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On one of my multiunit properties, however, there are no separate water meters. So I pay the water bill. In addition, there is a common-area electric bill (i.e., lighting in the hallway). And I pay a monthly landscaping fee. As a result, I estimated and added these costs to my total monthly costs when I was figuring the minimum monthly rents I would need to cover my expenses on the building.
Work with Legitimate Rental Values
Here’s another example of an inflated rental value on a property from
Recently, I bought a three-bedroom house in an improving neighborhood. The seller was originally asking $105,000. And to justify the price, the real estate agent told me he could rent it out “all day long” for $1,200 a month.
What he meant by that was that he could get that much by stuffing the house with transient tenants, perhaps three to a room.
A house two doors down was rented in just that way. That landlord got the maximum cash she could—all off the books, since local codes don’t permit that density. And because she had so many transient renters,
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she figured there was no reason to do anything but the bare minimum of upkeep on the property. The house was an eyesore.
But I had no intention of being a slum landlord. I get great satisfaction from renting out properties in good condition at fair prices—prices that also give me my rental margin of safety.
After doing research on normal rental values on a month-to-month basis (including checking with Section 8), I figured I could get $850 a month for that house. So I made my offer in line with what I considered to be the realistic rental value of the property. And I ended up buying it for $90,000. At that price, the rents would be enough to cover the hard carrying costs on the property, even though I bought it with no money down (that is, with 100 percent financing).
After cleaning it up, painting it inside and out, and doing some landscaping and minor rehab work, I ended up renting the property for $900 a month. I wound up with one of the nicest homes in the neighbor-hood—and with good tenants who pay on time and take good care of it.
I also now have another property that I can happily show to the bank when I purchase my next property. In the eyes of the bank, this property won’t be a liability with visible carrying costs but invisible income. It will be an asset that pays for itself as it increases in value.
Along with my other properties, this will be further proof to lenders that I am a borrower they should compete for and offer their best terms and rates.
How Much Should You Be Willing to Pay?
As far as hard numbers go, there are two major criteria you want to use in determining how much you’re willing to pay for a property. The first is the comparable sales values of similar properties in the neighborhood. The second is your rent versus your carrying costs.
Your first step is to calculate the gross rental yield that a property offers at different prices. To do that, you simply take the price of the property and divide it by the annual rental value. So, if the asking price is $100,000 and the monthly rent is $800, you’d have a gross rental yield of 9.6 percent—if you paid the full $100,000 asking price.
The $800 monthly rent multiplied by 12 equals an annual rental value of $9,600. Divide that by the asking price of $100,000 and you
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get a yield of 9.6 percent. But, again, that’s the yield you would get if you paid the $100,000 purchase price.
What if you negotiated the price down to $90,000?
At that price, your yield would be 10.7 percent. Why? Because the $9,600 annual rental value divided by the $90,000 purchase price is
Here’s another example:
The owner is asking $100,000 for a two-bedroom house. Based on your research, you estimate the rental value to be $700 a month. So now you . . .
• Multiply $700 by 12 to get a gross annual rental value of $8,400
• Then take that $8,400 and divide it by the asking price of $100,000 to get a yield of 8.4 percent
Again, that would be your yield if you paid the $100,000 asking price. If the owner accepted an offer of $90,000, your yield would be greater. How much greater? Well, the rental value stays the same. It’s $8,400 a year. So you divide $90,000 by $8,400 and you get 9.3 percent. That would be your gross rental yield if the owner accepted your $90,000 offer.
Start with Your Carrying Costs . . . Then You Can Figure Out the Minimum Yield You Need
We’ll suppose you’re putting 10 percent down on this $100,000 property. So you’re borrowing $90,000. And you’re taking a fixed loan at
6.5 percent for 30 years. That means your principal and interest will be about $570 a month.
At a sales price of $100,000, you learn property taxes will be $1,500 a year, or $125 a month. You also get an insurance quote and find out that it will cost you $420 a year to insure the property, or $35 a month.
So your hard costs of principal, interest, taxes, and insurance are $730 a month.