The Investment Scientist

Buying an Investment Property

Posted on: November 9, 2011

House

Invest in a house

In December of last year, a real estate agent who is a close friend brought our attention to a townhouse in short sale. The townhouse is in the fastest growing neighborhood inMaryland. It is within walking distance of the town center and a short drive away from an interstate highway.

The seller bought the townhouse for $350k five years ago, and he was now asking only $170k.

I did a quick search on Zillow and found out that similar townhouses in that area are renting for about $1,700 per month. I did another search on the county planning board and found that a new hospital is being planned nearby. Then, I went with my wife to check out the place, and it was in relatively good condition. We decided to buy it on the spot.

Three reasons for my quick decision:

  1. At $1,700 per month, the gross rental income per year for this property could be over $20,000.
  2. The townhouse sits in a convenient location that is close to restaurants, as well as arts and entertainment venues.
  3. My wife loves real estate; she could spend hours on Zillow.com, Trulio.com, and Redfin.com. What better way to use her energy and interest than in real estate investment.

What we did not expect was the hassle dealing with the short seller and the seller’s bank – Bank of America – but that’s another story. After eleven month and multiple tripartite renegotiations, we finally bought the house for $185,000. That’s still a good deal. Let’s run the numbers.

Capitalization (cap) rate

The price of the house is $185,000. After closing costs and a few thousands dollars for repairs and refurnishing, the actual cost of the house is closer to $191,000.

Annual gross rental income is expected to be $20,400. Property tax amounts to about $2,000, home owners’ association fee is about $1,000, and insurance is about $500. Management and repair costs are estimated to be $1,500 – we will likely not incur this amount since my wife will do the management herself and she will make me do the repairs.  These add up to about $5,000 in annual operating expenses. The net operating income (NOI) of the property is:

NOI = $20,400 – 5,000 = $15,400.

The capitalization rate of this investment is:

Cap Rate = $15,400/$191,000 = 8.06%.

My rule of thumb for property investment is that the cap rate has to be larger than 8%. Otherwise, it’s not worth the trouble. The property barely makes it.

Notice I did not include the mortgage in my investment decision. With leverage, even a lousy investment can be made to look like a great one. In this property, I was able to get a super low 3.99% rate mortgage. With that, the actual cash outlay for this property (including closing and initial repairs) is less than $48,000, yet future net positive cashflow is about $8,000 per year.

In conclusion, it’s a good deal made sweeter by the low rate mortgage, but it’s a big investment in time and energy as well. It’s not for everyone. Is it for you?

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4 Responses to "Buying an Investment Property"

Nice breakdown of the calculations. I agree that 8% is a bare minimum Cap Rate for an investment property to make sense – and I think Cap Rate is the best metric to use.

Don’t forget that on your $8k of positive cash flow, you’ll also offset that with depreciation of about 3.5% of the building value each year, so you might only pay taxes on half of your cash flow – another great deal.

I have three rental units in addition to owning an office condo (which is 2/3 rental and 1/3 my financial planning practice location) and can vouch for the fact that rentals are a big investment in time and energy. When there are no problem, it’s like a cash printing machine.

When problems pop up – such as a leaky roof on a three-story house that no one can find or fix so the entire roof needs replacing, a $2500 central air system dying, a tenant dealing drugs out of a unit, a neighbor dealing drugs scaring tenants, or having to evict tenants for non-payment of rent (three different times!!) – it’s a huge hassle. I had a tenant stop paying rent and it took me 4 months to get her evicted – that could eat up your entire cash flow for the year.

It’s still a good money maker, but it’s also a job. I figure that my overall return needs to be near 20% for it to exceed the opportunities available in the stock market with nearly no work involved.

Best of luck – keep us updated on your experience as landlords!

John,

Very good points. We have another rental property, bought for about $160k and is renting for $1300 per month now. Not great, but we have a great tenant who have not given us any trouble in the last 6 years.

For me, the lesson is never buy for the promise of appreciation, only buy if the cashflow makes sense. I have seen many rental property investments go awry. I have seen people who have millions in real property investments and barely have any positive cashflow to show.

Michael

Hi Michael,

I did the same thing as you, finding a deal on a short sale of a condo in 2009. Negotiating and closing took 2 months, not nearly as bad as in your case. My condo ROI is about 9.2%, which makes up for my first rental property (townhouse) lousy ROI of 7.3%. I guess I’m learning. On average, they are paying for themselves. I don’t depend upon them for income right now, but they both have 15 year mortgages, so they’ll be fully paid off by the time I intend to retire.

Jerry,

Good job there.

There are some even “better” deals in DC, but those are in really bad neighborhood. Can you believe? I could get a townhouse there for $50k-ish and still rent for $1500 per month – rent paid for by the government for low-income folks who live there.

Tremendous risk though. If the government runs out of money to subsidize rents, I am not sure I can collect any rents. Actually I am sure I can’t without going in with an armored vehicle and a body guard. All in life is fair: there is no easy good deal.

Michael

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Author

Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC. He is also a regular contributor to Morningstar Advisor and Physicians Practice. To explore a long-term wealth advisory relationship, schedule a discovery meeting (phone call) with him.



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