Buying Rentals Right

In my last post I mentioned buying your rental properties right.  There are several formulas out there to buying real estate.  Due to short attention spans, I won’t even begin to list them.

A common formula is After Repair Value (ARV) * 70% – closing costs – taxes – insurance – repairs – your profit = Maximum Allowable Offer (MAO).  This works great for rehabs and wholesale deals, but not always for rentals, because rentals are driven by the Net Operating Income (NOI).

Here is the formula used by used by Mike Summey, who co-authored “The Weekend Millionaire’s Real Estate Investing Program”, “The Weekend Millionaire’s Secrets To Investing In Real Estate”, “Weekend Millionaire Mindset” & “Weekend Millionaire Real Estate FAQ” (all are suggested reading).  The “Secrets” book has sold more copies than any other real estate investment book.

Gross Rent (what the tenant pays you)
- Vacancy Rate (usually 5% – 10%, depends on the area)
= Net Rent
- Management Fee (whatever the property manager charges)
- Maintenance Reserve (savings for future repairs)
- Utilties (what the owner may be responsible for)
- Taxes (1/12 of the annual property taxes)
- Insurance (1/12 of the annual insurance premium)
- Other expenses
= Net Operating Income

The NOI must be able to cover the principal and interest payment on your mortgage.  If it doesn’t, you can still “cashflow”, but you’re setting yourself up for failure.  If your gross rent is barely covering your Principal, Interest, Taxes & Insurance (PITI), you better hope that when your tenants move out, you can get new ones in right away and that the previous ones didn’t trash your property.  Otherwise, make sure you have a large cash reserve handy.

Let’s run an example of this formula:

Gross rent: $750 -
Vacancy Rate (10%): $75 =
Net Rent: $675 -
Management Fee (10%): $67.50 -
Maintenance Reserve (10%): $67.50 -
Utilities: 0.00 -
Taxes: $100.00 -
Insurance: $58.33 =
NOI: $381.67

Here are some mortgage amounts, rates and terms that can be covered by an NOI of $381.67:

10 years, 6% int., $34,378.03
30 years, 6% int., $63,658.80
10 years, 7.5% int., $32,153.41
10 years, 0% int., $45,800.00
30 years, 0% int., $114,500.00

Yes, that is ZERO percent interest on those last two examples.  For reference, the 30 year, $63,658.80 @ 6% has a total pay back of $137,397.81.  The zero percent interest can only be done with owner financing (if you find a bank loaning out at 0% for 10 or more years, let me know), and there are sellers out there that will finance you at that rate.  They won’t give it to you, you have to ask, they might say yes.

This formula is very similar to what commercial property owners use to determine Capitalization Rates (Cap Rates) and how much they can pay for a property.  Cap Rate is a posting all to itself.  I’m sure I’ll cover it eventually.  If you use this formula, your chances of being successful will greatly increase.