Good morning! Today Brandon Turner from Bigger Pockets explains how to analyze a property to make sure you get a great deal. Enjoy!
I know you are busy.
However, just because you are busy – doesn’t mean you shouldn’t seek to find an amazing deal when shopping for a rental property. In fact – I believe it’s because of your busy life that finding the best deal is so important. You don’t want to be stuck with a property that drains your time, empties your wallet, and makes you want to throw your tenant’s belongings off a twelve-story building.
Shopping smart is key, but at the same time – smart shopping doesn’t need to take forever. There are several “quick and dirty” techniques you can use to look at an investment property and decide if it’s something worth pursuing. This post is going to share my method for finding the best needles in the real estate haystack.
What Metrics to Measure
For me, cash flow is king.
Cash flow, in it’s simplest definition, is the profit left over in my bank account after all the bills have been paid on arental property. For example, if a property rents for $500 per month and all my expenses for the month come to $400 – then I’ve just made $100 in cash flow.
Cash flow is important because it adds money to my bank account each month, rather than take money away. It helps me save more and gives me a scorecard for measuring my investment’s potential.
The other side of the coin is “appreciation,” which is the value gained when real estate prices rise. While appreciation is a welcome thing, (I love when my property values rise) I don’t use appreciation to determine a good deal. After all – there is no way of predicting the future since my crystal ball broke last year. Appreciation is simply the icing on the cake, but should not be used to determine an investment’s future value. Again – for me, it’s all about cash flow.
So how much cash flow is good? We’ll get to that in a minute, but first- let’s look at the quick and dirty way to calculate it.
Knowing Your Expenses: The 50% Rule
One of the most valuable “tools” to a real estate investor is known as the 50% rule. This “rule of thumb” states that for a real estate investment – the non-mortgage expenses will usually average out to about 50% of the rent.
Let me explain. If you own a 4-plex that brings in $2,000 per month – you can probably assume that over the long run, this property is going to cost $1000 per month in vacancies, maintenance, and other charges (not counting the mortgage.)
Now, it’s easy to estimate your monthly cash flow by simply taking the amount of money you have left (known as the Net Operating Income) and subtracting out the monthly mortgage payment – which you can find using any online mortgage calculator. My favorite is this one.
For the example we’ll use in this post, let’s assume we bought the 4-plex for $140,000 and put a $28,000 down payment for a total loan amount of $112,000. At an interest rate of 5% for 30 years, the loan payment works out to approximately $600 per month. Additionally, this four plex rents for $500 per unit, per month, for a total of $2,000 per month in rental income.
Going back to that first example, here’s how it would look:
Monthly Rent: $2,000 per month
-$1,000 per month (50% Rule)
– $600 per month (Imaginary mortgage payment for this example)
= $400 per month in cash flow.
Now – you may be tempted to argue with me that 50% for expenses is high – and maybe you are right. However, this “rule of thumb” has been used by a lot of seasoned investors for many years for one reason: because it seems to just work. Maybe you’ll have no expenses for several months, and then be hit with a ton (like me, this month!) Maybe your roof will go bad and need to be replaced. Maybe the heating system will go out. Maybe you’ll have an eviction. The 50% rule allows you to look at cash flow over the long run, which is why I advocate using it. If it ended up being less – you win! But at least you won’t be tempted to buy a property that is actually going to cost you money to own (negative cash flow…bad.)
So, back to our example… is $400 per month in cash flow good? Well, maybe. Let me explain how I determine it.
How Much Cash Flow is Right?
For me – it comes down to 3 different methods:
- Return on Investment: Your return on investment is the tool used to calculate your investment’s use. If a $1,000 investment gave you $100 in profit over a full year, your ROI (return on investment) was 10%. So, let’s look back at that example of the four-plex. We determined that we could expect about $400 per month in cash flow with a $600 per month mortgage payment and a $28,000 investment (down payment.) $400 per month is $4,800 per year. $4,800/$28,000 = 17.14% return on investment. Also keep in mind that this ROI does not include any appreciation, tax benefits, or loan pay down (each month, the balance on the loan drops a little bit.) Officially, this number is known as your “cash on cash return on investment” and is a good way to compare your investment with other investments like stocks, bonds, or mutual funds.
- Per-Unit-Profit: Even more quick and dirty than the ROI measurements, sometimes it’s enough just to look at the “profit per unit.” This means – if I were to buy this property, would I clear a certain price per unit in cash flow? This is truly the “quick and dirty” way to analyze a property: begin with the total monthly income and use the 50% rule to take out the expenses. Next, subtract the mortgage amount. Using the example we discussed earlier, the fourplex supplied $400 per month in cash flow – or $100 per unit, per month – which is the minimum amount I’d ever generally accept though I like to see $200 per unit, per month.
The 1% Rule
Another “rule of thumb,” I should mention, and the fastest way to quickly decide if a property is worth pursuing, is known as the 1% rule. The 1% rule states that an investment property should rent for at least 1% of the purchase price. So, the fourplex we discussed earlier – which was bought for $140,000 – should bring in at least $1400 per month in total income (which, according to our example, it does meet.)
Some investors choose other ratios, such as the 1.5% rule or the 2% rule to achieve greater returns and greater cash flow. I typically won’t buy anything below 1.5% and try to aim for 2%, though your percentage may depend on your location and risk tolerance.
Did I lose you? Hopefully you stuck with me on these calculations!
The methods I mentioned above can be used to quickly analyze an investment property for further investigation. With thousands of properties listed for sale at any time, it’s simply impossible to do a thorough analysis of each. This is why these “quick and dirty” methods can be great for filtering properties and only looking at the best options.
One final disclaimer: never buy a property based entirely upon one of these methods. This is a way to filter out the 99% of properties that are not good deals and only focus on the best. Do your homework and learn what the actual expenses and income are, and buy amazing properties.
No matter how busy you are – I encourage you to spend some time trying out your new math skills to analyze some properties. Once you are good at it, you’ll be able to decide if a property is worth pursuing in just seconds – saving you time and helping you build wealth at the same time.
Do you have any questions about analyzing properties? Feel free to leave me a comment below and let’s chat!
Brandon Turner is the Senior Editor at BiggerPockets.com, the real estate investing social network. He can be found writing epic posts about real estate like the Ultimate Beginner’s Guide to Real Estate Investing or Tenant Screening: The Ultimate Guide.