Rich Dad Education Blog

However, another strategy is to buy as many properties as you can now and hold them as long-term rental properties, or at least hold them until the market rebounds in a few years. In order to successfully buy and hold rental properties, you must make sure that you buy them at the “right” price, which is a price that allows you to have a decent cash flow from each property. Negative cash flow properties are hard to hold onto for the long-term unless you have very deep pockets! The key is to buy the property at the “right price” to start with. But what is the “right price?”

How often have you seen an ad that says, “Positive Cash Flow Investor Special – Rent income is $1000/mo. – Buy at $800/mo. (PITI) – Call Today.” At first you think, gosh, $200/mo. cash flow … it must be a good deal. But, nothing could be further from the truth. This would be a negative cash flow property! If you want to be successful, you need to be able to determine the maximum you can pay for a rental property to provide you with a true positive cash flow right from the start.

Here is a way to analyze rental properties, from single family homes to large, multi-family apartment complexes, that will help you determine the “right price.”

1. First, determine the amount of monthly rent you will be able to get from the property. This is your gross monthly income. Note: if the property is an existing rental, the gross income is the current rent the property is generating, not the potential income once you do a lot of rehab.

2. Next, determine your net monthly income by subtracting all of the monthly operating expenses and a vacancy factor from the gross monthly income.

3. The vacancy factor you use will be partly determined by the general rental market in your area. Even in a tight rental market (more renters than units to rent), you will still have a vacancy factor. For example, if your rental property were vacant for an average of two-and-a-half weeks per year (time the unit is vacant for cleaning, refurbishing and re-renting in-between tenants), you would have a five percent vacancy factor. Find out from your Power Team real estate agents or landlords’ association what a reasonable vacancy factor is for your area. If the vacancy factor is five percent, for example, the wise landlord will put five percent of the rent into a reserve account each month to pay the mortgage during the time no rent is being received from the unit.

4. Monthly operating expenses should include all expenses associated with owning and operating the property. A typical list of expenses is shown below. This is not a complete list. You need to get a complete list of expenses from the property owner and add to it for projected future repairs. Don’t forget to ask for a copy of the owners’ schedule “E” for the subject property.

• Real Estate Taxes
• Insurance
• Maintenance (perhaps lawn mowing or snow removal, if the tenants are not required to take care of these items).
• Utilities (gas, electricity, water, sewer, garbage) if tenant is not required to pay for any of these items.
• Advertising for new tenants
• Legal and accounting
• Cleaning and refurbishing in between tenants – even if a tenant leaves a unit “clean,” it usually pays to repaint and clean carpets for the new tenant
• Repairs – you may not have repair expenses every month, but the wise landlord will set aside at least five percent of the rents each month, so that when the roof or furnace needs work, there is money to cover these repairs
• Management – even if you plan to manage the unit yourself, set aside at least six to eight percent of the monthly rent for a management fee (find out what the typical management fee is in your area to get an exact number. Pay yourself this fee, if you are managing the unit. If this is figured into your budget, you will be able to hire a manager when your time becomes too valuable to do the management yourself.

5. Next, determine the amount of “positive cash flow” you want to get from the unit. Most landlords want at least a $100 positive cash flow for each unit, right from the start, but you should decide what is reasonable and best for your situation.

6. Once you have the monthly dollar amount for the vacancy factor, all of the monthly operating expenses (including repairs and management), and the amount of monthly cash flow you want to receive from each unit, add these numbers together and subtract them from your gross monthly rent. What is left is your net monthly income that can be spent on the principal and interest for a mortgage payment.

7. You then back-calculate how much you can pay for the rental unit by determining a loan amount with a payment amount no higher than the net allowable monthly payment that you have calculated in Step 6. At this point, you will need to know the terms of the funding (loan interest rate and term) you intend to use to finance the property. Knowing the maximum payment amount from Step 6, the interest rate, and the term of the loan, allows you to calculate the loan amount. This loan amount is the maximum amount you can pay for the property and still get the cash flow you specified in Step 5.

8. If you have to pay a higher price than the amount you calculate in Step 7, you will have less positive cash flow than you want and may even end up with a negative cash flow property. If you can’t negotiate the price to give you a positive cash flow, move on to the next property.

An example calculation is given below. Please note that all of the percentages and dollar figures used are for this example only. You will have to determine the actual operating expenses and vacancy factor for each individual property you analyze. You will also have to determine what interest rate you can get on financing at the time you are buying the property.

EXAMPLE CALCULATION

Gross monthly rental income - $ 1,000/month

Vacancy factor – (5%) - $ 50/month

Monthly operating expenses –

* Maintenance / repairs (10%) - $100/month
* Insurance (5%) - $50/month
* Property taxes (7.5%) - $75/month
* Advertising (1%) - $10/month
* Accounting / legal (1%) $10/month
* Utilities (4%) - $40/month
* Management fee (8%) - $80/month

Total Operating Expenses - $ 365/month

Desired Positive Cash Flow (10%) - $ 100/month

Now add the vacancy factor, the monthly operating expenses, and the desired positive cash flow ($50 + $365 + $100 = $515). Subtract this amount from the monthly rent to get the amount of money left available to make a mortgage payment
($1000 - $515 = $485). Thus, in this example, you have $485 left each month to make a mortgage payment (principal and interest).

If you don’t have a mortgage calculator, you can go to: www.mybuildingwealth.com
and click on “student tools,” then click on the “mortgage calculator” and determine how much money you can borrow that will end up with a mortgage payment of $485/month. The payment will depend on the interest rate, the length of the loan, and the amount of money borrowed. Assuming you can borrow money at 6 percent interest for a 30-year term, a loan of $80,900 results in a payment of $485.04 per month (principal and interest). Thus, you could afford to pay no more than $80,900 for the property in this example and still get your $100/month positive cash flow.

This is a very conservative analysis method that assumes that you are borrowing 100 percent of the money needed to buy the property. But even if you are putting 25 percent down, don’t treat that 25 percent as “free” money. Money, even if it’s your own, has a cost associated with it. Include it in the analysis.

How many properties can you buy if the property pays all of the debt service, pays for all of its operating expense, covers its own vacancy, pays for a management company, and still gives you a positive cash flow? As many as you want!