Investment Property Tutorial
Welcome – Investors
- How to anticipate the profitability of a property before you buy
- How much should an investor offer when buying
- Before you sell, take advantage painting, landscaping and staging
- Keep and use your SEP IRA to purchase properties.
- Never buy a property without thoroughly inspecting it first.
- Properties of Exceptional Value
1- How to anticipate the profitability of a property
A simple way to calculate the potential net profit a property will yield prior to buying it is to multiply the gross scheduled income by 55% then subtract any bank interest you will pay for a loan. This is not an absolute, but allowing 45% of the gross scheduled rent for overhead is a reasonable average of what to expect. This allows for vacancy, management, maintenance, taxes, insurance and other miscellaneous expenses. I like to calculate deferred maintenance costs as part of the purchase price, that you should have in reserves when purchasing property.
Example: A fourplex scheduled to collect $1500 per unit per month would be:
$1500 X 4 units X 12 months = $72,000 annual gross scheduled rents X 55% = $39,600 net annual income. Any mortgage payments need to be subtracted from this.
Disclaimer: The above is not absolute but a good conservative approach to predicting profitability.
Factors affecting a rental property’s net income:
High maintenance and / or high tenant turnover can bring expenses to over 55% of gross scheduled rents. Low maintenance + low tenant turnover + self management can drop expenses to under 30% of gross scheduled rents.
Studio and one bedroom apartments often have slightly higher tenant turnover compared to two and three bedroom apartments. That is to say, tenants move out slightly more frequently from studio and one bedroom apartments.
Properties converted to multi-units versus properties designed as such can incur more maintenance costs.
Older properties can incur higher maintenance costs.
Above average rents for a property’s location, size, condition and amenities causes one of the largest expenses a property can have, Vacancy! Vacancies not only don’t collect rent they incur the additional expense of apartment refurbishing costs. This is particularly important when buying a property as many sellers raise rents prior to selling to make their property seem more profitable.
Vacancies in a property you’re considering buying can be a sign of the rents being too high or issues with the building or neighborhood. On the flipside, with the vacancy, you get to find a good tenant or use a tenant screening service to do it for you. I have seen good properties sold because the landlord was tired of dealing with difficult tenants. You also get to set the rent on a vacant unit. Current laws restrict how rapidly rents could be raised so a property with under market rents will be discounted proportionately to those rents especially if it’s in a rent control area.
Not following rental laws can cost you more money and headaches than you can imagine so be wise and obey rental laws.
2 – How much should an investor offer when buying
Supply and demand method: (The seller’s perspective)
Look to see how much every home of comparable size, amenities and condition, within 1/4 mile, has sold for over the last few months. Average the selling price and add or subtract 2% depending whether in a sellers or buyers market. Remember, yours might be one of several offers and the sellers need a reason to pick yours. Also, sellers see a cash buyer as more likely to close than a financing buyer. This being said, finance buyers often need to outbid cash buyers to look attractive to sellers. There are other nuances to make a financed offer more attractive such as being over qualified for the loan and having more cash than necessary to close if the appraisal comes in lower than expected.
Income producing method: (The buyer’s perspective)
note: Sometimes landlords fill vacancies with tenants who have bad rental histories at exorbitantly high rents to make the books look good when selling a property. “No credit check and first month free,” will attract tenants willing to agree to pay above market rents for below market housing. A little forensic bookkeeping such as rent rolls and schedule e’s going back a few years will show the stability of the tenants and the true income of the property.
Look at the total anticipated cost of acquiring and renting a property. Include the sale price, closing costs, needed repairs, cost of deferred maintenance and cost of vacancy and tenant placement. Using this total as the true cost of the property, calculate the CAP rate.
To calculate your CAP rate (the annual profitability of your property)… Take the gross scheduled rent (the total scheduled to be collected annually), Subtract from that all vacancies (5% of rent ±), Subtract cost of maintenance and capital improvement slush fund (10% of rent ±), Subtract cost of utilities (PG&E, water, garbage, sewer as applicable), Subtract cost of taxes (average 1.25% of purchase price ±), Subtract cost of insurance (check with provider), Subtract cost of management and placement fees (8% ±). These expenses typically add up to 42% to 48% of the gross scheduled rent. Divide this final number by the purchase price (which should include all purchase expenses including deferred maintenance and needed renovation costs). Adjust your offer to keep the annual profit in your comfort zone. I recommend the annual profit (CAP rate) needs to exceed current mortgage interest rates to allow for financing.
Example: $100,000 in annual gross scheduled rents less $45,000 in total annual expenses = $55,000 divided by a $1,000,000 total purchase cost ( $950,000 purchase price + $10,000 in closing costs and $40,000 in needed repairs) = $55,000 / $1,000,000 = .055 or 5.5% annual profit or 5.5% CAP
If you have a loan, include the additional closing costs in your total purchase costs, substitute the down payment for the purchase price and ad the interest portion of your loan payment in your annual expenses. When you divide the annual net profit by your purchase cost you will get your “Return on Investment” or ROI. Note: The principle portion of your payment is considered profit.
3 – If selling a vacant rental property, be sure to consider painting, landscaping and staging as part of the marketing of your property.
If you are selling a vacant property that has been a rental for a while or is simply not looking 100%, I can improve the look of your property with color consulting and painting, landscaping and its design, and staging that enhance the beauty of you property. I design and coordinate these services for my clients when in contract to list and sell their real estate. You can see my referrals on Yelp (be sure to also view the filtered section).
4 – Keep and use your SEP IRA to purchase properties.
If you have a SEP IRA you are allowed to have it invested. Real estate is an allowed investment; however you need to work with banks that will facilitate this for you. Here are two I have found, recommended by my clients. Equity Trust and Provident Trust Group
5 – Never buy a property without thoroughly inspecting it first.
The real estate market is so hectic these days, often purchases need to be decided quickly; however, you should keep and exercise your right to thoroughly inspect a property after you have an accepted offer. This needs to be done prior to releasing your inspection contingency by action or time lapse. I recommend you accompany your inspectors to see first-hand what they find. I have been to hundreds of property inspections and will assist you in this process. This help ranges from spotting something the inspectors missed to translating from contractorese to English.
6 – Properties of Exceptional Value
I continually scour through thousands of properties offered for sale to find what I consider to be properties that yield a better return on investment and mitigate your capital investment risk. Contact me if you want my help or if you have any questions. 707 332 8301 or or email@example.com or browse the MLS for yourself. You can see my referrals on Yelp (be sure to also view the filtered section). Or go to the referrals section of this website for different referrals.