Skyler Moore
Investors all across the country have been burnt by purchasing a proforma, rather than an investment property. I personally have seen this happen over and over again in the Denver market for both residential and commercial investment properties. Sure property values have dropped, which has caused real estate owners to become upside down, but often the proforma numbers they were given were set up for failure.
Evaluating real estate is quite simple once you know what you are doing, it just takes some experience. One of the first things that you should verify as a potential buyer is the price point. This can be done in several ways. The main way that the average investor checks this is through websites like Trulia or Zillow.
I hear complaints from prospective investors all the time about how prices seem high when conducting their due diligence and using these websites is usually why. The local MLS is the best site to use for pricing, but if you do not have access to the MLS for a market analysis, I will show you another way to judge value, or you can find a local Realtor to help you with accessing the MLS.
Trulia and Zillow are great tools, but that is about it. Trulia and Zillow typically give a very conservative value. I personally have sold several fix and flip homes for $30,000 to $50,000 over the Truila and Zillow values with plenty of value left that could have been used based on the appraisal (this is after the housing bubble burst). I personally use these websites for facts such as number of bedrooms and bathrooms, garage and value trends.
Even for bedrooms, bathrooms and square footage, I confirm with the county assessor’s website. The county assessor’s website is useful for several things (www.denverorg.gov). It will give you the number of bedrooms, bathrooms, finished square footage, basement size and assessed value. Do not be fooled again by the assessed value number, as it is nearly always much lower than the actual value. The assessor’s page will also show what price the property last sold at, which can be helpful if you know the history of the property.
The www.denverorg.gov site contains a section on how to calculate property taxes. This section breaks down step by step the process used by the county to calculate your actual taxes. The previous year’s tax information is usually available on the site as well, but using the mill levy rate will allow you to accurately set your expectations.
Now that we know the details of the property, as well as the taxes, we need to figure out the insurance and what a realistic rental rate is. Getting an accurate figure for insurance is as simple as picking up the phone and getting 2 or 3 written quotes from local insurance groups. In Denver, residential insurance is fairly cheap and I base my rule of thumb as $50 a month for $100,000 of value (this is my rule of thumb).
Craigslist is a great starting tool for deriving what a realistic rental rate will be. This is often the most inflated number on a proforma that disappoints real estate investors. Location and property details are what I have found to be the most important. Properties located in great areas, near parks, with open yards etc will demand more rent than similar properties with inferior property details.
After spending 15 to 30 minutes on Craigslist you should be able to gauge what a ball park rental amount will be. Then call a few different property management companies to see what they would expect for rent in those areas with similar property characteristics. The management companies will tell you that they need to see the property before judging, but going into the conversation telling them your ballpark range will generally get an answer.
Another tool I use is the Denver Housing Authorities website that list Section 8 rents. My company has used Section 8 renters several times and had a good experience. This article is not about using or not using Section 8 renters, but using their set rental rates to gauge market rent. Section 8 in Denver for example will pay $1,200 a month for a 3 bedroom house, which is nearly mirror the primary market.
Now that we have a realistic rental amount, taxes and insurance. Calculating the mortgage payment is easy, which leaves variable expenses, such as vacancy rate and maintenance. With newer properties, maintenance is generally low. Personally I would budget $500 a year, but this is where experience comes into play and how well you plan on maintaining the property.
If your exit strategy is to sell to the primary market, I would keep up with maintenance, but plan on replacing the carpet and painting the place before placing on the market. As for calculating vacancy rates, I would take into consideration how aggressively you market the property combined with the rental rate. If you are trying to get maximum rent without aggressive marketing, there is a good chance you could have 30 to 90 days vacancy. If you are average or below on your asking rent and market aggressively, usually you can mitigate any vacancy losses to 30 days or less in the Denver market. Typically our properties are rented within 14 days.
Even without using useful tools such as the local MLS, property values can still be backed into. There are three different systems used for evaluating a properties value on appraisals. They are the comparative approach, which is the best for residential and what the MLS is used heavily for. The other two are the cost approach and income producing approach.
The income approach can be used in our case to derive an appropriate value. When evaluating investment property, it is important that the property at least covers it expenses. Since we know what to expect for market rent, we can subtract our fixed expenses such as taxes and insurance and the variable expenses such as maintenance and vacancy. That will leave us an amount left that our mortgage payment will cover.
From here, we can back into what the price would have to be in order to break even. Since we are looking at a property for sale on the market, we know the price and can figure out the mortgage payment to determine if the value is too high. A good rule of thumb that I use to obtain the cash flow level that I am looking for is a price to rent ratio of 1.
The price to rent ratio simply compares the asking price to rent. For example, if a property owner is asking for $120,000, I generally am looking for around $1,200 a month in rent. I know from experience in my market that this will produce a cash flow ranging from $200 to $300 a month after expenses.
This method will hold true in most markets, but it is important to point out that the price to rent ratio is not everything. In more expensive markets such as California, a property may not have ratios as strong as Denver’s, but there may be more upside potential on future values due to supply and demand. An investor in more expensive markets will likely hold negative cash flow properties, which is an investment decision they will have to evaluate.
The process is similar for commercial properties, except it is much more complicated. I would not recommend jumping into a commercial property on your own if you have never purchased one before. The reward on commercial properties can be great, but the risk can also be great. How accurate are rents on the rent roll? Are the rents single, double or triple net? When do the current leases expire? What is the relationship like with the current tenant? The list goes on and on. Once again, evaluating after experience becomes much easier, but spending money upfront your first time will typically pay off to avoid any major mistakes.