4 Key Factors For Deal Analysis
Analyzing a property as a buy-and-hold investor is different than running numbers for a flip project. The primary difference is the expenses you will incur while “holding” the property. Because if Seinfeld taught me anything, anyone can take a reservation but it is the holding that is the most important part!
There are 4 expenses that, without exception, I include in each property analysis. I take these numbers off the top, before calculating cash flow or margin. I assume each expense will be an actual outflow each month. This way, I end up with a cash flow estimate that includes the day-to-day reality of holding investment property and this increases my chances for a profitable property.
Advertising costs: Now don’t worry, you won’t be paying advertising costs each month, but taking an annual assumption and splitting it over 12 months is a great way to normalize your cash flow and get a full picture of the year’s expenses. As you have heard me talk about in my videos (find me on IGTV and YouTube!), I hire professional property management on each of my rentals. These firms are great for advertising and showing the property as well as screening prospective tenants and ensuring a smooth move-in experience. These services are not free and are not part of the monthly management fee. In my experience, a property manager will typically charge you 50% of the 1st month’s rent to cover these services. I build this into my financial analysis by assuming my unit will turn over to a new tenant each year. If you are fortunate enough to have a tenant renew their lease for another year (yoo-hoo!), you will still owe a renewal fee, but at a lower amount (~$150). Don’t worry about this difference; simply assume annual turnover and be ahead of the game if your tenant renews.
Vacancy rate: Now is not the time to be overly optimistic about your property; that is, don’t assume you will have 100% occupancy regardless of the quality of your rental. You will face some amount of vacancy whenever a tenant moves out. This is the time you refresh the unit, take care of repairs and do some improvements. Then you can get it advertised, find a new tenant and wait for them to move in. The vacancy rate you use depends on the neighborhood, the type of property, the quality of the unit, and the rent amount, to name a few. My properties are in high-demand neighborhoods so I use a 5% vacancy rate. However I have used 8 or even 10% rates in some analysis for areas I am less familiar with or units that may take longer to rent. The seller may supply occupancy rates in the listing details, but don’t assume these are accurate. The rent roll from the seller is a better indication of actual occupancy. A quality property manager with strong knowledge of your market should also be able to give you an idea on vacancy assumptions to use if you are stuck.
Maintenance: Things come up (garbage disposals back up, freezers stop working, leaks show up under the sink) when you are holding rental property. Be prepared financially to address these issues when they happen without stressing out about your cash flow. I use 10% of rent as my assumption when performing the financial analysis on properties. Some months your actual maintenance expenses will be higher than this. Other times (and hopefully most of the time!) your monthly maintenance expenses will be lower. Either way, include this monthly expense in your evaluation of the property so you aren’t surprised by a slim or negative margin after the purchase.
Reserves: While maintenance expenses may be actual outflows each month, there are other improvements that occur less often, but cost more. These are things like installing new windows, adding a new fence, repairing a retaining wall, or putting in a new garage door, as a few examples. I use 10% of rents for this line item as well in my financial analysis to ensure the income will be enough to pay for these improvements over time. Continued improvements to your properties not only will help sustain the value of your asset, but they will also help you get higher rent. This isn’t any different than your own home. I’m sure you have seen that one house in your own neighborhood that is run down. Maybe it needs paint, new landscaping, or a new driveway. It’s possible that the owners had enough money to buy the home, but are running short on cash flow to maintain it. Now it looks run down, is losing value, and is bringing down the whole block. Don’t be that owner – budget for reserves.
Next time you are evaluating properties to purchase, look beyond the obvious financing costs and management fees when calculating your anticipated net cash flow and margin. The four expenses outlined above will help you develop a more realistic financial model for the investment and give you a clearer picture of its performance. Remember, you are buying property to make you money; not cost you money. Proper analysis upfront will get you headed in the right direction.