I’m always “running the numbers”. I am always telling the turnkey company to let me run the numbers and I’ll get back to them whenever they send me a pro forma (remember from the last turnkey series post, that’s just a fancy word for the details of a property, the projected rent, and projected expenses, showing the monthly cash flow).
What does that mean? What am I really doing? This is a short and sweet post about the pretty simple math I do to make sure a property is worth my time.
Let’s start by taking a look at an example. In fact, since I am taking you through the process of finding my second property, let’s take a look at that one specifically. First, check out the information that was sent over to me:
Wow! I could be making $659/month! Woo hoo! Hold your horses there. You definitely have to realize that they are trying to sell you something and are making this look much rosier than it is. First of all, this return is if you don’t get a mortgage at all. That’s right, in this scenario, you would be paying $97,000 upfront (not to mention closing costs). Plus, some of the other numbers are a bit low in my opinion. Let’s take a look at the numbers I came up with and why. Note: we negotiated down to $93,000 for the house, so my numbers are based on that.
20% Downpayment: $18,600
Interest Rate: 5.125%
I was actually pre-approved by the bank for a 20% loan at this level. This is the interest rate that they quoted me. HOWEVER, that is not locked in. The interest rate fluctuates and may increase. Luckily, this is the same interest rate I got on my last purchase, so I am hopeful it remains at 5.125%
Projected Monthly Rent: $1050
I spoke with the turnkey company about this and they recently rented out a very similar home on this street (in the little neighborhood community) for $1050 recently and they were very confident about that number, so I am rolling with it in this case.
Monthly Mortgage (just principle and interest): $411
Monthly Taxes: $150
Monthly Insurance: $50
Property Manager: $84
TOTAL MONTHLY EXPENSES: $905
For the mortgage, I have a fancy formula set up in my excel doc, but if you just Google “Mortgage Calculator” you can figure out this number pretty easily. Let’s look at some of the differences between my estimations and theirs. I have taxes a shade higher because I asked about them. After a discussion about taxes with the turnkey company and the fact that I know property taxes in Indianapolis are rising, I upped my estimate to $150. I consider this conservative and hopefully the taxes will end up being a bit lower. I had a similar conversation about the insurance and decided to up that to $50.
Look at that! The property manager fee actually went down. In the last installment, I spoke about the changing of my property management. The new property manager only charges 8% of rent instead of 10%!
As far as the vacancy and maintenance are concerned. The turnkey company sets those at 6% of the projected rent each (they combine them in their flyer for a total of 12%). Good for them for including that at all. One of the biggest mistakes new investors make is not considering those numbers at all! But what if my eviction happened and I didn’t have rent guarantee. What if something major breaks in 4 years. I want to make sure that this is still a good investment, even with those inevitable hiccups. I increase those numbers to a more conservative 10% each. I hope that I don’t average more than 1 month vacant per year, but I want to be safe here.
Rent Income – Monthly Expenses = $145/month
That’s what I’d be making, overall. $145 every month isn’t life changing, but another $1,740/year for doing no additional work isn’t bad. That income will be there even when I decide to leave the daily grind. I am also planting seeds for myself. Every month that I am making $145, I am ALSO paying off the mortgage on an asset – the house. I don’t count on appreciation, but even if the house is worth only enough more in 15 years to account for inflation, I will still have built equity in it. So that means I can choose to sell and get that money out (paid by the tenant over the years) or, I can pay off the mortgage and start getting a monthly cash flow that’s $411 higher! In this game, it is always important to have multiple exit strategies.
Yup, as usual, I am playing a slow game here. I am planting seeds that will really start to flower in 10, 15, or even 30 years. In the meantime, I get a nice cash flow!
Quick Note: This cash flow is NOT as good as my first rental property. I think it is NOT a good idea to nix a deal just because it isn’t as good as a previous deal, though. Is it still a good deal in its own right? Then it’s worth consideration!
Additional Easy Math
There are a few more quick and easy computations that are prominent among real estate investors that you should know. These will give you a quick idea if the deal is worth looking at. I use them to raise red flags if they don’t meet the criteria.
1% Rule – Your monthly rent should be higher than 1% of the overall purchase price. For me that means $1,050/$93,000 = 1.13%. The higher this number the better, but just use it as a quick reference check.
50% Rule – Another quick reference rule. This one states that 50% of the rent you collect will probably go towards expenses like maintenance, vacancy, taxes, etc – basically everything other than the principle and interest. So a quick calculation you can do is cut your expected rent in half (for me, that’s $525) and then subtract the mortgage ($411). After that, are you still in the positive? I am by about $114, so that works out well. This is not a replacement for the more accurate math above, but I like running this test to confirm that I’m not being dumb with the numbers.
Cash-on-Cash/ROI* – This is basically the money you make each year, as a percentage of the money you spent. The easy formula is ROI = Yearly Net Income / (Downpayment + Closing Costs). I am setting aside my closing costs for now (we’ll get to that), and seeing that my ROI is 9.37%. You can compare this number to a return you might see in another investment, so I am happy with 9.37%, especially since again, it doesn’t take into account the equity that I am building in the property over time.
But What About Closing Costs?
What are closing costs? These are things like the appraisal (the bank wants an unbiased party to come out and decide what the house is worth), fees to the title company who is processing your title, fees to the government and a host of others. I left this out on purpose until now because I JUST found out that my closing costs might be much higher than I anticipated (going off my closing costs for my first property). Right now, they are estimated at a whopping $4576.95! Adding that to the initial outlay of cash takes my ROI down to 7.52%. At that point, even with building equity, the deal, while still in the positive, doesn’t look as attractive as using that money for other investments (where there is less work and debt involved). I will keep you updated as I go. But as much as I preach moving forward, I want to be smart about it. With my disposition, I need to be aware that I can’t have my mind set on a property such that I don’t back out when I need to. If it doesn’t work out, then no problem! I have time and I can look at the next opportunity that comes up. Patience is key!
No matter what happens, I plan on taking all you readers through the process. If need be, I will just switch over to use my first rental property as an example. Onward!
*Technically, ROI is based on the TOTAL investment, so what you put down AND what the bank put down. But I don’t really care about that number since I am looking to the rent I am getting to pay off that mortgage for me.
Like this post? Sign up to receive posts via email and never miss a tip for living well and saving money!