This article could also be titled “how to determine if a rental property is a good deal.” This is also the story of my first duplex, which has always generated positive cash flow. I had always been interested in real estate, and had heard that many millionaires had made their fortunes in real estate. I just never knew when something was a good deal. Then one day my neighbor came over and said he wanted to buy a couple of duplexes but the seller would only sell if he could sell all three at the same time. My neighbor said that it “pencils” and do I want to buy it.
I was busy at the time and didn’t know what kind of analysis to do or how to do it but relied on my neighbor and bought the place. It turned out to be a lot of fun, I kept getting rent checks and it wasn’t nearly as much work as I imagined. I had positive cash flow. Nobody called me to unplug a toilet. So what did “it pencils” mean? My neighbor used the rule of thumb that if you pay no more than 100x the amount of gross rent a place will generate, the income will cover the expenses and you will have a positive cash flow. That assumes that the tenant pays electricity but not sewer and water. Note that this rule of thumb does not work for condos unless you first deduct the condo fee (homeowner’s association fee) from the rent before multiplying by 100. This is a simplistic evaluation but it actually works fairly well here in Washington State. There is another rule of thumb called the 1% rule. That says that the rent should be at least 1% of the purchase price. Other people say that 10 years of rent should exceed the purchase price. These rules of thumbs are fine for a rough analysis but you have to be careful. For example, in states like Texas and New York, property taxes are very high and you may need to use a lower number than 100.
A better analysis is to perform a “cap rate” calculation. I calculate cap rate as gross annual rent minus vacancy rate minus all expenses other than interest all divided by purchase price. The higher the cap rate the better. This is basically your rate of return if you would have paid all cash.
For example:
$100,000 duplex that generates $500×2 rent per month.
Without asking for details from the seller, you can first check your rule of thumb multiplier. The rule of thumb is a crude way to estimate if a rental with generate positive cash flow. Where I live, any multifamily property priced at or less than 100x one month’s rent will generate positive cash flow. The multiplier may need to be adjusted depending on local property taxes, size of property, or age of property. But 100x works here and this property passes. Now I can ask the seller for income and expense information (preferably three year’s of schedule Es).
500x2x12=$12,000 gross annual rent.
Vacancy rate in the town is currently 5%.
Adjusted gross rent is 12,000-.05×12,000=12,000-600=$11,400
Annual water, sewer, lawn mowing and snow removal=$1000
Annual taxes=$1000
Annual insurance (fire plus liability)=$500
Annual maintenance and repairs and misc=$2000.
Net income=$6900. Cap rate equals 6900/100,000 or 6.9%. So if you paid all cash, you’d get a rate of return of 6.9% ASSUMING ZERO APPRECIATION. In reality, there will be some appreciation, if there is inflation, and you will get a leveraged rate of return from that appreciation. But the main point is to use these calculations to compare similar properties. If you use 5% vacancy for one, use it for another. If you assume a management expense for one, assume it for the other. Even without the appreciation, 6.9% sure beats what you would get from a bank CD.
You will want at least a 7 or 8 cap rate to be reasonably sure of positive cash flow (depending on maintenance expenses and interest rates) but the important thing is to use this calculation to compare multiple options OF SIMILAR AGE AND CONDITION. An older property should have a higher cap rate because of the additional risk of repairs involved. Also beware that some real estate agents or sellers may overstate income and understate expenses. If they have a fourplex with one unit rented for $500 per month but the other three are rented at $450 per month, they may make their calculations based on $500×4 and call it a “proforma” rent. You should not accept this kind of calculation.
My trick is to ask sellers for the last two or three years of schedule E’s. Sellers are not likely to underestimate expenses or overstate income when reporting to the IRS. You can make it a contingency in the offer; e.g., “Offer is contingent on seller providing three year’s of schedule Es for the property.”