How Do You Know if a Rental is a Good Investment?

Do not make the mistake that many novice investors make when buying income property and fail to properly analyze the income and expenses.

Your first glance at the property’s performance will often be through an operating statement showing income and expenses created by the broker. However, you should never take this statement at face value, but rather build your own projection of how the property will actually perform if you were to buy it. This step is important, because the net operating income (NOI), which is the income after all expenses, is used to determine the value of the property.

Below is a sample of an operating statement taken from LoopNet – a popular site to search for income properties. The property is a duplex in a major southwestern city.

The gross income line above may be one of the following:

• The actual in-place rents received for the units
• Market rents that the broker or seller thinks one could get if the property’s performance is maximized, or
• A combination of in-place rents for units that are currently rented plus market rents for vacant units.
  

You will need to check with the broker or seller to determine which of the three the gross income number represents. More often than not, it will be one of the latter two.

In the above example, the broker deducts a 10% vacancy rate. Novice investors may find this confusing. How can a duplex be 10% vacant? Wouldn’t it be 0%, 50% or 100% vacant at any given time? Actually the vacancy rate reflects the average annual vacancy an income producing property is expected to experience during its economic lifetime or the holding period of the investment. It is meant to serve as a cushion or a sort of reserve that you would set aside to meet the turnover expenses and lost income when a tenant moves out. This rate is estimated based on the vacancy rate seen among similar property types in the property’s submarket.

Inexperienced or overly optimistic brokers will not even deduct vacancy factor. Therefore, if you see an income statement where no vacancy is deducted, or the vacancy rate seems too low based on what you know about the market, then you deduct your own vacancy estimate. Ask the broker representing you to provide a report on the local apartment market. If the broker has any experience in income properties, he should have access to such reports.

While this property doesn’t have it, sometimes there are other sources of income such as late fees, pet fees, vending, storage etc. Late fees and pet fees can be inconsistent and therefore should not be relied upon. Vending and storage may be more consistent and may be included in the proforma. If a broker does include this income, ask for a schedule of receipts for the prior year or even two years. Otherwise, don’t use it to determine your offer price.

After computing all rental and other income as well as deducting a vacancy loss, you arrive at the effective gross income or EGI.

Next you will need to analyze expenses. In the broker’s analysis, the maintenance, insurance and taxes have been estimated. I would the owner to provide maintenance and insurance bills for the past year or years to get a true estimate of what the costs might be after your purchase the property. However, today, with many bank-owned properties, that might not be possible. In this case, you will have to rely on either the broker’s or your own estimates. However, once you have a property inspection done, you should have a better picture of what maintenance costs might be.

For taxes, look for the current tax bill from the county web site. If you are unable to find the current bill, estimate a 2% to 3% increase from last year’s tax bill. Some counties have set a limit on property tax increases. To be safe, you can add the maximum allowed increase from last year’s bill.

There are two more expenses that I would include in this analysis that the broker did not include: Management and reserves. I recommend adding in a management fee equal to 6% to 8% of EGI for small apartments. You can call different property management companies to get some bids for the property. I’ve seen fees as high as 10% for small residential properties. For larger properties with more units, those fees will go down to 3% to 4%.

There are differing opinions on adding a management fee. Some brokers might argue that you could manage the property yourself. That may be true, but you would still want to be compensated for the time and energy you expend on managing a property. Furthermore, if you are a novice investor, you may find that managing a rental is way over your head. If you end up contracting with a management company, you will be eating into your cash flow because you failed to adjust the price accordingly when you made your purchase.

The other expense you most certainly want to add is a $250 to $300/unit annual reserve. This is the amount you should set aside for major repairs and capital improvements. Even if you don’t feel the need to set this money aside, when you go to sell, the subsequent buyer will likely price his offer assuming a certain amount of reserves.

Once you deduct an annual management fee of 8% of EGI ($1,512) and reserves of $500 or $250/unit from the EGI, then your NOI would be $11,888.

As mentioned previously, the price you offer will be directly related to the NOI, i.e. the bottom line of the operating statement. The price of a property is related to NOI through the capitalization rate or cap rate. The cap rate is the before-debt return that you and the market in general require on a certain property given the risks of owning the property.

In the example case, the broker is implying that the property is worth an approximate 7.77% cap rate, or that the buyer should expect to receive a 7.77% return on the price (before debt payment). That is, if you take the broker’s estimated net operating income of $13,900 and divide it by the asking price of $179,000, you arrive at an approximate 7.77% cap rate.

If 7.77% is truly the market cap rate for such a property, and if that is the before-debt return you would like to achieve in your investment, then you would not pay $179,000, but rather $153,000. That is you would take your new estimate of $11,888 and divide by the given cap rate of 7.77%. In looking at the difference in price, you can see why it’s so important not to ignore expenses such as management and reserves.

Unfortunately, when you are buying or selling properties this small, you often have to compete with unsophisticated buyers who will more often than not fail to properly analyze the property. Because of this, these types of buyers will drive prices up to artificial levels and will outbid more experienced investors. Luckily, there are fewer of those these days and plenty of such properties available on the market. Therefore, if you are venturing into your first investment, tread lightly and be conservative in your NOI and cap rate estimates. You will be rewarded for your due diligence.