At the time of this episode airing, we are celebrating Labor Day, September 3rd, 2018. Traditionally, both Memorial Day and Labor Day have marked the beginning and end of summer. But each of these holidays has more meaning than just the coming and going of road trips, water sports, and heat waves.
Labor Day marks a special time in United States history. As a nation that was founded on hard work, first agriculture then the industrial revolution, its people have made the United States one of the most prosperous countries ever. It’s with this same work ethic that many people still have today that drives our economy and society. However, work today looks different than it did during the late 1800’s when Labor Day was first celebrated. Labor Day started out as a revolt against poor, unsafe working conditions as the Industrial Revolution was taking off. It was during this time when there were few to no labor laws and very low standards for work environments. Men, women, and children alike were submitted to long hours with little pay. It was around the 1890’s these problems were recognized and American workers stood up to demand better working conditions.
Today our society still has certain professions that are notorious for long working hours and tough schedules. But the labor strikes in the 1890’s set the stage for much better conditions today.
So why does all of this matter? Well for several reasons. First, as a real estate investor, you are not shy of hard work. Many people start out building their investment business as a side hustle, putting in hours outside of their day job, working nights and weekends. And for this, you hard work and dedication to helping yourself and others is recognized and applauded. Secondly, it’s jobs that make our society function. Jobs indicate production, be that an assembly line worker at an automobile manufacturing plant, an accountant auditing financial statements of a Fortune 500 company, or the bank teller at your local bank managing deposits and withdraws for your bank account. Without jobs, we would just consume and not produce. This is the equivalent to swiping your credit card all the time, but never earning a paycheck to be able to pay for those things. And lastly and most importantly, jobs are what pay you as a real estate investor, rent every month. Without jobs, tenants cannot afford to pay rent, and without rent, your real estate investment will probably not fair well.
So to those of you working, creating jobs for others, and investing so that others can have a better quality of life, congratulations. Keep it up. Our nation needs you.
Well let’s get into the more nuts and bolts of this week’s episode. I wanted to give our guests a break from their work this week, in respect of labor day, so today it’s just you and I. If you’ll recall, last week in Episode 137 with Clayton Morris, we discussed the 7 steps to your first rental property. To recap those seven steps, they were:
7 Steps to Your 1st Rental Property
- Set a goal. Write that goal down and put it where you will see it every day. Reverse engineer your Freedom Number, and determine what it will take to reach that.
- Find a deal. Use wholesalers, turn key providers, real estate agents, or hunt for deals on your own.
- Calculate the Return on Investment (ROI). ROI = (Monthly Rent x 12 months x 0.6) / All in cost of property
- Take action! Analyze deals, make offers, and follow through with consistent action. Don’t get stuck in analysis paralysis.
- Get a property inspection. This will help you protect your downside. You will uncover any potential problems with the property and use that information to determine if you want to purchase the property.
- Find a property manager
- Rinse and repeat!
Today we’re going to focus on analyzing deals and how you can turn this process into a relatively easy one with the help of some rules of thumb and then bringing in a good calculator for further analysis.
Here’s how I personally go about analyzing properties.
I first set some criteria. My end goal for a single family home may be to cash-flow $250/month after the mortgage is paid and then all expenses are paid included vacancy, insurance, maintenance, taxes, utilities, and management (VIMTUM). Knowing this criteria, if a property doesn’t meet it, I don’t have to stress over whether I should make an offer, or what offer to make. I know my minimum cash flow per door I need, and don’t deviate from this
I use some rules of thumb to help me determine which properties are worth analyzing further. One of my favorite metrics to use is the Rent-to-Value Ratio. Some call this the 1% rule. Only 1% doesn’t work in every market. In my lower cost markets I invest in, 1% isn’t that great, and I can usually find deals that produce a little better than that. In San Francisco, you might only be able to find 0.6% RVs. It all depends on your market. But once you figure that number out, you can use it as a filter to analyze the deal further. If you are searching for properties and see a bunch of them that don’t meet this filter criteria, then don’t spend the extra time analyzing the deal.
Once I find a property that meets my initial criteria (usually the 1% RV rule, but sometimes I use others), I’ll analyze the deal further. This is where a good software calculate comes in handy. There are lots of calculators out there for your use on the internet. Most are Microsoft Excel based. Lots of them are free, and others are more sophisticated and cost. Regardless of what you use, make sure you are comfortable with is and it does what you need. For a single family buy and hold analysis, you won’t need anything super fancy. Just something that can calculate you income and expenses, and perhaps calculate the amortization table of your loan and project property values based on appreciation.
Remember a calculator is only as good as the information you put in. So if you’re calculating rents that are 25% higher than the market rents, and not accounting for maintenance, then you likely be disappointed when you buy the deal and the numbers aren’t what you calculated.
When analyzing a deal, I make several analyses revising and refining my numbers each time. To begin, I use the 1% RV rule of thumb. Then if it meets that, I use a calculator and estimate expenses, taxes, insurance, and vacancy rates, based on my knowledge of that particular market. If the numbers are still looking good, I’ll take another pass at refining those expenses. I will look up the how property values are assessed by the county assessor for that particular county. Note – this is a common pitfall for some investors. Most of the time, when you buy a property, the property value is reassessed by the county assessor. So that tax bill that the previous owner was paying will likely not be what you are paying. Lots of times, and especially if the owner has owned the property for a significant amount of time, a property is assessed for much less than the true value. So once that owner sells the property assessed at $50,000 for $120,000, you’ll be liable for a much higher tax bill. Looking at the current tax bill is a lagging, not leading, indicator of the future tax bill. Don’t make this mistake.
Next, I’ll call or email my insurance broker with a request for a quote for property insurance. He’ll need to know a few basic things about to the property, like age, construction type, roof type, etc. With that, I can get a more accurate insurance quote.
When I’m buying 1 to 4 family properties, I always buy a Home Warranty insurance policy. This insurance covers systems like HVAC, appliances, how water heaters, plumbing, and electrical. These home warranty policies have saved my lunch on more than one occasion. They usually cost the same for every single family property, this it’s easy to estimate. From my experience, a home warranty policy costs about $50/month for a single family. Well worth the money in my opinion.
For expenses like maintenance and vacancy, I use rules of thumb. I set aside 5% of the rents for maintenance. For vacancy, I’ll use anywhere from 4-8% of rents, depending on the property type, condition, and market. By setting aside money for maintenance and vacancy every month, you’ll be prepared for those expenses, when they happen. These expenses are sure to happen, so it’s smart to be ready for them.
Now you have all of the data to really analyze the property. Once you plug all of this information into your calculator, you will see what the property will cash flow. Some calculators will tell you your Cash-on-Cash return, show you how much money out of pocket the project will require, and other important metrics.
Next comes the most critical part – financing. As we all know, leveraging debt on a property magnifies your return (or loss!). By borrowing money you are able to control more property and grow your portfolio. By this point, you know the property makes financial sense to you, but what about the bank? How will they look at the property? For the longest time, this is where I would get stuck. This used to cause me a lot of fear due to the unknown. See banks have different metrics they look at. First, they want to know a property’s value so they don’t lend more than it’s worth. That’s understandable. The bank also looks at other metrics like the debt service coverage ratio. This is a metric that shows if the rents, minus the expenses are enough to pay the mortgage to the bank.
For those of you who listened to Episode 127, you remember our guest, John Matheson, from Commercial Loan Success. The CLS software allows you to put in the income and expense numbers you’ve already determined from your financial analysis and in minutes you know if the deal is favorable in the bank’s eyes. I’ve personally started using CLS to vet a few deals I’ve been working on. It’s very intuitive to use, and in just a couple minutes I was prepared to go to the bank armed with a One Sheet on the project with those metrics that banks care about. Not only can you vet a deal for lending, if you own rental property and are looking to sell or refinance, you can establish a realistic selling price, or find out how you look before going to the bank to refinance your property (remember velocity of your money is important!).
Analyzing properties is a numbers game, both literally and figuratively. You have to look at a lot of deals to find the ones that make sense to really crunch the numbers on. Then only a few of those deals that you analyze will be worth making an offer on. Then only a small percentage of those that you make offers on will actually be accepted by the seller and actually close! This is one big funnel, and it’s important to keep that funnel full and flowing, and be able to weed out deals quickly. Systems, processes, and tools all help you do this. Setting your criteria and sticking to it, sorting though deals, and taking action on the ones that meet your criteria is a recipe for actually buying deals.
Every step of this process is critical, from analyzing deals, to making offers, to lining up financing. The first deal you analyze will seem like it takes forever. Then the next one goes quicker, and then the next one goes even quicker. You’ll get a better idea of how to estimated expenses, from taxes to insurance and vacancy. You’ll get a better idea of market rents in your neighborhoods. You’ll pick up a good calculator that you like and find a good financing tool like CLS to help you automate and streamline the process.
But please, I emphasize, please, don’t do all of this and never make an offer. This is a crucial phase, but not one to get stuck in. You must act on all of your hard work, else it’s all in vain. Rely on your numbers, and not the emotion. If the deal looks good according to your numbers and your research, then take action and make that offer. Soon enough you’ll have closed your first deal, and you next one and you next one, each one getting easier than the last.
If you have any questions about how to set your criteria, what tools and resources I use, or anything else, reach out to me. I”d be happy to show you what has and hasn’t worked well for me.
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