Earlier today my realtor sent me a link to a house listed on the MLS. After a quick look, I decided to analyze it as I create this blog post for the benefit of my readers. It is a registered duplex with a 2 bedroom main floor unit, and a 2 bedroom second floor unit. The basement has a 3 pc bathroom, a kitchen, and a rec room that can also be rented out, but this is probably where I would stay! Located slightly east of the downtown core, it seems to be a relatively decent neighbourhood. It has an asking price of $181,000. Let’s see if this will make money!
The first step in estimating cashflow is to figure out how much rent the property can bring in. Look at similar properties in the same area and see what they are renting for. You can do this by calling as a potential renter, or just asking. Remember to always be conservative. Similar properties around here average about $750. Since I will be renting out two units for $750, I have a gross monthly income of $1500 to work with. It is often a good idea to include your own unit’s rent in your calculations as well. This ensures that you will be including the cost of repairs and maintenance in your own unit. You will get any excess back in equal amount as cashflow. The small unit I am living in could fetch about $500/month [and it’s paid on time in full every month, I’m a great tenant! :-)]. Accounting for 10% vacancy in the other units [mine will never be vacant] makes the contribution from them $1350. Next is to figure out if the property can bring in income in any other ways. Some people rent out garages, sheds, parking, or storage. Add this to your total. This property has a garage that the current owner has been renting out for $75/month. So the actual gross monthly rental income from this property is $1925.
The next step is to estimate your expenses. This will be your mortgage, property taxes, utilities, maintenance, repairs, advertising (for tenants), insurance, and maybe even a property manager. When calculating your mortgage payment, always calculate it as if you received 100% financing, even if you will be providing a downpayment! Otherwise, you are forcing cashflow. For example, if you break even with a 5% downpayment, you shouldn’t increase your downpayment to 20% and get excited about the higher cashflow. You are essentially buying cashflow by paying more in cash. To get higher returns on your cash, you want to leave as much of your money out of the deal and get as much leverage using other people’s money!
Calculating your mortgage payments will require you to know three things: Loan amount, Amortization Period, and Interest Rate. At this point, you should probably be pre-approved since you’re looking for your rental, so it is easy to estimate. I have been pre approved for a 25 year amortization mortgage at 3.19% interest. The house purchase price is $181,000. The closings costs will be around 1.5% of the purchase price, so $2175. This will be stated in your pre-approval. I am budgeting $5000 for repairs and changes after I buy the house, but I have not had a proper home inspection yet. That means at closing I’ll be responsible for $7715 and my downpayment which is required to be $8000 minimum. All of this adds up to $15,715 cash to get the house’s title in my name. The mortgage payment on $181,000 (remember, 100% financing even if you arn’t!) is $874.32. In reality, the mortgage payments will be lower, but that is because I will be adding my downpayment into the deal, and borrowing less.
Now, there are a lot of other expenses related to owning a rental property that are nigh impossible to predict. Your tenant kicks a hole in the wall? $150. Furnance bites the bullet? $4000. Can’t find a tenant? A month of rent lost. Roof falls apart? $500. You can’t predict these well, but there is a great rule of thumb for estimating these backed by years of experiencing owning rentals. I came across this rule of thumb on the forums of www.biggerpockets.com, so credits to them. It is called the 50% Rule. To estimate all of the other expenses, I like to use the 50% rule since it is backed by professional real estate investors with over 20 years of experience and many rental properties. Keep in mind that this may not be the case for our particular rental: we may do better, and we may do worse. Be diligent in your inspections, maintenance, and tenant screening to avoid surprises! I will be using it since I have no experience, and trust these experienced investors. Perhaps I will change it to suit my needs as I see fit! Using this rule, calculating your Net Operating Income (the money available to pay your mortgage and provide cashflow!) is as simple as dividing your gross income by 2. In this case, our NOI is $1925/2 = $962.50. Success! This can pay our mortgage and leave us with $88.18. Or so it seems…but remember we paid $500 rent! So we’re actually losing $500-$88.18 = $411.82/month. Living here will suck cash out of me. That is still a pretty cheap house compared to what most people would pay, but we are aiming higher. If I could find an apartment nearby for less than that, I could pocket the difference, but I want to live in the house AND make money. What can be done? Well, not much if my estimates are accurate. Perhaps setting the other units up as rooming units and renting rooms out at $400-$450 a piece would work, but probably reduce the tenant quality. My biggest bet would be in reducing repair and maintenance costs. If I could reduce my expenses to 25% through a variety of means such as:
- Taking care of my own unit very well
- Being on top of repairs and maintenance of the other units
- Managing it myself
Then I will be able to cashflow this property. Working with the $1925 number, I would now have a NOI of $1443.75 per month. After paying my mortgage, I would be left with $569.43 which is $69.43 of cashflow after I pay my $500 in rent. It works out: I’m getting paid $69 per month (and will own a house in 25 years) to live here. Pretty sweet deal.
A good goal is to aim for $100 in cashflow per unit per month, so our goal for this triplex was at least $200 (not including mine) per month. This triplex does not meet that goal, so normally I’d move on. However, I have not seen many houses in the market yet and have a good chance to view this one so I will be viewing it tomorrow. Overall, it will increase my net worth.
There are more ways to make money with a rental property than just cashflow. Keep in mind that cash is KING – and buying a rental that does not cash flow (and so relying on other methods) is not recommended. Having said that, I think the other methods are important to discuss.
One way, that is sometimes overlooked, is appreciation. It is often a safe bet to overlook this, as relying on it could get you in trouble. Appreciation can make you money just as easily as depreciation can lose you money. But, for example, if a house is valued at $175,000 and appreciates at 4% per year, you can sell it for $212,000 5 years later. That is an extra $37,000 in your pocket.
Another way that the rental will bring in money is the equity that is built up with every mortgage payment. The mortgage payments slowly build equity which you can take advantage of down the line by refinancing or selling the property. This property will be making monthly payments of 874.32 and over time, more of that will be going to the principal. The first payment builds an equity of $395.16 with $481.16 going to pay the interest on the loan. After the first year, these payments will have accrued over $4500 in equity.
A relevant method for me, but not an option to many investors, are the features of the house itself. Since I plan to occupy it, I get the benefits that the house provides. Does it have a backyard? Great, I can garden to grow more of my own food and save money. Is it closer to work or school? Great, I can ride my bike and save time. Will it get my away from a poisonous environment that drains my energy? Yes! Additionally, since I am planning on moving in with my girlfriend, I get the benefits of economies of scale and us working together towards a common goal.
This house would likely make me money but it is still early in my search and I am looking for a house that will cashflow even more. Perhaps I will even find a nice fourplex in the $200,000 range!
If you are analysing a potential purchase right now, feel free to leave a comment or email me and I will help you as much as I can! It is very likely that we will both help each other 🙂