People from anywhere in the world have a common trait. No matter what the product, the words “on sale” attract everyone (especially my wife, but that’s another story).
When it comes to real estate, it’s no different. The phrase “you make money when you buy, you realize that money when you sell” continues to ring true. The challenge is being able to spot that good deal which stands out amongst many poor or mediocre deals.
For the purposes of this article, let’s focus on finding a deal on a rental property.
Keeping your properties fully occupied with good tenants creates good cash flow. If you have ever owned properties with high turnover, high maintenance and therefore high management, you will appreciate importance of the following checklist I use before I reach for my calculator.
You must understand the areas you are buying in. This can be the difference in having a low stress property with reliable tenants or lots of bounced cheques and many trips to the property and your local rental tribunal.
1. Employment – must be an area that attracts good working people with local employment opportunities or jobs within a reasonable commuting distance.
2. Schools – having elementary and high schools in the area will attract more families. Families will typically stay put longer when there are children going to the local schools.
3. Amenities – the property should be close to shopping and restaurants as well as easy accessibility to the main thoroughfares.
4. Crime – obviously you want your property in a low crime area. You can check with the local police station as well as ask people in the area about the crime rate.
5. Future building – this can be good or bad. If the area is growing and there is new housing development happening, box stores and schools being built, that’s great. If there is a nuclear plant, jail, low income housing projects etc., that’s probably not so great.
6. Parking – there must be enough parking to accommodate your tenants. Parking issues are one of the main forms of complaint received by the municipality, so it’s best to stay off their radar.
7. Vacancy rate – you can check with the latest CMHC reports as well as local realtors regarding vacancy rate. This rate has a lot to do with the previously mentioned factors.
8. Real estate cycle – determining where you are in the cycle should determine if you are buying, selling or waiting. As mentioned previously, the fact that you make money when you buy and realize it when you sell comes down to where you are in the cycle.
Getting the above information can also be gathered by checking with the local City Hall as well as talking to renters and homeowners in the area. They are often upfront and honest about any negativity in the area. Visit the area at different times of the day and evening to get a clearer picture.
In general, try to choose your properties in middle to lower income areas where tradesmen and possibly some businesses might reside intermingled with houses. You also never want your property to be the worst-looking one on the street as you will not have a huge desire for your property. If you choose a property which visibly needs maintenance, you need to have a budget to correct these issues as soon as possible.
Now let’s crunch some numbers. Doing a full property analysis where all income and expenses are calculated is crucial but time consuming. I only engage in the full analysis once the property has passed the “litmus test” as it were. These 3 calculations can be done in minutes and will gauge whether any further number crunching is necessary.
The 1% Rule: monthly rents should total 1% of the purchase price. (Factor in any initial repairs into your purchase price)
A property for $100,000 should get $1000 per month rent. Therefore a $250,000 property should receive $2,500 per month. If it rents for more than this, you have found a nice cash flowing property.
This “rule” has some factors surrounding it. If the property is in a solid area with low vacancy and good economic factors, then accepting slightly less than 1% may be fine. If the property is in a less desirable area, you may want to consider 2% as your standard.
Gross rent multiplier (GRM) = market value divided by the annual rental income (The lower the percentage, the better) This calculation allows you to calculate the price you should offer based on the comparable GRMs in the area.
A recent comparable sold for $400,000 with an annual income of $36,000. $400,000/36,000 = 11.12%
If others in the area were 6.84%, 7.58%, 9.82% and 5.4%, you add these up and divide by 5 (the number of examples you are using) to get your area average. In this case 40.76/5 = 8.15% as the area average.
To determine a fair purchase price, take the gross income on the property you are looking at and multiply by (in this case) 8.15%.
Let’s say the gross income on your property is $37,800 annually.
Calculate GRM x gross annual income. So, 8.15 x $37,800 = $308,070.
This is the price which makes sense for the area based on the gross income the property is generating. When calculating this, be sure to note what economic rents are. These may be more than what the subject property is generating and using these numbers may increase your purchase offer amount.
Cash on cash Return = annual NET income divided by your cash invested (downpayment, closing costs, initial repairs)
Let’s say the purchase price is $250,000. So 20% down is $50,000; closing costs are typically around 1.5% of the purchase price which equal $3,750 plus HST in many provinces, so let’s say $4,200 for closing. Let’s also put in $5,800 into repairs to make it an even $10,000, plus the down payment so you are in a total of $60,000.
Let’s say the property meets the 1% rule and generates $2,500 per month. In this example, the tenants pay their own water, heat and hydro, so you must cover:
Mortgage = $1,052/month (based on a 4.00% rate for this example)
Property taxes = $250/month
Insurance = $98.00/month
Vacancy = $125.00/month
Maintenance = $125.00/month
Expenses total $1,650/month so your NET income is $2,500 – $1,650 = $850/month or $10,200 annually.
Cash on cash return = NET income/ cash invested, so ($10,200/$60,000) x 100 = 17%. So you are making 17% on your cash invested per year which improves over time as your equity increases.
These calculations should be used as consideration for a property purchase. It is necessary to do your full diligence and complete property analysis with actual numbers prior to making any purchase.
Derrick is a Memphis native specializing in locating, purchasing, renovating and managing single-family and multi-unit properties and possesses over 8 years of experience in real estate investing and property management in the Memphis and Nashville markets… Learn More…… www.memphisbuyandhold.com