There are two hurdles you need to clear to ensure that you’re buying at the right price. First, you need equity in the home on Day One to ensure a margin of safety and that the property will make money or at least break even each month.
Your total property acquisition costs should be no more than about 80 percent of what the home is worth once it’s repaired. So that means purchase price plus closing costs plus renovation expense should be equal to or less than 80 percent of the home’s market value.
Why is the 80 percent important? First, it gives you instant equity that is powerful in wealth building and safety. Second, 80 percent of the value is usually about what a bank will let you refinance a home for so you can feasibly refinance all of your money out of the deal. Third, this helps — doesn’t guarantee — your rental income will exceed your expenses each month, giving you positive cash flow.
If you have a property financed at 90 percent or more of its value, it’s usually pretty hard to make money each month from the rent. You’ll also run the risk of being overleveraged, which makes it difficult and dangerous to buy more properties.
Make sure you know your expenses. Holding costs such as taxes, insurance, utilities, maintenance, management, vacancy and homeowner association fees typically equal between 35 and 55 percent of your gross rent. Note that doesn’t include your mortgage payment.
Now, does 20 percent equity guarantee you’ll have a positive-cash-flowing property? No, it doesn’t. This is a rule of thumb, a starting point. Depending on the market and prevailing rents, you may be able to get away with 15 percent equity, or you may need 25 percent or more. In most of the Washington area, you’ll probably need much more than 25 percent equity to make a rental house cash flow.
Instant equity alone doesn’t make a home a good deal. What good is equity if you can’t make the payment each month? So after a property meets the equity rule, you need to make sure it will cash flow. The monthly rent on the property needs to be equal to or greater than 1 percent of your total property purchase cost. I actually shoot for about 1.2 to 1.4 percent.
Contract purchase price = $65,000
Total property costs = $80,000
In this scenario, your monthly rent needs to be $800 or more per month to justify that property cost. So, as a very general rule, you need to get $1,000 of monthly rent for every $100,000 of property cost, not market value.
If you know a property will rent for only $1,000 per month, then you know you can pay only about $100,000 for that home. It’s hard to get that in the Washington area.
I did a quick search in Burke, Va. Burke is a good community. It’s not too far out. It’s not too close. It’s not the most expensive or the cheapest community in our area. I would consider it right about middle market for Northern Virginia.
I pulled all the single-family houses that sold last month in Burke that are about 2,000 square feet in taxable living area. It looks like a home in good condition is worth about $625,000. Similar homes rented for about $3,000 per month in the same time frame. That means landlords are getting less than $500 in monthly rent for every $100,000 in home price if they’re buying at current prices.
So if you were able to buy a home in Burke that was rental-ready for 80 percent of its market value, that would be $500,000 in this case.
But if you could rent that home for only $3,000 per month, that deal would not make good sense from a rental-property cash-flow perspective. You’ll either have to leave a lot of money in the deal, or you’ll have to come out of pocket each month to cover expenses. Even if you financed only $400,000 on this deal, assuming a 6 percent interest rate (because it’s an investment property, you’ll pay a higher interest rate) and on a 30-year amortization loan, your monthly principal and interest payment would be about $2,400 per month. Your average monthly operating expenses will probably exceed $1,000 per month for a home such as this. That means you’re coming out of pocket at least $400 per month.
So imagine the wealth-building power if you bought one property per year for the next 10 years using this criteria. Let’s say you have $20,000 to work with and bought a home that’s worth $100,000, but you pay only $80,000. Then at the end of the year, you refinance out your money and then do it again the next year, and you did that for the next 10 years.
With some very safe assumptions about property appreciation and debt pay-down, you could easily have equity of over $500,000 at the end of 10 years. If you let it ride another 10, you could expect your equity to grow to nearly $1.5 million.
Can you find a $100,000 home in the Washington area that rents for $1,000 per month? Probably not. But I just bought six homes in North Carolina for an average cost of about $50,000 each. You don’t have to buy where you live, but there are challenges to buying and holding real estate out of state.
I’ll talk about buying out-of-state rental properties in my next post.
My calculations are highly simplified, but the key point to remember is that real estate rentals provide three powerful wealth-building forces: rental income, asset appreciation and mortgage reduction. They also allow you to leverage debt, but leverage is a double-edged sword. It will compound your gains or your losses, so make sure you invest wisely.
Justin Pierce is a real estate investor and real estate agent who regularly writes about his experiences buying, renovating and selling houses in the Washington area.