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How to Evaluate a Rental Property
A solid framework for identifying deals that will make money
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My real estate investing journey is just beginning. However, I’ve done a few deals that cash flow. I have a solid framework for identifying deals that will make money. At the very least, I can figure out if a property won’t cash flow pretty quickly. I’m sharing how I evaluate deals in the hopes it is helpful to others.
My main focus in buying property is cash flow. The plan is to get my passive income high enough to replace my main job. I’m not trying to crush 60 work weeks until I am 60. As you will see in this example, it doesn’t take many properties to retire. Or at least have a lot more flexibility.
These are the numbers on a purchase I did last year:
The purchase price was $258,000 for my 3 bed/2 bath-per-unit duplex in Wichita, Kansas. It was built in 2007. I buy duplexes in good shape built within the last 25 years. Newer houses usually don’t cash flow as well. But they don’t fall apart as fast. Fixing a house is expensive. The duplex is in more of a blue-collar neighborhood. The schools in the area are not great. Initially, this concerned me. I’ve never been to Wichita. I relied on my property manager, realtor, Google, and the property inspector to tell me how nice the area was. I’ve done a few deals with them, so I trust them. I don’t buy property in areas with high crime rates. Cash flow in areas with high crime rates can look awesome on paper. The cash flow becomes less awesome when tenants don’t pay you and destroy your house.
Cash flow = income – expenses. People often lose money because they don’t factor in all the costs involved.
P&I: $855 is the principal and interest on the mortgage.
Taxes: $307. You can look these up by Googling the county + tax bill or Zillow.
Homeowner’s Insurance: $122
Vacancy: $114.5 (5% of rent) I only do 1-year leases. Sill, tenants will move out at some point. The leases are staggered, so we don’t end up with 2 units vacant at the same time.
Maintenance and Repairs: $114.5 (5% of rent) This is for normal wear and tear on the property.
Utilities: $0 (tenants pay these)
Property Management: $206 (9% of rent) A good property management company is key. I don’t have time to fly to Kansas and deal with tenants, or field calls at 1am about a clogged toilet.
Total Expenses: $1719
Total Income: $2290. One side rents for $1095. The other side rents for $1195. I bought the property fully rented out, so I did not need to guess what it would rent for. Realtor.com rentals, Zillow, Craigslist, Rentometer, and the property manager are good resources to determine how much you can get for rent. You can also ask a realtor for comps.
Total income ($2290) – Total Expenses ($1719) = Cash Flow ($571)
How Much Did I Put into This Deal?
Down payment %: On a 2-unit investment property you have to put 25% down, unless you live in one of the units. Down payment on this property was $64,500.
Closing costs: $6243
Total Cash to close: $66,098 (The cash to close is less than the down payment + the closing costs because we had a seller credit of $4645).
Was this a Good Deal?
One common metric used by real estate investors is cash on cash return.
Cash on cash return = Annual cash flow divided by total invested capital. $6852 (annual cash flow)/$66,098 (total invested capital). Cash on cash return is 10%. I’ve seen a lot of investors shoot for 12% cash on cash return.
Another common metric used by real estate investors to measure cash flow is the 1% rule. If a property passes the 1% rule, it is likely to cash flow well. A property passes the 1% rule if the monthly rent is 1%+ of the purchase price. For this property to pass the 1% rule, it would need to rent for $2580. At $2290, we are close. We should be able to get to the $2580 with rent increases in the next few years.
I’m content with $571 per month in cash flow. The duplex usually brings in $800 per month. Repairs are rarely needed because the property is not very old, and tenant turnover is low. Also rents continue to rise. The units are identical, and one side currently rents for $100 more than the other. On future buys, I’m looking to cash flow $1k per month.
On top of the cash flow, this property has appreciated quite a bit in the last year. It is worth close to $300k now. I don’t factor in appreciation when evaluating property. No one knows if house prices will go up or down in the short term. Still, $40k in equity is pretty sweet. This will be valuable if I decide to sell, do a 1031 exchange, or take cash out to buy another property in the future.
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