Work Backwards to Make Money
Many new investors buy a property based on various popular "rules" and then discover that they cannot rent the property at a sufficient rate to break even let alone have a positive cash flow. In this article we will talk briefly about why such "rules" fail and the approach we use to determine the offer price as well as provide a free tool that you can use on virtually any property to estimate what we call the "break-even price".
The Problem with "Rules"
We frequently hear or read about new investors who bought properties that conformed to various "rules" including the: 1% rule, 2% rule, 20% rule, etc. yet they lose money when they rent the property. Some of the reasons these rules do not work include:
- They primarily concern the purchase price not net income
- What you pay for a property has no connection to what the property will rent for.
- The rules do not take into account costs like insurance, property taxes, management, vacancy, repair, etc.
- These rules imply that there is the option of increasing the rent above market rate if necessary in order to make the property profitable. This one misbelief has lead to financial disaster for many.
You Have Little Control Of the Rent
How much a property will rent for is largely based on two factors:
- The condition of the property
- What similar properties have rented for in the immediate area
If you are considering buying a property and all the similar properties in the area are renting for $1,000/Mo. your property is going to rent for about $1,000/Mo. However, if the property is not market ready, it will rent for less than similar properties. Can you "improve" a property such that it rents for significantly more than similar properties? No. For example, if you installed a $50,000 pool you might get $100 more per month but your costs (to maintain the pool) would increase by more than $100/Mo. Once you accept that rent is almost a constant you are well on the way to being able to determine what we call the break-even price, which is when rent equals recurring expenses. If you offer more than the break-even price you are virtually guaranteed to lose money (pre tax) in the short term.
Working Backwards from the Rent
Our approach is to start with the market rent and then work backwards to a break-even price. Our software then compares the break-even price to the asking price. If the break-even price is not significantly less than the asking price, we remove that property from further consideration.
Before we introduce the Break-Even Price Estimator tool, a little of the philosophy behind the tool.
The basic cost/profit elements in investment real estate are as follows:
- Debt Service (dependent on the purchase price and financing terms)
- Taxes (a percentage of purchase price)
- Management Fee (a percentage of rent)
- Periodic Fees (HOA dues, assessment, etc.)
There are more cost elements but these will suffice for this explanation. These elements can be divided into two categories: elements over which you have limited or no control and elements over which you have total control. (Note,"profit" is another recurring "cost" item but we will leave it out in order to simplify the math and the concept. The actual tool does include profit. )
Note: You have total control over the purchase price because you decide how much to offer. However, it does not mean that the offer will be accepted. Our offers are based on return, not the asking price, and our acceptance ratio is about 1 out of every 5 offers.
If we define break-even price to be the purchase price such that rent exactly equals recurring expenses, we can express this in a formula as shown below.
Rent = Debt Service + Taxes + Insurance + Management + Periodic Fees
Several of the elements are interrelated:
- Debt Service is dependent on purchase price and financing terms (down payment, interest rate, term)
- Taxes can be expressed as a percentage of the purchase price. For example, in Las Vegas a reasonable approximation of annual property taxes is 0.86% x the purchase price. In Austin, a reasonable approximation would be 2% x purchase price.
- Management fee is rent x the management fee rate. For example, the management fee our clients pay is typically 8% of collected rent.
Restating the above equation:
Rent = function(Purchase Price, Financing Terms) + (Purchase Price * Property tax Rate) + Insurance + Management % * Rent + Periodic Fees
The method of solving the above equation for Purchase Price is beyond the scope of this article. Fortunately, you don't need to solve the equation yourself now because we created a free software tool which solves it for you.
The Break-Even Estimator
One step in our property selection analytics is to determine the break-even price for each of the 10,000 to 13,000 available properties and compare this to the asking price. If the break-even price is not significantly less than the asking price, we remove that property from further consideration. Note, just because a property passes the break-even price test does not mean that it becomes a "candidate" investment property. Each property must still pass about 50 more tests and failing any of them eliminates the property from further consideration.
Since the only subjective data required is the estimated rent (plus known constants) this is a very fast way to make an investigate/reject decision. Below is a screenshot of the Break-Even Estimator tool and here is a link to the tool.
To use it, simply enter the data for a property and click Estimate. For example, suppose you are considering a property with the following characteristics.
- Estimated rent: $1200/Mo.
- Monthly fees: $35/Mo.
- Your profit goal is 5% (ROI)
- Your loan terms are: 20% down, 30 year term and 4.5% interest rate
- Real estate taxes are .86%
- Annual landlord insurance is $450/yr.
- The management fee is 8% of collected rent.
If you entered the above information into the Break-Even Estimator and clicked the Estimate button you would see the following:
So, the break-even price for the above property is $203662. Try changing some of the variables and see the effect on the break-even price. Remember that this is only a quick investigate/reject tool. There are more recurring costs than what this simple tool allows. So, for example, if you could acquire the property for $180000, I would investigate further. If you thought you have to pay $200000 for the property, I would reject this property and look for another. Watch the video for more information.
What you pay for a property does not determine what the property will rent for. A fast way to evaluate whether a property has a chance of being profitable is to estimate its market rent and then work backwards to a maximum purchase price. This fundamental approach, together with about 50 more tests which our software performs, is how we are able to consistently find profitable properties for our clients. You too can use the Break-Even Estimator to do a quick investigate/reject test anywhere you are considering investing.
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