Buy-and-hold up, wait a minute
Buying and holding good cash flowing properties long term is one of the goals of real estate investing. But do you know how to evaluate a deal to see if it does cash flow?
If you don’t, that’s okay. Because today I’m going to show how we run the numbers on a deal to decide if a house has a good enough cashflow to be a rental.
To determine the cashflow on a property you take the income and subtract all the expenses associated with a property. So the formula is: Cashflow = income — expenses.
If the resulting number is positive, you have a positive cash flow, which means you are making money. If the number is negative, then you have a negative cash flowing property and you are losing money.
Let’s say you have a house that rents for $1,600 a month and you have a mortgage payment of $1,000 a month. It is easy to subtract those two numbers and think the house produces a $600 per month cashflow. But that’s not the case. A rental property has other expenses to consider than just the mortgage payment.
There are things like property taxes, insurance, vacancies, repairs, and management costs that you need to budget and save up for out of each month’s payment. And in order to prepare for those costs, you need to figure out your expense factor.
The way you figure out the expense factor is you take the cost of all the things I just mentioned, consider them on an annual basis and divide that number from the total rent to give you a percentage.
For example: You have a house that has a total annual cost of $6,720 and a total income for the year of $19,200 (this is a rent rate of $1,600 for 12 months). If you divide the expense by the rent, you get 6,720/19,200 = 0.35. Multiple that by 100 to get an expense factor of 35 percent.
Now that you know your expense factor is 35%, you can use it to figure out how much of each rent payment you need to save. So 35% of our $1,600 a month is $560.
And if you will recall, we said our mortgage payment was $1000 a month. So to calculate our cashflow, we need to take the rents and subtract both the mortgage payment and the expense factor:
$1,600 in rents — $1,000 mortgage payment — $560 in expense factor = $40.
We started out thinking this house would make us $600 a month. But as you can see, it only makes $40. So with that knowledge, would you do this deal? I wouldn’t. These days we want to make at least $200 a month to take on a deal.
Last week I talked to you about some out-of-town investors who were in a precarious position. And just to remind you, they had bought a house subject-to and had planned on selling it on a wrap.
Their problem was they had overestimated how much they could get as a monthly payment and were now considering renting the house out as a long-term rental. As we talked, I asked them about what their mortgage payment was. As it turns out, it was $1,100 a month. I estimated the house would rent for $1,800 a month. Using the above expense factor, does this house have a positive cashflow?
Cashflow = $1,800 — $1,100 — 35%= $70.
So, this house would make $70 a month. But there was another factor. They had an additional payment to an investor that equaled $500 a month. This means this house has a negative cashflow of $430 each and every month. In other words, to rent this house out they would be losing money.
This is something I want to harp on. The investor and teacher Jimmy Napier always said, “You don’t buy alligators.” What he meant by that was a house with a negative cashflow is just like an alligator — it will eat you.
This house would eat our out-of-town guys quickly if they didn’t know how to sell this thing on a wrap.
But what I want to emphasize is that because of the recent interest rate hikes, the idea of buying houses subject-to has become attractive. This is because of the vast difference in interest rates from a year ago to today. And if you can gain those lower interest rates from before the hike, you can use them to your advantage.
What I want you to understand is that just because it has a lower interest rate, doesn’t mean it will make a good rental.
Our guys here had an interest rate in the 3’s on that house. But the mortgage was only a year old. That means the house sold for top dollar and the balance on the mortgage was high. And even with a low interest rate, that put the payment too high to get a good positive cashflow.
So don’t get sucked into the idea that the deal is good just because it has a low interest rate. You still need to have positive cashflow to make money. Because the last thing you want to do is to buy-and-hold, only to say “wait a minute, I am losing money.”