How to Run Numbers for Rental Properties-Back of the Napkin Analysis
Purchasing the right rental properties in the right locations with the right numbers is the best way to achieve Financial independence. However, without getting these factors right, rental properties can be an absolute nightmare.
Finding the right type of rental for an area or for your real estate investing niche can be extremely challenging. If you are planning to invest in a rural area chances are there may be little to no multi-family properties. This will definitely have an impact on your investing niche and what type of properties you can purchase in that area.
Investing in the right location is arguably the most important factor when considering real estate investing. The location will determine the price, rents and expenses. Here, in this article I will show you how to understand the numbers. We aren’t going to use in-depth rental property spreadsheets, instead I am going to share with you how to analyze a rental property using Back-of-the-Napkin (BON) methods.
Why Back- Of- The- Napkin (BON) Analysis?
You are probably asking yourself “Why would anyone want to run numbers for such an important investment on the back o f a napkin? Isn’t that crazy and reckless?”
In reality this is what most seasoned real estate investors do. Successful investors have a large flow of potential deals coming across their desk daily. If they were to deep dive into every property that crossed their desk, they would never have time to actually buy a property. If the BON analysis meets, or almost meet, your criteria then you can spend the extra time to do a deep dive analysis. You will want to make sure you have as much information as possible i.e ask for up to date rent rolls, expenses, and leases. Do not offer on a property unless you have all the numbers you need. The last thing you will want to do is try to renegotiate using information you should have known about prior to writing an offer. You should only renegotiate items that you discovered during the due diligence period, that were not found during the pre-offer stage.
Now that you have an understanding of why the BON analysis method is important lets look at the different ways to quickly analyze a rental property. You can click on the different methods to jump directly to that section.
· 1% rule
· The 50% rule
· Cash on Cash Return (COC)
· Cap Rate
1. Why a few good deals are better than 1 great deal
2. Cash flow or appreciation, what’s more important
The 1% Rule
I have thoroughly explained the 1% rule in greater detail in this article. But to explain it briefly the 1% rule is where the market rents for a property should be 1% of the purchase price. So, a $100,000 property should rent for $1,000 a month ($100,000 *.01), you can also figure out what the purchase price should be by turning the formula around. Instead of $100,000*.01 flip it and take the $1,000 a month in rent and multiply it by 100 ($1,000*100= $100,000). The formula is extremely straightforward and easy to use, making it the perfect candidate for a BON analysis tool.
The 50% Rule
Using the 50% rule is fantastic to quickly run numbers on a deal. However, much like any of the BON analysis tools it is a shortcut and not something to base your entire deal off of.
This analysis tool simply states that 50% of your gross rents will be lost to expenses. This means that your NOI will be 50% of gross rents. This type of analysis can be used in commercial investing as it deals with cap rates.
If the property you are underwriting has gross rents of $100,000, 50% of that is lost to expenses so you are left with $50,000. Let’s say you are buying a $1,000,000 investment property your $50,000 would be $50,000 / $1,000,000 = 5% or a 5 cap. Depending on your market this could be a good deal or a terrible deal. As with any of these analyses you will have to know what is common in your market.
Cash on Cash Return
Cash on Cash Return (COC) is the formula that tells you what your payback percentage is compared to what you have invested. It helps show you what you can expect to make on the money you have invested. To find your COC return you take the yearly net income / your total cash invested. Total cash invested includes your down payment, closing costs and any rehab costs you incur. For example, you buy a property with a $10,000 down payment and you anticipate $5,000 in rehab costs, your total invested amount if $15,000. Let’s say this property cash flows $100 a month, you would take ($100*12) / $15,000 = 8% COC return. Now if you have a very small amount of money in the deal the COC return can look amazing. Let’s say you are house hacking with a $0 down payment loan, your COC return would be infinite as you could bring virtually $0 to the deal.
So, just like every other BON analysis the COC return can be quite useful and easy to figure out, BUT it can be very misleading and should not be used alone to qualify a rental property. COC can be a lot more useful when dealing with larger properties or large down payments. I use COC as well as requiring a specific amount of cash flow, which is dependent on the property type and location.
Cap Rate
Cap rate is often times misused by many people. Cap rates should not be used to value residential properties. This valuation method is used for commercial properties, this includes all commercial buildings and commercial multi-family (5+ units). Cap rates are used to find the rate of return that the property is anticipated to generate. Cap rates are based on the net operating income (NOI) and are calculated by dividing the NOI by the value of the property. Cap rate = NOI/ Total purchase price (or current value). This is then displayed as a percentage and shows the investors potential return on their investment.
Measuring the value of a property using the cap rate is a good quick analysis tool but, again, should not be the only tool you use to value the property. When working with value add properties you can estimate future cap rates (using a proforma) and this will help you estimate future values using future cash flows. There are no clear ranges for a good or bad cap rate, and they largely depend on the context of the property and the market.
1- Why a few good deals are better than 1 great deal
If you have ever played baseball, or been around the sport, then you have probably heard the phrase “base hits win games”. This holds true in real estate investing for many reasons. I know a few investors that were paralyzed from doing deals because their first deal was an absolute “home-run” of a deal. Sounds like it shouldn’t be a problem, right? Your first deal was a wild success, why is that bad?
Having a very successful first deal can make you believe that every deal should hit that high mark of success. It can be quite difficult to find a good deal that hits your criteria, now imagine you 10x your criteria because your first deal was so good that you pursue only deals like that. I know one investor that stopped buying rentals for years because he could not find deals that hit that wildly high criteria. This shows why just a couple base hits can really set you up for success.
Imagine buying 5 rental properties in 2 years that hit your original criteria “base hits” and the cash flow from each of those is $200 a month. You could be making $1,000 a month from passive rental income. Now, imagine you bought one property that was an absolute cash cow and made you $700 a month cash flow. Wow great deal, right? Yes that could be a great deal, but what if now for 2 years you don’t buy another property because you are looking for that second property producing $700 a month. You have essentially struck out and left $300 a month on the table for 2 years, that’s over $7,000 you missed out on.
Now, I am not saying go buy all the properties that make $200 a month and own 100 properties. Everybody has different criteria, return expectations and goals. All I am saying is continually buying good solid deals is better than waiting for one great deal.
Cash flow or Appreciation
The answer is both. It is my belief that cash flow is so much more important because cash flow will pay the bills if anything happens to the market. Whether it be a decrease in the renter pool, home prices, rental prices or jobs adequate cash flow and savings will get you through it. If you have adequate cash flow and accounted correctly for vacancy, cap ex and repairs you should be able to get through anything.
If you only bank on appreciation of your investment property you may lose big. Only taking appreciation into account can be more like gambling than investing. An investment where you are breaking even or losing money on every month, with hopes it will be worth a lot more in the future, can be quite costly. I am mostly speaking on market appreciation and not forced appreciation, these are two very different methods.
If you are planning to add value to your investment property, then you should be taking forced appreciation into account as well as potential future rents. Adding value could be anything from remodeling a kitchen to splitting utilities between units (if multi-family). It is important to consider your after repair value (ARV) when performing updates because you want to ensure you will get your money back either in a refinance, sale or increase in rents. You do not want to over improve the property and end up sinking money into the property that you might not get back.
The perfect combo is to take cash flow and appreciation into account. For me if I am underwriting a property in an area that might not appreciate all that much, then I would require more cash flow to offset that risk. What I would never do is take less cash flow than my minimum because the property is in a high appreciating area. I have seen neighborhoods go from high appreciating class “A” neighborhoods to warzones that nobody wants to buy in. Although this is an anomaly it can happen, and it is why I would never take less cash flow than my set minimum.
Putting it all Together
Congrats! You have made it through the entire BON analysis. This means you now know how to underwrite real estate investment properties quickly and effectively! Now, remember not one of these methods, alone, shows you enough to completely understand if a property is a good investment or not. These analyses are great to check if a property is worth spending more time analyzing or if you should just pass.
If you love spending your time in spreadsheets, don’t worry you will still have plenty of time spent in them. This just helps make sure you are not wasting your time.
Thank you for reading this article and I wish you the best of luck in your real estate investing career!