,000 per month – so my cash flow would be $200 per month.”
False.
You see – you forgot about a lot of other expenses, including:
Taxes
Insurance
Flood Insurance (if needed)
Vacancy
Repairs
Capital Expenditures
Water
Sewer
Garbage
Gas
Electricity
HOA Fees (if needed)
Snow Removal
Lawn Care
Property Management
and more.
Now, some of these items are easy to calculate because you can simply call up someone important to find out about the cost. For example:
Taxes – Call your local county or look online at the county assessors page.
Insurance – Call your insurance salesman and ask for a quote.
Flood Insurance (if needed) – Same as above.
Water – Call your local water department.
Sewer – Call your local water or sewer department.
Garbage – Call your local trash provider.
Gas – Call your local gas company.
Electricity – Call your local electric company.
HOA Fees – Call the HOA president or hotline.
Snow Removal – Ask local landlords what they pay or call a snow removal company.
Lawn Care – Ask local landlords what they pay or call a lawn care company for a quote.
Keep in mind, not all of these will apply to every property (or tenants may pay their own expenses) and some properties will contain more expenses than I’ve listed here. Don’t get overwhelmed though – the more properties you look at in your local area the more you will understand what the “normal” expenses are.
Now, the numbers we just looked at are fairly easy to determine, but other numbers are more difficult to determine, like the vacancy, repairs, capital expenditures, and property management. But just because these numbers are difficult to nail down doesn’t mean we shouldn’t include them. Instead, we just need to use “averages.” And for that, we look at those numbers as a percentage and translate those percentages into dollar amounts. Let’s look at a few of the most common:
Vacancy: Properties are usually not rented 100% of the time; tenants move on and your property will likely sit vacant for extended periods of time. The length of time will depend on your local area and how good you are at filling those vacancies so I can’t give you an absolute number. If you are unsure, try talking with some local property management companies to see what their typical vacancy rate is.
Once you know the vacancy rate, as a percentage, you can break down the percentage into a monetary amount. For example, if a property rents for $1000 per month, and you believe the property will have a 5% vacancy rate, you simply take $1,000 x .05 to get $50. This is the amount you will want to include for your vacancy expense each month.
Repairs: Repairs are difficult to estimate because there are a lot of variables that come into play. A house that is 90 years old will likely have significantly more repair costs than a house built last year. A recently rehabbed house …read more