This article originally appeared in Forbes.
Consider this hypothetical real estate opportunity: A property owner approaches you with a house he or she is trying to sell in Cincinnati, Ohio. They tell you to take a look at it and make an offer. Knowing this area of Cincinnati is hot right now and rents are rising, you tell the owner you would be happy to take a look. You expect to make an all-cash offer for the property.
But before you make this offer, you need to crunch the numbers. As the founder of a real estate company that works with investors looking to rent their properties, I’ve seen that the arithmetic of investing is deceptively easy: Rent minus the vacancies, repairs, taxes, insurance, utilities and management equals your profit. Be cautious, but do not get caught in “analysis paralysis.” If investing were risk-free, everyone would do it.
Take a deeper look at this theoretical opportunity in Cincinnati to see how you can learn to “buy the numbers” before you buy a house.
Walk the property.
Once inside the Cincinnati home, you see that the house is in good shape, but it needs $10,000 or so in cosmetic updates. You figure that with these updates you should be able to rent the property for $1,200 a month. You check online to see what similar homes in the neighborhood are renting for, and your research confirms your estimate.
How to do it yourself: For every property in which you’re considering investing, physically walk through it. Unless you have an agent you trust on the ground, do not buy an investment property based on pictures or simply the information you’ve gathered online.
Estimate vacancy and repair costs.
Because of the demand in the Cincinnati area, you forecast a vacancy rate of only 5% of the collected rent. The home has no carpet, just hardwood floors throughout. After your initial rehab, the ongoing maintenance should be minimal. Based on this, you feel comfortable budgeting repair and maintenance costs at 10% of the collected rent.
How to do it yourself: Investors (myself included) almost always underestimate the cost of initial repairs and ongoing maintenance. To save yourself some grief, increase your estimate by 20%. When determining your potential vacancy costs, do your research. Real estate databases can be helpful, but remember that these websites are far from perfect. Use them as another data point when estimating values or collecting market rate rent information.
Estimate ‘other’ costs.
When considering the house in Cincinnati, a quick visit to the county auditor’s website tells you the taxes for the home are $1,800 per year (or $150 per month). Your insurance agent tells you that you should expect to pay $900 a year or so for insurance coverage. Because this is a single-family home, the tenant will be responsible for all utility bills.
How to do it yourself: Don’t overlook the obvious. Check out the auditor’s website that serves your property’s area to confirm property taxes, and make a call to the auditor’s office as well to be safe. Every market is different when it comes to insurance, so ask your insurance professional for a worst-case estimate based on the actual address.
Create a property analysis.
This Cincinnati property would likely make around $8,100 per year. You might have also found that the property is forecasted to appreciate 3% this year, so you decide, based on the strength of the market, an annual operating return of 8% would be acceptable. Based on these facts, you value the property at $101,250.
You anticipate that your total return on investment at this price will be 11% (8% return on investment plus 3% appreciation). There might also be significant income tax savings to be captured, depending on your personal financial situation. You do not wish to pay a premium for the expected appreciation, so the hoped-for 3% annual increase in the value of the property will be a bonus to you. To find the value of the rehabilitated property, divide the $8,100 annual return by the required return on investment (ROI) of 8%, which equals $101,250.
Your property analysis will look something like this:
|Vacancy Reserve 5%||-$60||-$720|
|Repair Reserve 10%||-$120||-$1,440|
|Trash/$18 Per Unit||$0||$0|
|Mowing/Average Over 12 Months||$0||$0|
|Professional Management 10%||-$120||-$1,440|
|Value based on an ROI of 6%||$135,000|
|Value based on an ROI of 8%||$101,250|
|Value based on an ROI of 10%||$81,000|
You now know the maximum you should pay for the property in Cincinnati is $91,250 (the $101,250 value minus the $10,000 you are planning to use for cosmetic updates immediately after purchase). You decide to open negotiations at $80,000. Regardless of where the negotiations end up, you are in a powerful position because you are working with hard facts.
How to do it yourself: When it’s time to make an offer and negotiate a price, determine the maximum price you should pay by deducting the costs of renovations from the value of the property. You can make an informed decision to either move forward with the best deal you can make or wait for the next opportunity to come along.
In the end, remember a few dos and don’ts.
Even the most successful investors get excited about new opportunities. But it’s important to keep your excitement in check by always keeping a few things in mind:
• Stay calm, and collect your data.
• Err on the side of caution.
• Set your boundaries — and stay within them.
• Be intimidated by the process.
• Let the excitement of the opportunity cloud your better judgment.
• Feel forced to respond before you are ready.
In my experience, these tips, tricks, tools and mindsets can help you make logical and financially sound business decisions about your existing or future investments. Math is not everyone’s cup of tea, but it is a language we must learn to converse in to be successful in real estate. “Buying the numbers” is just as important as buying the property itself.