Most rental properties that you evaluate are not going to immediately look like great investments.
Does that mean you should just give up?
No way.
It’s up to us as real estate investors to research, negotiate and buy properties only at the right prices. Or, to buy properties that have untapped potential.
Ideally, we can do both.
The other day, we ran the numbers on an example property in Chicago that had caught my eye in.
Through that example, we learned what costs to include in our initial analysis to quickly determine if a property was worth pursuing further.
Today, we’ll look at the next step of the evaluation process.
Specifically, we’ll focus on what we can do when the initial math on a potential property doesn’t look very attractive.
Now, let’s get to it.
Our example property is a small multifamily building in Chicago.
Our example property is a five-unit apartment building listed for $1,800,000 and located directly in my target zone in Chicago.
Remember, this analysis is for educational purposes only. You are responsible for running your own numbers on any potential deal.
Here’s the listing description from my preferred listing site, Redfin:
Fully Gut Renovated 5-unit building, a prime turnkey investment opportunity in the best Logan Square Location Possible. Double Vanities, Fully built out walk in closets, in unit W/D, tankless hot water heaters, thin shaker kitchens and full height quartz backsplashes are just a few of the features that make this building feel more like condo living. Perfectly situated just steps from the Logan Square Farmers’ Market, residents can enjoy an eclectic mix of trendy bars, restaurants, cafes, and shops right at their doorstep. Renovation done with full plans and permits, include a new roof, windows, insulation, drain tile system with sump pump, back deck, and still warrantied appliances!
This property passed my initial screening, so we ran the numbers to see if it would be a good investment.
Here’s what the initial numbers looked like:
Asking Price: $1,800,000
Monthly Rent: $13,840
| Mortgage Payment (Principal and Interest) | $8,982 |
| Taxes | $1,429 |
| Insurance | $400 |
| Utility Bills | $350 |
| Property Upkeep | $200 |
| Preventative Maintenance | $200 |
| Vacancy Rate (5%) | $692 |
| Unexpected Repairs (5%) | $692 |
| Property Improvements (5%) | $692 |
| Total Monthly Cost | $13,637 |
Monthly Cash Flow (Rent – Costs): $203
It took me less than five minutes to do this initial evaluation.
A few notes on the above numbers:
- For the mortgage payment, I estimated a 25% downpayment, which is common for investment property loans, and a 7% interest rate.
- Taxes are a major cost that can make or break any deal. Make sure you are familiar with how taxes are assessed in your market. For example, in Chicago, property taxes are reassessed every three years. That means taxes go up every three years.
- Many property listings will indicate the prior year’s taxes because they are lower. This particular listing has the prior year’s taxes, which I know are soon going to change for the worse. For now, I’ll run the numbers with the current taxes but would definitely account for higher taxes before moving forward with this deal.
- Property insurance is a real wildcard these days. Insurance costs are going up everywhere. You’ll need to talk to a good insurance broker for an accurate estimate. I used my experience in the neighborhood with similar properties to make a reasonable estimate.
The initial math on this property did not look great.
In the end, I concluded that this is a beautiful property in a great location but would not be a good investment for me.
The reason is simple: I invest for cash flow. For me, this property is way too expensive for only a couple hundred dollars of monthly cash flow.
More specifically, I am not interested in shelling out a down payment of $450,000 (not to mention more for closing costs) to earn $2,400/year in cash flow.
At a price point of $1.8 million, I would only be interested if this property had a monthly cash flow of at least $4,000 per month.
For another investor, it’s possible that this would still be a good investment based on appreciation and debt pay-down. For me, that’s a big risk I’m not willing to take with that kind of money.
So, what now?
Is that the end of the analysis?
Cross this property off the list and move on?
Not even close.
This is when the fun starts.
What to do if you don’t like the results of your initial evaluation.
Most of the time that you evaluate properties you won’t love the initial results.
You should expect that to be the case.
Think about it from the seller’s perspective. Ask yourself: why is the seller putting this property on the market?
Obviously, the seller is trying to make a profit. Maybe the seller is a developer or flipper who just completed an expensive rehab. He might even have investors who paid for the project that now expect to be paid back, at a profit.
The seller wouldn’t be doing is job if he didn’t try to find a buyer at a high asking price. He can always lower the price later on.
Also, you can think of it another way.
If a seller owns a wonderful property that is making tons of money every month, how motivated is he to actually sell?
He may list the property at a high price just to see if anyone will bite.
In our example, if the seller was cash flowing $4,000/mo, he’d probably just keep it.
And, if he had that kind of cash flow coming in, he may just list it at an astronomical price because he doesn’t really need to sell it.
Sure, there are exceptions. Some sellers don’t want to be landlords and others might just want to cash out. But, I don’t see very many of these situations.
When these situations do pop up, you need to act fast because other investors will take notice.
The point is these are just a few reasons why you will rarely find great investment properties based on your initial evaluation.
Don’t give up.
Your job is to figure out if a property has untapped potential that would make it a good investment.
Now, let’s return to our example to see what I mean.
Is the property overpriced?
The listing price is only the start of the negotiation.
The listing price may just be too high. In recent years, the listing price has oftentimes been too low, leading to bidding wars because of high demand and limited supply.
Your job is to find a price that works for your cash flow needs. The seller may not accept your price, and that’s OK. You may need to move on.
Let’s explore putting a price on our example property where it would be attractive for me.
Keep in mind that I would want a monthly cash flow of $4,000 to move forward on this property.
With that target in mind, I can return to the online calculator on Redfin to see at what price this property might make sense for me.
Playing around with the calculator, I learned that I would need the price to drop to $1,100,000 to get around $4,000 in monthly cash flow (holding all other costs constant).
That’s about a 40% price reduction.
Do you think the seller would go for that?
Not a chance.
Depending on your market, sellers may be willing to negotiate the price. But, if you come in too low, they won’t take you seriously.
If I were to move forward with this property, I would need to find ways to improve the math besides just the price. Still, I might be able to get it for below the asking price.
For our example, let’s assume the seller would agree to knock 10% off the purchase price.
Here’s what the numbers look like at 10% reduced purchase price.
Offer Price: $1,620,000
| Mortgage Payment (Principal and Interest) | $8,083 |
| Taxes | $1,429 |
| Insurance | $400 |
| Utility Bills | $350 |
| Property Upkeep | $200 |
| Preventative Maintenance | $200 |
| Vacancy Rate (5%) | $692 |
| Unexpected Repairs (5%) | $692 |
| Property Improvements (5%) | $692 |
| Total Monthly Cost | $12,738 |
With monthly rents of $13,840, that means this property is now cash flowing $1,002/mo.
We’re heading in the right direction, but I think we can do better.
Besides negotiating the purchase price, what if we can shop around and improve our mortgage?
Start with the purchase price but see if you can further to reduce the overall cost.
For example, can you shop around for a better mortgage?
Let’s assume you can find a loan with a 6.75% interest rate instead of 7%.
With a 6.75% interest rate, your mortgage payment drops from $8,083 to $7,880.
Now, your cash flow increases to $1,211/mo.
You can start to see how this part of the analysis works.
The point is to reduce the costs of owning this property to improve your cash flow.
What other ways can you reduce the costs?
You should go through this process with each cost associated with the property.
Maybe you can find insurance for less than $400/mo.
Or, maybe you are willing and able to handle more of the maintenance responsibilities yourself.
The idea is that each time you reduce your monthly costs, your cash flow goes up.
If you can reduce the costs enough, a property may start looking appealing to you.
On top of reducing the costs, can you can earn more income from this property?
At the same time you look to reduce the costs, you should look to see if you can earn more income from a property.
In other words, can you earn more rent per month than the current rate?
This is where you’ll need to study the neighborhood to see what similar apartments are renting for. Your broker should be able to help you with this.
In our example, let’s assume that you do your research and determine that the apartments are under-rented.
In fact, you learn that each of the 5 apartments could earn $200 more per month.
Adding that additional $1,000 per month brings our total cash flow to $2,211/mo.
Now, this property is starting to look more enticing.
You might be surprised how many sellers under-rent their properties.
Over the years, my wife and I have been successful in finding properties that have been severely under-rented by the previous owners.
We don’t renovate properties ourselves because we are busy professionals with full-time jobs and a family. We try to find properties that have bee nicely rehabbed but are currently under-rented.
You may be surprised to learn that a property flipper doesn’t always know the local market as well as you. It could be that he is just in a hurry to get a property rented out so he can sell it and move on to the next job.
If you become an expert on market rents in your local area, you can be the one who benefits.
A few years ago, my wife and I purchased a three-flat in our local area. It was about a half-mile from where we lived at the time and was on our regular walking route. We took an interest in the rehab and followed its progression closely.
When the property was completed, I saw the rental listings online. It was a beautiful property in a great location. I was shocked when I saw the units were listed for only $1,700/mo.
This was my local area and I knew these units could easily go for $2,500/mo, if not more.
When the property hit the market a few months later, we pounced and had it under contract the next day.
When the original tenants chose to move out at the end of their leases, we quickly found new tenants happy to pay $3,100/mo.
Sometimes sellers just don’t know what they have.
Don’t fool yourself into thinking a property is a great investment by unrealistically changing the numbers.
After reading this post, you can hopefully start to see how to run the numbers to make a potential property more attractive.
In our example, we tweaked the purchase price, mortgage rate, and rental income to improve the cash flow enough to make this deal potentially attractive.
After going through an analysis like this, you may be ready to make an offer. Just don’t get your hopes up too high.
Sellers won’t always negotiate.
Properties won’t always be under-rented.
Many of your offers will end up getting rejected.
Don’t quit.
There will always be another property out there.
If you can’t get a property with numbers that work for you, it’s time to move on to the next one.
No matter how much you love a property, don’t fool yourself into thinking it’s a great investment if it’s not.
Readers, have you made offers on properties that you knew were undervalued? Did you successfully cash flow on a deal that did not look great on paper at first?
Let us know in the comments below.
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