Practice: Analyzing Potential RE Investments
It’s been toooo long! Summer vacation ended very recently so I’m back in good ole Korea – Trump and Kim Jong Un be damned. While home, I was able to have an inspection done on my primary residence. The inspection gave me a sense of the items I need to repair to get the highest buy offer I can, once I put the house on the market. During my vaca, I also listened to a few more Bigger Pockets (BP) podcasts and continued reading my HOLD book (almost done!). Some things that struck me as I read/listened:
- I need a better understanding of cap rates.
- I’ll need to have systems and a team in place before I tackle being a landlord.
- Calculating a reasonable estimate of value for a property is difficult but necessary for making a smart offer
What in the world is cap rate?
Cap rate along with cash on cash return and other REI metrics are thrown around quite a bit in the BP forums. It’s easy for me to read and understand a rate formula on its face. For example:
*Net operating income (NOI) is the money left over after expenses like property taxes (but not mortgage payment) are taken out of gross rent.
So for instance, let’s say I’m thinking of buying a 2bed- 2bath duplex. The owner states it brings in $1200 a month in total rent. Her monthly expenses for this property are $750 – this includes expenses like property taxes and property management fees. This also include monies she puts away in case of vacancies, maintenance repairs, and capital expenditures (e.g. roof replacement).
So this property’s monthly NOI is $1200 – $750 = $450. It’s annual NOI = $5,400. If I purchase this property for $100,000, the cap rate would be:
But for me, it’s hard to get a sense of exactly what 5.4% means (without a laymen’s explanation). So I hunted around a bit and found a great BP article by Che Chiu Wong .
He defines cap rate in a simple fashion:
If you purchase an investment property in ALL cash – cap rate is the profit you receive for each $100 invested per year (after expenses have been paid).
So a cap rate = 5.4% for this REI deal means if I paid $100,000 ALL in cash, every year I’d receive $5.40 profit for every $100 I invested (after paid expenses).
From what I understand, the ALL cash assumption helps to make this a standardized metric. In other words, if debt service (mortgage payment) was included it would cause the resulting number to vary widely from person to person (based on mortgage interest rates, fees, etc.). That’s not to say that two people can’t calculate two different cap rates – but that difference is based more on what expense numbers are used.
So overall, I now understand how cap rate can help me identify whether I’m getting a property at a good price. I also think I have a basic understanding of cash on cash return (CoCR) and return on investment (ROI). CoCR being a way to know how much I’m getting back (return) for any cash I’ve put in (e.g. down payment). CoCR takes into account debt service unlike cap rate. ROI seems to be the total amount I’m getting back (return) for everything I’ve put into the deal (up front cash, financing, appreciation, etc.). But, I’m still hunting for a literal explanation of the numbers similar to Che Chiu Wong’s…. for a more thorough understanding…we’ll see if I can find.
Analysis is my plea-sure
I was lucky to link on BP with a realtor with Century 21 Premier in Canton, shout out to Taylor Johnson (313) 333-5324 or firstname.lastname@example.org! Taylor took time to set up a portal for me to receive regular alerts and access to MLS listed properties in my target areas. Using that portal I was able to pull three possible properties for analysis.
My analysis process went something like this……
After finding the three target properties through the portal setup by Taylor – I took note of the listing price and any info listed on collected/projected rents (for MF only).
I then I looked up as many comps for each property as I could. The comps (or recently sold properties) closely matched each target property in terms of property type (MF vs SFH), location, square footage (sq. footage), and bed/bath. I was able to find a good amount of comps from 2017 for the Ferndale and Westland properties. It was more challenging to find 2017 comps for the Oak Park property so I used a mix of props sold in 2017 and 2016. I used Zillow and the portal to find these comps.
I noted pertinent information for each comp – including listing and sold price, bed/baths, sq. footage, etc. For MF properties specifically – I also listed rents and whether they were projected or actual. I used the portal to find these numbers (when listed). For each comp, I also noted how they compared to the target property in terms of condition and sq footage.
Based on a trick I learned from the HOLD book I then calculated averages for sold price, bed/bath, rents (MF), sq. footage, and year the comp was built. This allowed me to come up with a “model” house to compare my target property to. Analogy: It’s like taking an average of the measurements of American women in the Midwest and coming up with the “typical size” for women in the Midwest.
Once I had the “model” house I compared it to my target property to make a determination of fair market value (FMV) and rent estimates. I also used Hotpads.com to confirm whether my rent estimates were in line with what other properties were being rented for in the area. Determining FMV was the most difficult part. For instance, there were comps in worse condition with less sq. footage that sold for more than comps in better condition with more sq. footage. So, I used an article I read on BP about quickly estimating value, to come up with a process for calculating FMV ranges for each property.
Now, armed with an estimate of FMV, the listing price, and rent projections (MF) I used the HOLD worksheet I pulled from the author’s resource website and an app called DealCheck to plug in the numbers and get an analysis. The HOLD authors state investors should never pay market value for a property. They suggest discounting a property at least 10% when coming up with your purchase offer number. So for each property, I started by discounting my calculated FMV by 10%.
I then plugged that max offer price number, along with down payment percentage (3.5% or 20%), mortgage interest rate, mortgage insurance (PMI) rate, rehab costs, projected rent, and expenses into the DealCheck app.
Plug and Play
For the MF properties I assumed I would be taking out a FHA mortgage (as an owner occupier) with a 3.5% down payment (3.5% of purchase price). With FHA mortgages if you put down less than 20% you also have to pay yearly mortgage insurance (PMI) and an upfront premium. The DealCheck app has a option for plugging this in. For the SFH I assumed I would be taking out a conventional mortgage (as an investment property) with 20% down.
For all properties, I entered a mortgage interest rate I thought was reasonable based on current rates (4.25%). I took the rehab costs from the HOLD book I’m reading. The authors state $11,000 is a reasonable number for light rehab. The projected rent (MF) again comes from the comps I pulled and Hotpads.com. The expense numbers I entered came from:
Property taxes: I looked up property taxes for each property on accessmygov.com for each city. You can plug in an address and get current and historical property taxes for properties this way (for free in many but not all cities) in MI.
Insurance: hard to estimate without calling around. So I just used the number I pay now for my house.
Property management (PM): based on the PM companies in MI I’ve contacted, 10% of gross (collected) rent is standard. I didn’t include additional fees for finding tenants and lease renewals. Though I plan to manage my first property myself, both the HOLD book I’m reading and BP contributors all suggest accounting for PM fees in case I change my mind.
Maintenance: to calculate a maintenance reserve for possible repairs I used either 7% or 8% of gross rent depending on property age.
Capital expenditures: to save for possible CapEx (major repairs like roof replacement) I used either 8% or 10% of gross rent depending on the property’s age.
Utilities: I only included this for the Ferndale property. Since it seems that the two units share a water heater and furnace (i.e. not separately metered) – I assumed I as the landlord would need to pay the bill (I increased the projected rent to try and account for this). I pulled water bills for the Ferndale property on the same accessmygov.com site. Getting a estimate for heating is difficult without calling the utility company so I based my number off my primary residence.
Once I had all my numbers I plugged them into the app to get my analysis.
Drum roll, please
Thus far, my personal/investment criteria for deciding whether to make an offer on a property is:
Property must produce at least $200 net cash flow per month
As I gain more experience analyzing deals I plan to zero in on my criteria for CoCR and cap rate. But for now, for each property, if the net cash flow was a negative number I played around with the offer price until it was positive. If the net cash flow was a positive number but lower than $200/month – I played around with the offer price until it was at least $200. I realize I could have played around with other numbers (perhaps interest rate or down payment) but to keep it simple -for now I just decided to stick with one variable. Next time I’ll play around with multiple numbers. My analysis is below:
279 Fielding, Ferndale
I couldn’t make the Ferndale MF property work. I think including utilities as an expense was the main issue. I tried accounting for the utilities by raising the projected rent (from $1,525 to $1,700). But to fully account for utilities I would’ve needed to raise the projected rent to $1,775. However, raising it that much would put it over what I found the market rental rate to be for 1-1 and 2-1. In addition, the 1bed 1bath (1-1) in this MF is quite small, compared to other 1-1 I found. The seller for this house projected rent for the 2-1 as $1,100 but I couldn’t find any 2-1 of comparable size that matched this rent. Full houses are being rented for $1,100-$1,200 in this neighborhood so that projected rent seems excessive. So a question arises for me – how do you walk the line between increasing rent to cover shared utilities in a MF while staying competitive in terms of rent?
15220 Nine Mile, Oak Park
The numbers work here – except for ROI. I think this is mainly because the estimated FMV I used is too low (or offer price is too high). My calcualted FMV range for this property was $135,000-$163,000. However, I wasn’t able to do any comparisons for condition because listings for each comp lacked interior photos. Also I could only find 3 comps for 2016-2017. Playing with the numbers in the DealCheck app – increasing the FMV resulted in positive ROI. Lowering the offer price resulted in the same.
31814 Hazelwood, Westland
The numbers work here too. Except cash needed exceeds what I would be bringing to the table: 20k. This is because I’d be required to put down 20% (unless I could find a lender who would accept a lower down payment).
So out of the three properties – I’d be looking to make an offer on either Oak Park or Westland. Since I’d be house hacking the Oak Park property at least the first year – my net monthly cash flow would not actually be $203. If I assume I’d rent one unit for $800 – that rent would basically cover the mortgage ($679) and property tax ($136). I’d need to pay the insurance ($54) and all other expenses (as they arise) out of my pocket. So essentially – I would be living in the MF for $54 month plus utilities (probably $200/month total). If the amount I’m able to save each month (from by W-2 paycheck/job) exceeds $528 (the total amount remaining for the expenses I calculated above) – that would be an even better deal. But another question arises though – do people who house hack usually put away money for these expenses just as they would if they weren’t living there?
If I went with the Westland property I’d be banking $203/month but would also have to find someplace to live….ideally cheaply and ideally a place I own. This would be potentially difficult to do since my free cash would be tied up in this investment.
So which property would I make an offer on?
Oak Park! I’m going to track this property to see what it eventually sells for.
I also analyzed how the numbers for each property would change if I rolled the repair costs into a renovation mortgage like 203k. But this post is already too long – so I’ll save that for another day!
Anyone else in love with spreadsheets? Please leave a comment below!
Motivating Mantra: “Surround Yourself With Like Minds”
I was reminded recently how motivating it is to be in the company of those who are also trying to make significant steps to change/mold their own destinies. People with goals of their own who validate your aspirations are positive forces. Other’s without goals or aspirations may see my plans as unattainable and could potentially impart the type of negativity that may lead me to question my decisions….I’ll side step discussions on my goals with those folks.