October 26, 2008

How to value rental property prices.

If you are considering buying a rental property as an investment one of the most important things is to make sure you're getting a good buy. To property evaluate a purchase of a rental property you need to know what the income is and what the expenses are.

Key information you should find out about a property to evaluate a purchase : are Income, costs and Price.

What is the gross rent and vacancy rate? Rental income may be stated in the sale listing but it is possible the seller or realtor is exaggerating the income by either neglecting the impact of vacancies, assuming that you can rent for more than it currently is or both. You should get the actual income data on the property and then assess if the rents are practical for the location.

The fixed costs and bills including taxes, insurance, all utility bills paid by the owner. The variable costs associated with running the property such as repair and maintenance costs, management fees and lawn care costs. I would also ask the seller about any liability for major repairs or services, for example the city may plan to install sewer service in the near future and paying for a connection could be a pending liability on the property. You can request documentation on the costs from the seller. If the seller is hesitant to provide copies of bills or cost records then its possible they are hiding something.

Generally the asking sale price plus any closing costs is all you'd as far as the price. This one is fairly straight forward.

There are some other items to be aware of. You should determine if the property is in poor condition or not. A property that is in disrepair would likely have higher ongoing maintenance costs. The quality of the tenants in the unit would also impact the value of the property.

Once you have the income and expense data then there are a few ways to evaluate a price on a property:
You can use the Rule of thumb of 100 x rent, Calculate ROI on your equity or figure the CAP rate. The 100x rent rule of thumb will give you a decent starting point. Determining ROI or CAP rate are both more in depth evaluations to put a property purchase in terms of return. Using these methods will help you compare different purchases in terms of investment return.

Rule of thumb method: Don't pay more than 100 times the monthly rent.

With this method you're using a basic rule of thumb. You take the monthly rent and multiply by 100 and that is the maximum price you would pay for the property. This is a good starting point for property measurement.

Example #1: A single family home is on the market for $110,000 and it rents for $950 a month. Since 100 x 950 is $95,000 then this is not a good buy.
Example #2: A duplex is on the market for $95,000 and the rent is $500 per unit. Total rent is $1000 a month and 100 times that is $100k so the $95k asking price is OK.

Calculate the cash flow and rate of return estimate.

Using this method you are going to do a little more math and estimate your income and expenses then make sure you're getting a good cash flow. For this to be effective you need some good data on the expenses and rent income. First figure out the rent income. Next add up the estimated expenses including mortgage if its financed. Subtract the expenses from the income to determine cash flow. If the cash flow versus equity is favorable % return then the house would be a favorable investment.

Example #1: The single family home is generating $950 a month. Your total rent is $11,400 and you expect 95% occupancy rate for income of $10,830. Your expenses are going to be property tax and insurance of $2000 and your mortgage is $528 a month x 12 for $6,336 annually. You estimate other expenses and maintenance of $1000 a year. So rent = $10,830 and expenses = $9,336. Rents less expenses gives a cash flow of $1,494. If you put down 20% for $22,000 then you'd be making about $2k a year on $22k or roughly 6.7% return on your down payment. This might be an OK buy.

Example #2 : A duplex is selling for $95,000 with $1000 rent combined for 2 units. You think it might be harder to rent here and so you estimate occupancy rate of 90%. The property is an old building in a bit of disrepair so you may have higher maintenance costs and would run about $1500 a year. The owner pays water and sewer of $75 a month for $900 annually. Insurance and property taxes run $1800. With 20% down the mortgage payments are $456 a month or $5472 a year. The rental income is $10,800 and total expenses are $9,672 which gives a cash flow of $1,128. With $19,000 down this would result in a return of 5.9%

Calculate the Capitalization Rate

The Capitalization Rate or CAP is the rate that you gain income for the investment. You figure the CAP rate by figuring the net operating income and dividing by the price. So for a general example if the property nets $10,000 a year and it costs $100,000 then the CAP is 10,000/100,000 = 10%. This represents the income return from the property if it is owned outright. CAP rates can be in the 3-10% range typically. The higher the % the better.

Example #1: Your net rent would be $10,830 and if you subtract he expenses then your net operating income is $7,830. The asking price is $110,000 so that would give you = net income / price = 7830 / 110000 = 7.18%
Example #2 : Rent of $10,800 and expenses of $4200 for a net income of $6,600. The price is $95,000. Therefore the CAP would be = net income / price = 6600 / 95000 = 6.94%

Taking the time to evaluate all the costs and expenses of buying a property as well as examining the condition of the unit and the nature of the tenants is certainly worth your time.
we looked at an apartment building that looked like a great deal on the surface. It was being sold for around $150,000 and it was a 6 unit with rental income of over $25,000 a year. On the surface the property looked like it should have a good return. But the more we looked at it the more problems we saw. First the property was in need of repair. This would lead to higher maintenance costs. Second the owner had some difficult tenants which could ultimately cause the need for evictions, losses in rent and repairs, and extra vacancies. Lastly the property was using shared heating and electric so the owner was responsible for paying all the heat and electric utility costs which would be a major expense. I added it up and the expenses amounted to over $20,000 leaving less than $5000 annual income after expenses. That would be a pretty poor return on a cash investment of $150,000 and the property would have caused us a LOT of work as well. If we had jumped into the purchase too soon without getting more data then we might have ended up with a very poor investment. The extra time we took to get more details paid off in saving us from making a bad purchase.

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