Week 22: Property Valuation & Case Studies Funnel
Week 22 – Property Valuation & Case Studies Funnel
I have put together a number of case studies for your benefit; some are properties in my personal portfolio, some are client managed properties, and some are purely hypothetical.
Repairs and Maintenance
Investors rarely budget enough for repairs and maintenance. I set aside 20% of collected rent. Some may find that excessive, but in my experience, it is the minimum acceptable reserve. Not every property I own costs 20%, but some have cost far more. By applying this percentage across all of my properties, I am usually not surprised and almost never caught short. If I have 50 properties renting for an average of $500 a month that is $25,000 a month in gross income. 20% of that figure is $5,000 or $60,000 over the course of the year to cover labor and materials. If I don’t need all of it any given year, it is additional profit to me that I can use for new properties or upgrades to existing properties. (More on maintenance and repairs coming soon.)
Professional Management
I have used 10% of collected rent for ‘Professional Management’ fees in each of my case studies. As you know, professional management is critical to your profitability as a real estate investor.
Valuing a Property
Generally, a single-family home will rent towards the high side of the local rent range. Side-by-side doubles will earn less, over/under duplexes will rent for even less, and three to four units in a single building will often rent for less still. Single-family homes obviously should cost more to purchase on a per unit basis than a multi-unit building costs.
When considering a purchase, our goal is a rent price that is affordable for a substantial portion of the population. In the downloadable Case Studies Bundle, I put together examples from different price points, different financing options, and very different ROIs, and show you why each property makes sense for an investor.
Case Study #3 – Columbus Avenue
| Single Family Home | |||
| Purchase Price: | $12,000 | ||
| Rehab: | $4,538 | ||
| Total Investment | $16,538 | ||
| Potential Rent | Monthly | Annually | |
| Unit 1 | $565.00 | $6,780.00 | |
| Unit 2 | $0.00 | $0.00 | |
| Total | $565.00 | $6,780.00 | |
| Vacancy Reserve 10% | -$56.50 | -$678.00 | |
| Repair Reserve 20% | -$113.00 | -$1,356.00 | |
| Insurance: | -$50.00 | -$600.00 | |
| Property Taxes: | -$45.00 | -$540.00 | |
| Interest Expense | $0.00 | $0.00 | |
| Water | $0.00 | $0.00 | |
| Trash/$18 Per Unit | $0.00 | $0.00 | |
| Mowing/Average Over 12 Months | $0.00 | $0.00 | |
| Professional Management 10% | -$56.50 | -$678.00 | |
| Total Expenses | -$321.00 | -$3,852.00 | |
| Net Profit | $244.00 | $2,928.00 | |
| Estimated Appreciation: | 0.00% | ||
| Annual Return on Investment: | 17.70% |
This property has averaged a 17%+ ROI every year. My goal is 20% ROI, but I am happy if I average 15% to 17%. I also include examples below 15%, because the rehab cost more than planned. Overall, my portfolio exceeds a 15% return.
When evaluating a potential purchase, you must first analyze potential rental performance. This is called a pro-forma. Market rate rent is fairly easy to determine, just by perusing rental websites. Be sure that you are comparing rental rates in similar blocks and neighborhoods.
The second step is to determine your target ROI. In Springfield, that target may be 15% to 20%, but in an appreciating market, 10% may be great. In a place like Melbourne, Florida, where market values are going up by over 6% a year, anything over 6% is a win. The recent appreciation history and near to medium term potential (one to three years) has to be considered when you set your ROI targets.
In the previous case study, we calculated my ROI based on the forecasted profit and the total invested in the property – that is a hard number, not an estimate. Expected profit is based on past performance. In this case, it’s easy to calculate ROI.
If we have no history for a property, but need to estimate its value, the only hard number we have at this point is our target ROI. However, we can estimate profits based on a market analysis and past experience. If we have a target ROI and a profit estimate, we can calculate the value.
Consider a house in a hot area where rents are rising. The house is in good shape, needing only $10,000 in cosmetic updates. Similar homes in the area rent for $1,200 a month, so that is a reasonable estimate. Demand is high, so you forecast a vacancy rate of only 5%. Ongoing maintenance should be minimal, so you budget repair and maintenance costs at 10% of the collected rent.
| Hot Market Hypothetical Purchase | ||
| Single Family Home | ||
| Potential Rent | Monthly | Annually |
| $1,200.00 | $14,400.00 | |
| Vacancy Reserve 5% | -$60.00 | -$720.00 |
| Repair Reserve 10% | -$120.00 | -$1,440.00 |
| Insurance: | -$75.00 | -$900.00 |
| Property Taxes: | -$150.00 | -$1,800.00 |
| Interest Expense | $0.00 | $0.00 |
| Water | $0.00 | $0.00 |
| Trash/$18 Per Unit | $0.00 | $0.00 |
| Mowing/Average Over 12 Months | $0.00 | $0.00 |
| Professional Management 10% | -$120.00 | -$1,440.00 |
| Total Expenses | -$525.00 | -$6,300.00 |
| Net Profit | $675.00 | $8,100.00 |
| Value based on an ROI of 6% | $135,000.00 | |
| Value based on an ROI of 8% | $101,250.00 | |
| Value based on an ROI of 10% | $81,000.00 | |
| Estimated Appreciation: | 3.00% |
This hypothetical property should make at least $8,100.00 a year and appreciate 3%. Based on the strength of the market, an annual ROI of 8% is acceptable, so you value the property at $101,250. 8% ROI plus 3% appreciation puts your total potential return at 11%, before any income tax savings. (Appreciation is a bonus, but not a part of the calculated ROI.) Here is the math:
$8,100.00 annual return/buy the required ROI of 8% = $101,250.00.
The most you should pay is $91,250 plus the $10,000 budgeted for updates. You open negotiations at $80,000. Regardless of where the negotiations end up, you are in a powerful position because you are working with hard numbers, and you can make an informed decision to move forward with the best deal, or wait for the next opportunity.
The Cost of Financing a Single Family Home
I am going to use a house that I own in Springfield to illustrate the cost and benefits of financing a purchase. Here is the return on investment analysis.
| Case Study #4
Murray Street/As Cash Purchase Single Family Home Purchase Price: $25,000 Rehab: $0 Total Investment $25,000 Potential Rent Monthly Annually Unit 1 $550.00 $6,600.00 Unit 2 $0.00 $0.00 Total $550.00 $6,600.00 Vacancy Reserve 10% -$55.00 -$660.00 Repair Reserve 20% -$110.00 -$1,320.00 Insurance: -$40.00 -$480.00 Property Taxes: -$48.00 -$576.00 Interest Expense $0.00 $0.00 Water $0.00 $0.00 Trash/$18 Per Unit $0.00 $0.00 Mowing/Average Over 12 Months $0.00 $0.00 Professional Management 10% -$55.00 -$660.00 Total Expenses -$308.00 -$3,696.00 Net Profit $242.00 $2,904.00 Estimated Appreciation: 0.00% Annual Return on Investment: 11.62% |
My ability to buy this house via land contract was the main reason I compromised on my 15% default goal. I paid $25,000 and it had a tenant in place at closing. I agreed to a $2,500 down payment and a mortgage of $22,500 at 10% over 10 years. This meant a monthly principle and interest payment of $296.
From a profitability perspective, the interest I pay becomes an expense and negatively impacts my return. As you can see below, my ROI drops from 12.10% to 6.38% with the added interest expense factored in. To simplify this example, I am averaging the total amount of interest I will pay over the ten year period. In reality, the interest peaks during the first year and steadily declines over the remaining term until the last few payments are almost all principle. (Bankrate.com has a great mortgage payment calculator that allows you to print amortization schedules based on whatever parameters you choose.)
Case Study #5
| Murray Street – With Interest Expense | |||
| Single Family Home | |||
| Purchase Price: | $25,000 | ||
| Rehab: | $0 | ||
| Total Investment | $25,000 | ||
| Potential Rent | Monthly | Annually | |
| Unit 1 | $550.00 | $6,600.00 | |
| Unit 2 | $0.00 | $0.00 | |
| Total | $550.00 | $6,600.00 | |
| Vacancy Reserve 10% | -$55.00 | -$660.00 | |
| Repair Reserve 20% | -$110.00 | -$1,320.00 | |
| Insurance: | -$40.00 | -$480.00 | |
| Property Taxes: | -$48.00 | -$576.00 | |
| Interest Expense/Average over 7 Year Term | -$109.00 | -$1,308.00 | ① |
| Water | $0.00 | $0.00 | |
| Trash/$18 Per Unit | $0.00 | $0.00 | |
| Mowing/Average Over 12 Months | $0.00 | $0.00 | |
| Professional Management 10% | -$55.00 | -$660.00 | |
| Total Expenses | -$417.00 | -$5,004.00 | |
| Net Profit | $133.00 | $1,596.00 | |
| Estimated Appreciation: | 0.00% | ||
| Annual Return on Investment: | 6.38% | ||
| ① Total interest over the life of the mortgage is $13,031.35/120 months = $108.59 per month. | |||
Now let’s look at how having a mortgage on this property affects my cash flow. Financing negatively impacts my cash flow because I have to pay the total amortized payment of $296 a month out of my gross income. The interest portion of each payment over the term of the seven year loan is expensed, while the principle portion of each payment is part of my profit.
Case Study #6
| Murray Street/Cash Flow Analysis | ||
| Single Family Home | ||
| Purchase Price: | $24,000 | |
| Rehab: | $0 | |
| Total Investment | $24,000 | |
| Potential Rent | Monthly | Annually |
| Unit 1 | $550.00 | $6,600.00 |
| Unit 2 | $0.00 | $0.00 |
| Total | $550.00 | $6,600.00 |
| Vacancy Reserve 10% | -$55.00 | -$660.00 |
| Repair Reserve 20% | -$110.00 | -$1,320.00 |
| Insurance: | -$40.00 | -$480.00 |
| Property Taxes: | -$48.00 | -$576.00 |
| Total Monthly Mortgage Payment, Principle and Interest | -$296.00 | -$3,552.00 |
| Water | $0.00 | $0.00 |
| Trash/$18 Per Unit | $0.00 | $0.00 |
| Mowing/Average Over 12 Months | $0.00 | $0.00 |
| Professional Management 10% | -$55.00 | -$660.00 |
| Total Expenses | -$604.00 | -$7,248.00 |
| Free Cash Flow Until Mortgage is Paid Off | -$54.00 | -$648.00 |
| Estimated Appreciation: | 0.00% |
As you can see, I am planning to be upside down from a cash flow perspective as much as $648 a year on this property. I am comfortable with this possible worst case outcome, but so far I have had no vacancies and my repair expenses have been minimal. Consequently I am breaking even on this property and have yet to put any additional cash towards it to keep it afloat.
Financing this property made perfect sense for me. I was able to buy a house I did not have the cash for, and at the end of ten years I will own it outright. I structured the deal so that if I do find myself in a negative cash flow position, my exposure is limited. There is also room to raise the rent another $50 to $75 a month after this tenant moves out, and in all likelihood I will pay the mortgage off early. In my opinion this is how an investor should utilize financing.
The Cost of Financing a Side By Side Double
Here is another property that I financed:
Case Study #7
| Center Street/As Cash Purchase | ||
| Side By Side Double | ||
| Purchase Price: | $20,000 | |
| Rehab: | $43,125 | |
| Total Investment | $63,125 | |
| Potential Rent | Monthly | Annually |
| Unit 1 | $550.00 | $6,600.00 |
| Unit 2 | $550.00 | $6,600.00 |
| Total | $1,100.00 | $13,200.00 |
| Vacancy Reserve 10% | -$110.00 | -$1,320.00 |
| Repair Reserve 20% | -$220.00 | -$2,640.00 |
| Insurance: | -$60.00 | -$720.00 |
| Property Taxes: | -$26.00 | -$312.00 |
| Interest Expense: | $0.00 | $0.00 |
| Water | -$35.00 | -$420.00 |
| Trash/$18 Per Unit | -$36.00 | -$432.00 |
| Mowing/Average Over 12 Months | -$35.00 | -$420.00 |
| Professional Management 10% | -$110.00 | -$1,320.00 |
| Total Expenses | -$632.00 | -$7,584.00 |
| Net Profit | $468.00 | $5,616.00 |
| Estimated Appreciation: | 0.00% | |
| Annual Return on Investment: | 8.90% |
This property is comparatively superior to most of the other properties I own. It is also in a neighborhood that has been easy for us to rent in. I initially bought the house for $20,000 on a 7-year land contract and sat on it for almost 3 years before rehabbing it. The house had new vinyl siding, a new roof and all new windows, but it was just bare studs inside. It cost me an additional $43,125 to make it habitable over the course of a year.
I did over-improve this property to some degree, but I did a quality job and I expect it to outperform my portfolio over the long term. By the time I started the project I had opened a line of credit at a local bank secured by a couple of properties I owned free and clear. I used the line of credit to rehab the property. Once it was completed, I financed the property with a $33,800, 15-year mortgage at 5% interest. I used the proceeds to pay down the line of credit.
Here are the numbers including the average monthly interest expense. Like with the Murray Street property, I averaged the total amount of interest I will pay over the 15 year/180 month term of the mortgage. In reality, the interest peaks during the first year and steadily declines over the remaining term until the last few payments are almost all principle.
Case Study #8
| Center Street/With Interest Expense | |||
| Side By Side Double | |||
| Purchase Price: | $20,000 | ||
| Rehab: | $43,125 | ||
| Total Investment | $63,125 | ||
| Potential Rent | Monthly | Annually | |
| Unit 1 | $550.00 | $6,600.00 | |
| Unit 2 | $550.00 | $6,600.00 | |
| Total | $1,100.00 | $13,200.00 | |
| Vacancy Reserve 10% | -$110.00 | -$1,320.00 | |
| Repair Reserve 20% | -$220.00 | -$2,640.00 | |
| Insurance: | -$60.00 | -$720.00 | |
| Property Taxes: | -$26.00 | -$312.00 | |
| Interest Expense/Average over 15 Year Term | -$79.51 | -$954.12 | ① |
| Water | -$35.00 | -$420.00 | |
| Trash/$18 Per Unit | -$36.00 | -$432.00 | |
| Mowing/Average Over 12 Months | -$35.00 | -$420.00 | |
| Professional Management 10% | -$110.00 | -$1,320.00 | |
| Total Expenses | -$711.51 | -$8,538.12 | |
| Net Profit | $388.49 | $4,661.88 | |
| Estimated Appreciation: | 0.00% | ||
| Annual Return on Investment: | 7.39% | ||
| ① Total interest over the life of the mortgage is $14,311.88/180 months = $79.51 per month. | |||
The cash flow analysis for this property shows that worst case, I should have positive cash flow by…?
Case Study #9
| Center Street/Cash Flow Analysis | ||
| Side By Side Double | ||
| Purchase Price: | $20,000 | |
| Rehab: | $43,125 | |
| Total Investment | $63,125 | |
| Potential Rent | Monthly | Annually |
| Unit 1 | $550.00 | $6,600.00 |
| Unit 2 | $550.00 | $6,600.00 |
| Total | $1,100.00 | $13,200.00 |
| Vacancy Reserve 10% | -$110.00 | -$1,320.00 |
| Repair Reserve 20% | -$220.00 | -$2,640.00 |
| Insurance: | -$60.00 | -$720.00 |
| Property Taxes: | -$26.00 | -$312.00 |
| Total Monthly Mortgage Payment, Principle and Interest | -$267.08 | -$3,204.96 |
| Water | -$35.00 | -$420.00 |
| Trash/$18 Per Unit | -$36.00 | -$432.00 |
| Mowing/Average Over 12 Months | -$35.00 | -$420.00 |
| Professional Management 10% | -$110.00 | -$1,320.00 |
| Total Expenses | -$899.08 | -$10,788.96 |
| Free Cash Flow Until Mortgage is Paid Off | $200.92 | $2,411.04 |
| Estimated Appreciation: | 0.00% |
Cash on Cash Return
Another way to evaluate this property is to look at its ‘cash on cash’ return. I have roughly $29,325 of my own money in this deal. The bank started with $33,800. My net profit after interest expense is projected to be $4,661.88 annually (See Case Study #8). Taking the net profit of $4661.88 and dividing it by the $29,325 I have in the deal, equals a cash on cash return of 15.9%. I really like owning this property.
