I do not see why you divided by 2, unless it is used as a “buffer” to serv as your lowest mean to defend a logical purchase. OK, I see, It lowers the net value, so as, to include the cost of replacing the furnace, expenses etc. RIGHT?

1,000 x 12 = 12,000 divided by 2 = 6,000 div. by 135,000 = (hit percent key) is 4.44%

formula leaving out div. by 2 is:

1,000 x 12 div. by 135,000 (hit percent key) is 8.88%.
This is the “real” accounting.

I see your point, but for me, $400,000 cash in hand and buying for no money are not things I think I’ll achieve anytime soon. I would not choose to do 100% financing because I know people who have gotten into lots of trouble that way.

To maintain my own financial stability and avoid placing my other monetary assets at risk, I need to make sure a deal is affordable first and foremost.

It’s true, there are lots of houses which would never allow you to achieve that spread. And I’d never buy them as rentals. I’d wait for that golden deal to appear, because it’s so very worth it.

I think one thing people do when trying to calculate whether an investment property is a good deal or not is start thinking about financing….this is a mistake…it further complicates analysis of the deal…Just assume you had the cash…Imagine you had $400,000 CASH in hand..What would you do with it? You could invest it in a savings account and earn about 5.05% right now..That’s 20,200 a year income. Now if you invest in real estate it’s riskier so you’d expect a higher return. Using the 1% rule you’d probably net around 9% or 36,000…see the difference? Now if you finance 100% of the property your profit will be the rate of return 9% minus your mortgage rate roughly 7 percent…so 2% of the deal or 8000…not bad for investing NO money!!!

The $500 spread is just my minimum–you need to calculate what will work for your situation and market and use that as your guide. The same goes for your question about pricing–what can you get in rent, can you afford the maintenance costs and mortgage, and how much in repairs will you need to put in? These are all important factors which keep me from being able to give you a pat answer.

As far as time to buy, I believe anytime can be a good time to buy. This is because you don’t need all properties to be below-value, you just need one. That special one you seek can pop up in any market, but will be gone in a flash. Sure, there are better times to buy, like when people are murmuring that the market’s about to crash so sellers get nervous, or I’ve had especial luck in Feb/March after a long, cold Winter, but if you are well-informed, you can get a good deal. With lots of looming mortgage delinquencies, you may pick up a deal that way, either from pre-foreclosure or foreclosure itself.

About the structure–as my next 2 entries in the series will cover, a sound structure is paramount. It’s the foundation of your investment. I’ll also cover more on property mgmt companies, which I personally would avoid like the plague. It’s removing you from a vital part of the ongoing managment of your investment, and at a cost to you. That topic will get an entry of its own, but it does indeed eat away at your spread and profit. You can find your own tenants, probably better, doing a $20 credit and reference check, and I’d never settle for someone else’s word on whether maintenance work or repairs to my property were done properly. If I manage it, I can ensure the work I’m paying for is done to my standards.

Your #1 tool is a home inspector if you’re not experienced in construction. This can help you avoid big mistakes and better understand just what the property will need.

Hope this helps! I will address some of your questions more in depth in future entries since there’s just so much to say….

I appreciate your posts here. As I have just begun considering purchasing rental property for equity/income, I’m still trying to grasp the realities of the situation.

For example, I live in Los Angeles. The properties here now are beginning to come down in price, in part due to the creative financing crisis. Will next year be a better time to buy when presumably the market for buyers will hit a nice low?

Also, as you’re probably aware, you’d be lucky to get a decent condo around here for 400K when considering location and resale benefits. There is some cities on the outskirts of Los Angeles that sell rental properties for just under 400K for four units. Now, my question is this:
Is buying a four unit 400K rental property in good condition (considering it’s at an all time low price) a decent investment?
When you talk about a $500 spread, does it mean that no matter what price you buy the property at, you should be profiting $500? Shouldn’t you be profiting more from a more expensive property, if the renters mark up is just as high in that area?
Does this information differ from state to state?
Would it be a better investment to buy properties in less than desirable areas to begin with as long as the plumbing/foundation/etc is in decent condition?
What are your views on hiring a management company to take care of the properties for you? Do you know what their fee is on average and how to find a company that will do their job well? Does this differ depending on what area your properties are located in? Would it ultimately take away the $500 spread you were mentioning?
What accessors (if any) do you hire to help you analyze the potential property you are considering?

I realize these are basic questions, but I’m still learning and I have to start somewhere.

Thank you for your time and sharing your experience!

Shan

I appreciate your overview of the 1% rule, and I think it could potentially be a helpful high-level measure of long-term profitability, although it doesn’t do much to help assess affordability and profit margins for the begining real estate investor. My assessment above based on one of our properties showed that 1% wouldn’t have cut it for my situation, but I’ll use this rule across my properties and see how things stack up.

Whether it’s 1000/Mo for 100,0000 property OR 10,000/Mo 1,000,000 property it’s a 12% gross rate of return.

You must next assume that at least one month a year the property might NOT be rented out while you’re looking for a tenant. One month…One more percent. Now a gross ROI of 11% a year.

Now you must subtract property taxes from income…Usually about 1 to 2% a year of property value.

Now we’re at 9 to 10% annual ROI.

Now most properties might have some additional cost such as association fees, repairs, etc…This can take the annual ROI down to around 7 or 8%. This is a good fair return.

Anything LESS than this and it’s just not worth it. If you’re only going to get a 5 or 6 percent annual return you might as well just put the money in a savings account or savings bond. Unless you’re hoping to make money on appreciation or just want the tax break.

Here are some recent interesting posts from the MoneyBlogNetwork and beyond: Five Cent Nickel discusses longevity insurance. Blueprint for Financial Prosperity gives details on Wilmington Trust Direct. Consumerism Commentary kicks off a series on renta…

There’s a lot to be said about assessing overall rental property profitability over the long term, and lots of factors to be figured in. I hope to do a future piece devoted to this, but it’s beyond the scope of my current “10 tips” series. My spread is a measure of affordability on a short-term vs. long-term basis, (more cash flows than anything else) based on the goal I mentioned of having the property be able to cover its own expenses each month/year without needing to tap my other capital. If I had more initial money to invest, I might have chosen a bigger down payment or more renovations to increase my long-term profitability. At the most basic level, however, I needed to know that based on a reasonable down payment, I could afford to keep the property and more than cover reasonable maintenance costs over the term based on anticipated rent. This doesn’t speak as much to profit as to just keeping-on-keeping-on, but it’s important for avoiding property neglect and potential foreclosure.

A higher down payment beyond the usual 10% does mean a bigger spread and therefore more potential monthly profit, but most important is that my onetime expense still allows me to cover the ongoing expenses.

Thanks,

Joe

Thanks so much for sharing your experience. My partner and I very much enjoy the tax benefits from our rental properties, and I do think this can make a big difference for certain investors.

For some investors, it might be enough to bank on tax benefits and property value appreciation, breaking even on income and expenses if there’s a nice slush fund elsewhere to tap (they then need less of a spread, much like those without a mortgage would need less of a spread), but my personal goal was to have my rentals cover themselves, since when I bought my first property, I had few funds to spare.

I’m not clear what you’re including as expenses, just tax and mortgage, or other expenses too? One of my aims through the tips is to raise awareness of other expenses, such as repairs. If you’d been less lucky with tenants in the first 2 years, would you have been able to cover repair to damages or a period of vacancy with money generated from the rental or from your own capital?

Banking exclusively on property value unfortunately can work for or against you. Luckily, in your case, it worked for you and you had few damages along the way, the ideal situation. My first-ever tenant was great in year 1 but a nightmare by year 2, so if I’d not had reserves from the income by then, I would have a very sad story to tell now.

It’d be wonderful if we knew with certainty that our property values would always rise, but, like so many investments, nothing’s guaranteed, though you can help by buying at a good price in a market expected to remain strong.

Also, if you bought at the bottom of real estate market, then as long as you end up selling higher, you may be OK as long as your rent covered your costs. And don’t forget that if you have fixed mortgage, but raise the rent, it may be a good deal long term.

Personally, I’ve done well with rent income being about equal my expenses (without tax consideration) until I refinanced and better thereafter but a) I was renting my own condo after I bought a townhouse, and the only alternative for me was to sell with a loss during the 90s b) I was renting out a condo in the most sought-after complex in town with hardly any units available for rent and plenty of people who wanted them c) I got lucky with very good tenants who’ve never missed a payment and kept the place much cleaner than I did when I lived there d) I sold shortly after they left 5 years later with a very nice gain as the prices went up. Thus, my most income was not from renting but from the sale of the property. So I agree that timing is really important.

Having said that – now seems like a really bad time around here, but this area is outrageously expensive even with the current downturn. The one bedroom condos here are selling for $300K nowadays (wish I waited another couple of years before I sold, I sold with a nice gain, but maybe a year or so before the top), and I don’t see how you could get more than $1500 in rent for them. Co-ops are cheaper (about $150K), but many of them have boards and rent restrictions, not to mention high maintenance fees. They are not as nice, so you would have to rent them for less. Not too many rental properties around for sale. Wish bought a little co-op without rent restriction in the 90s … The prices went up so much that even if I just locked them up and paid mantenance I’d still come out ahead. But who knew?

If I was getting $465 a month in rent on the property I just mentioned, I’d be getting just a few bucks more than my mortgage payment, not even enough to cover the sewer and other unavoidable expenses. So I’d be operating at a loss each month, which *would* manage to help me reduce my taxable income come filing time, but that and the potential appreciation of the home would be my only benefits. I want short-term income too, which means more than just covering my own costs .

I’d be interested in reading the arguments behind the 1% idea, but it seems too one-size-fits-all for me. The equation isn’t quite that simple–had I followed this rule, I’d likely be in some serious financial trouble right now. I’m sharing my experiences to hopefully save some readers from getting hurt by overly-simple advice.

I once heard that you shouldn’t should be able to rent it for at least 1% of the purchase price per month, but I have no idea if this is accurate (said another, don’t pay more than 100 times the monthly rental rate)