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is really what you’d be looking for, since rents are usually quoted on a monthly basis.
What If the Asking Price Is Too High?
Bad luck. The property doesn’t rent for $550 a month. It rents for only $500 a month. So what’s the maximum offer you’d be willing
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to make? Well, reverse the math a little bit and you’ll get your answer.
Multiply the monthly rental value of $500 by 12 ($500 X 12 = $6,000). Then divide that number by your gross minimum rental yield of 11 percent ($6,000 0.11 = $54,545). So $54,545 is the most you
would be willing to pay.
Of course, if you can get the property for $50,000 or $45,000 or less, all the better. But now you have a ballpark number for the maximum price you should pay if at the very least the property is going to cover your PITI and allowances for maintenance and vacancy.
The More You Put Down, the Less Rent You’ll Need to Cover Your Carrying Costs
The magic number we just came up with assumes a down payment of 10 percent. Change that, and you change the gross minimum rental yield you’ll need to cover your carrying costs.
If you put down more—say, 20 percent—the amount of interest you’ll pay on a monthly basis will come down, reducing your overall carrying costs. And your interest bill will come down for two reasons: First, you’re paying interest on a smaller loan. Second, as a rule of thumb, the more you put down, the lower the interest rate the lender will require.
All other costs stay the same, except for the amount of the loan and the interest rate. And if, for example, your effective interest rate comes down by half a percent to 6 percent, you’re now paying a lower interest rate on a smaller loan amount—$80,000 instead of $90,000. As a result, your principal and interest payments will now be $480 a month instead of $570 a month. Taxes and insurance stay the same. So your PITI are now $635 instead of $725.
Your maintenance allowance still works out to $85 a month. So your PITI plus maintenance are now $720 ($635 + $85).
Now, you don’t need a $900 monthly rental value to cover your PITI plus allowances for maintenance and vacancy. You need a monthly rental value of only $800. Here’s why:
Monthly rental value of
Less 10% vacancy allowance of
Equals expected average monthly rent of
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That $720 is exactly equal to your PITI plus maintenance costs of $720.
In other words, putting 20 percent down, you’d cover your carrying costs on this $100,000 property with an $800 monthly rental value, instead of $900. This means you need an annual rental value of only $9,600 ($800 X 12). Divide that annual rental value of $9,600 by the $100,000 price, and you get a minimum gross rental yield of 9.6 percent.
Your yield has gone down from 10.8 percent to 9.6 percent because you’re putting more money down and so you have lower carrying costs.
Now you can use this as your new magic number for any property in your area that you might buy with 20 percent down.
If you see a property for $50,000, for instance, you’ll know it’s a potential deal if it has an annual rental value of at least $4,800 (which works out to $400 a month).
Why $4,800? Because $50,000 X 0.096 = $4,800.
The Problem with No-Money-Down Deals
We’ve just seen how putting more money down reduces your carrying costs—and so it reduces the minimum rent you need to get in order to cover those carrying costs. Consequently, it reduces your gross minimum rental yield.
By the same token, if you were going to buy this property with no money down, you’d be increasing your loan amount to $100,000. The higher loan amount, in itself, makes your carrying costs go up. It’s also likely that you’d pay a higher interest rate by putting zero down than if you were putting 10 percent or 20 percent down. And that means your total carrying costs are going to go up even more.
Now, instead of $800 or $900, you may need $1,000 or more a month to cover your PITI and allowances for maintenance and vacancy. So your minimum gross rental yield might go up to 12 percent or more. It depends on what your ultimate interest rate is.
When I invest with a 20 percent down payment, I like to get 11 percent. But when I invest with Justin Ford, we are happy with a minimum gross rental yield of 10 percent for 20 percent down . . . and
10.5 percent for 10 percent down . . . and about 11.5 percent if we can do a zero-down deal.
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These benchmark numbers help us quickly determine the viability of a property. They don’t tell the whole story. We still have to do the comps. Justin does the homework, figuring out the appreciation potential of the overall neighborhood. He has to thoroughly check out the condition of the building. And he has to be reasonably sure there’s not a much better deal for our money right down the block.
But our benchmark rental numbers are a very important part of the equation. If we’ve got good cash flow, we’ll have a property that gives us a margin of safety and that has the potential to make us money on its own after we buy it.