The Personal Finance Podcast - How to Run the Numbers on a Rental Property (And the Mistakes You MUST Avoid)

Episode Date: June 30, 2021

60. How to Run the Numbers on a Rental Property (And the Mistakes You MUST Avoid) Got questions? Ask me on Instagram Here. @mastermoneyco This is the fastest way to get a response from me.  Sponsors Thanks to Policygenius for Sponsoring this episode of the podcast! Get your insurance quote at Policygenius.com  Thanks to our sponsor Manscaped (Manscaped.com) for sponsoring this episode of the podcast. Use code PFP20 at checkout for 20% off + Free Shipping! Thanks to Mini Cooper for Sponsoring the show! Check out the all-electric Cooper SE. Reserve yours at MINIUSA.com Want to Support the Show? Follow on Spotify or Follow and Leave a 5-Star Review on Apple Podcasts! Today We Discuss:  How to calculate income  The rules of thumb in real estate  How to calculate the expenses on the property  How to figure out what is a good deal.  My EXACT system.  More Episodes You Will Love:  How much you need to save to retire  Why Understanding Your Savings Rate Will Change Your Life (and Allow You To Retire Early) How to Negotiate Your Salary Like a Pro How to Save Your First $100K Check out all the Stuff I Recommend!  M1 Finance Open a Roth IRA Personal Capital Free Wealth Management + Budget App and Fee analyzer!  CIT BANK (Best Savings Account) Best Personal Finance Books  The Simple Path to Wealth - J L Collins  The Millionaire Next Door - Thomas Stanley I Will Teach You To Be Rich - Ramit Sethi  Rich Dad Poor Dad - Robert Kiyosaki ** Some links may be affiliate links and we earn a small commission at no extra cost to you. We only recommend products we truly believe in.  Check us out on social fam!  Twitter Dollar After Dollar Instagram www.thepersonalfinancepodcast.com www.dollarafterdollar.com Learn more about your ad choices. Visit megaphone.fm/adchoices

On this episode of the personal finance podcast, we're going to talk about how to run your numbers on a rental property. What's up, everybody, and welcome to the personal finance podcast. I'm your host, Andrew, founder of dollar after dollar.com. And today on the personal finance podcast, we're going to talk about how to run the numbers on a rental property. If you have any questions about this episode, hit me up on Instagram at DollarAF and follow us on Spotify, Apple Podcasts, or whatever podcast player you love listening to this podcast

to. And please, if you want to help out the show, leave a five-star rating and review on Apple podcast. Now, as we've talked about in the past, real estate is one of the best ways to start building wealth. It's an absolutely amazing way to build wealth. But the biggest factor in being successful in real estate is understanding how to run your numbers. Because if you go into a property and don't know how to run your numbers and you don't run your numbers correctly, you, my friend, have a problem. Because what you're doing is if you don't run your numbers and you just think, hey, this house has X amount as a mortgage and all the rest of the money on top of that that comes in for rent, that's just all gravy. I can keep that money. That's what a lot of people do when

they're newbie real estate investors. But there's so many other factors. that come into play when you buy a rental property or when you flip a house, that you have to be able to understand how to run the numbers. So today, we're going to be talking about how to run the numbers on a rental property so that you can understand exactly how to do this. And I'm going to take you through step by step exactly how to do it. And this is actually the exact way that I've done every single real estate deal I've done. And I've made thousands of offers on rental properties using this exact system. So before we jump in, there's three things you need to know. And the first thing is, if you want to actually get into

real estate investing, to acquire properties, you have to make a lot of offers. So you have to put a system in place to be able to make a lot of offers. And what that means is you're going to be running your numbers on different properties every single day, because you truly need to offer on 100 properties before you can get one. You know, at the time I'm recording this, we're in a super hot market. There's not a lot of properties out there that makes sense at their current asking price. So you're going to need to be analyzing multiple properties, making offers every single day, and consistently putting this system into place because that's the only way you're going to be able to acquire properties. The second thing you need to know is you make all your money when you buy the property.

What do I mean by that? What that means is the profitability of any deal is actually determined before you even close the property. It's not determined when you start managing it. The purchase price of the asset, the purchase price of the property is that, the single most important factor in the transaction. Because if you can buy the property right, if you can purchase the property at a good price, at the price that it needs to be at, then it's very hard to fail. And that's why you have to run your numbers because every single deal makes sense at some price. It could be a dilapidated building, but that dilapidated building

makes sense at a certain price. Maybe it's $50,000 and you have to fix it from the ground up. But it still can make sense at a certain price. The key to real estate investing is to not overpay. So if you're desperate for your first property, you're desperate to get a hold of that first property. Do not overpay. Because if you overpay, you are going to be behind before you even start. Every single property in the world can make sense at a certain price. Let me give you an example. So a few years back, I bought a duplex, and the duplex I bought was right on the edge between being in a good area and a really bad area. And it was an area that I thought would be developed quicker than it was. So I actually saw purchasing this duplex as an opportunity.

But right when I bought the property and actually got a hold of the property, I realized a bunch of external factors in buying this duplex really did not work in my favor. I had terrible tenants. The tenants that were attracted to that property were tenants that were not fun to deal with. The property had exploding plumbing, meaning all the pipes were completely shot. And I had to go in and spend thousands on new plumbing and piping. and redoing the plumbing inside the house, and it had issues all over the place.

So we were constantly fixing this property. But I ran my numbers properly. So even with all of these issues that were coming up, tenants turning over, I had to evict tenants constantly, had to change the way I actually ran my systems because it was so bad. It was the worst property I ever bought,

and I counted as a mistake. But because I ran my numbers correctly, when we sold that property, we still made $80,000 on that deal. The reason why is because we knew how to run the numbers. And when you run the numbers properly, you can take hold of any situation and make sure you don't lose money.

Now, the only way you can lose money is say the house burns down, you don't have insurance or something like that, but we'll talk about that in a second. But having your numbers run correctly is the safety net in real estate. Because the last thing you want to do is be investing your money in something like real estate,

which takes active work, and then losing money. That's the worst feeling in the world. And then the third thing to understand before we jump into this is rejection is the name of the game when you're making offers. So understand that you're going to get rejected all the time because properties make sense at a certain price. And if you have elevated prices in specific markets, you're going to be offering 20, 30, 40% less than what they're actually asking for.

They're either not going to answer you, they're going to laugh at you. There's a lot of different things that happen. It happens to me all the time, but you still have to offer at that price because what if somebody says yes. and there has been plenty of times that I've thrown out offers that I think are going to get completely rejected and they accept the offer and I am blown away. But it happens all the time. It's about volume. It's a numbers game.

So let's get into how to run the numbers on a rental property. So when analyzing rental properties, there's a bunch of different ways to look at it. And the first way to look at it is you're going to want to figure out what the income of the property is. Now, this is the most simple part for most people to understand. usually people who get into rental property investing only think about this side of the equation and don't think about the next pieces that we'll talk about. So you can have income from a number of different ways. The first one is rental income and that's the standard collection of rent that comes to you every single month. When you collect rent, you're getting rental income. But then

there's also other forms of income that some people don't think about. And this is typically more common in multifamily properties like duplexes, triplexes, quadplexes, quadplexes, is five, six, seven, eight unit apartments, depending on what you can buy, there's other forms of income that may come into play. And that could be things like storage. You can charge people, if you have many storage units on the property, you can charge people for things like that. Or laundry. If you have a localized laundry area, you can charge for that. Or covered parking for things like tenants, RVs and boats. Or even late fees. If you charge tenants late fees so they actually will be incentivized to pay their rent on time, that's another form of income

that can come in. And what you want to do is the first thing you want to do when you're analyzing a property is you want to total up all the income. The reason why you do this first is because I'm going to give you two quick rule of thumbs that you can utilize to say if it doesn't really meet this criteria, I probably don't even want to analyze this deal. The first one is what I call the 2% rule. And the 2% rule is extremely hard to come by these days. But what that means is you're going to take the purchase price, the price that you purchase the property at, you want to get two percent. of that purchase price every single month in rent. So if you bought a property for $100,000, then you want to try to get $2,000 a month. When I'm recording this podcast, the market we're in

is red hot. That is not something that is going to be very common if you can find it at all. It's becoming harder and harder and harder to hit that 2% rule. So what you really want to target is the 1% rule, which is the same math. It means if you buy a property for $100,000, you want to make sure to at least get 1% every single month in rent. So if you buy it for $100,000, you want to get $1,000 a month in rent. And as you can see, that becomes a little more realistic because you're buying a $200,000 property, then you want to try to get $2,000 a month in rent. If it doesn't meet this criteria, the odds are very high that you will not have a property

that makes financial sense. So this is the criteria you want to make sure that you hit right off the bat. You can still analyze the property if you want, but I'm giving you the quick math to do in your head so that you can scan through properties and say, these are the ones that I want to analyze today because you have to be constantly analyzing as we continuously talk about here. So that's the quick math you can utilize with the income to say, hey, here's the added up income. Does it meet this criteria? If it doesn't, throw it out, move on so that you don't spend all your time analyzing constantly.

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that I'm about to give you right now. I'm going to give you all the expenses that I factor in, the percentages I use for some of these things and things like that. But if you want a quick rule of thumb, usually expenses on a property are typically 50 to 60% of the rent. So that's where people get in trouble because they take the price of the mortgage and that's all they factor in. But usually expenses are much more than that.

So let's go through the expenses that I'm. utilize. Number one is taxes. Taxes you have to factor in. Where do you find how much you have to pay in taxes on a property? You can go to your local county's property appraiser website. Just type in your county name and type in property appraiser. And then you just type in the address. You can search it by address and find how much you have to pay in taxes every single year. Then what I do is I divide that by 12 and factor it in monthly. Number two is insurance. Insurance is extremely important to factor in. Some people who have rental properties think you don't need insurance, you absolutely need insurance. You're dealing with tenants who don't care about the property as much as you do.

Let's say, for example, they leave their stove on. They just completely forget and a paper towel catches on fire. Well, I've seen people have their houses catch on fire because of tenants. And if your house burns down and you have no insurance, you're left holding the bill. So you need to ensure that you have insurance. How do you find how much insurance costs? Just call local agents in your area. If you really want to get into rental properties, you're going to want to have insurance agents on your team. One of my best friends is my insurance agents on my property. And so you want to make sure that you do that. Have someone on your team that's an insurance agent so you can get quick quotes right back to you. Number three is water and sewer. You want to

factor in. If you have to pay for the water and sewer, you want to factor that in. A lot of times if I can, I want to make sure that my tenants are paying the water and sewer so they don't jack the price up. But you want to make sure that you factor that in. And this is more needed to be factored in, not in single family houses, but in multifamily, duplex, triplex, quadplex, those types of properties, because if they're not separately metered, which is an expensive process to get, then you're most likely going to have to pay for the water and sewer. And then there's garbage. Make sure you factor in garbage as well. Call the local garbage companies or call your local city to see if they cover the garbage. In electric, same goes for electric. If it's not separately metered, then you're

going to have to figure out how much does this average for electric. Now, if it's a single family house, make the tenant pay it. But if it's not, then you're going to get stuck with that bill and you just need to make sure that you have a good system in place for paying that. Then there's gas. Gas goes the same as the other utilities. And then HOAs. So HOAs sometimes, really, I should say, most of the time can kill a deal because a lot of HOAs are really, really high fees. Now the one thing you want to check on the HOAs is do they have special assessments? Now what a special assessment is, is if say the roof on the building caves in and you're in an apartment complex. Well, a special assessment, they will issue to every single person in that building who owns

a property in that building so that they can fix the roof. So not only is the monthly fees a factor, but also special assessments. Or if you have a single family house, typically you got to make sure that you maintain the property more so than you would in other areas. So just factor in all the cost surrounding HOAs. And for me, I avoid properties as rentals with HOAs because there's just too many external factors that can happen. They can raise the HOA rate. And it's completely out of your control. You get into real estate investing instead of investing in the stock market so you have more control. And the HOA takes that away. Lawn care or snow plowing. You have to factor that in as well to maintain the property. Now, you can ask the tenants to do that and you can put that in your lease.

But if you have multiple units, then you're going to have to take care of the lawn yourself and hire out of company or do it yourself if you're that involved. Now the next four are some that are always miss and they're extremely extremely important. So these ones I want you to pay special attention to because you really have to factor all of these in. So the first one is vacancy. And vacancy is extremely important to factor in. Vacancy is the amount of time it takes you to find another tenant once your tenant leaves, the turnover time. And so what I do is I factor in 8% of the monthly income for vacancy. This ensures that you have a little savings account when you're not collecting rent and income and you could still pay all the bills. Repairs. Now, these are normalized repairs like

someone has a leaky sink or their faucet isn't working or their water heater breaks down and you have to fix it. All the little things factor into repairs. And I factor 8 to 10% of the rental income on repairs as well. And a big one, capital expenditures. Now, capital expenditures, what that is is this can also fall into the repair category, but you've got to double it up. What that is is the big stuff in your property. For example, if you need to replace a roof, which you always will have to,

if you're going to hold these properties for a long time, then that would come out of the capital expenditure account. You need to account for that. Or if you need to replace a water heater or an AC unit or windows or do complete remodels, all of this falls into capital expenditures. Because all this stuff is going to need to happen, especially if you're going to hold these properties

for 20, 30, 40 years, you're going to have to replace stuff. So you need to factor that in with 8 to 10% so that you can make sure that you have the money just sitting there if something happens. That's the beautiful thing about capital expenditures and having this there is if something happens, you don't have to stress at all. The money's just there. The next one is property management.

Now, if you plan on managing the property yourself, you still should factor in property management. Why? Because down the line, life changes, and you may not want to manage these properties anymore. And so factoring in property management up front allows you that flexibility to be able to hire a property manager down the line. So what a property manager's cost? You have to look in your local area because the rates are localized, but typically it's somewhere between 8 to 12%. So call a couple property management companies in your area and factor in that number.

Then your mortgage. If you get a loan on the property, you're going to have a mortgage. You need to factor that expense in. And then any other loans, hard money loans or whatever you utilize, to remodel the property or anything like that also need to be factored into the expenses. Then you're going to take all these expenses and total them up and that is your total monthly expenses. Now, let's get into how to calculate cash flow. Now the next thing we want to understand is cash flow.

And cash flow is the number you obviously want to get as high as possible because that's your profit. That's what you're making each and every month. And cash flow is actually really easy to calculate. your total income, your income that we calculated earlier, minus your total expenses equals your monthly cash flow. So if you bring in $2,000 a month in rent and your expenses are $1,500, then your cash flow is going to be $500 a month. And then if you multiply that number by 12, then you get your yearly cash flow. So for example, if your cash flow is $500 a month, you would just multiply $500 by $12 to get

$6,000 a year in cash flow. That gives you your yearly cash flow or some people also call it your net operating income. And understanding your total cash flow is how you're going to find out if you're going to get a good return on investment. Because that is the number that matters the most. Because the last thing you want to do is go into real estate, buy property when you could just be investing in index funds and get the same return. You don't want even returns here on real estate. Real estate you go into because you know that you can make more money in real estate than you potentially could in the market. So that's why we run these numbers and make sure the numbers are correct because why would you want to invest in real estate when you could just passively

invest in an index fund? That's why we need to make sure that we're going to be making more money every single month than an index fund would make. That's what makes all this work and effort worth it. And there's two other things I want you to do. So we're going to look at cash on cash return on your investment, and then we're going to look at the cap rate as well. So cash on cash return, to put it really simply, is the return on the money that you put into the deal. That's how to put it as simple as possible. So what you're going to ask yourself is, how much did we put into this deal? So you can think through a couple of options. Usually it's your down payment, which typically on a rental property, if you're putting a down payment and going

and getting a loan, you typically have to put down 25%. Some lenders may allow you to put 20% down, but you typically have to put right around 25%. Then you have your closing costs, which usually totals up to about 3%, but it's your loan closing costs, your appraisal, your inspections when you inspect the house prior to purchasing the property. And then there's other costs that you put into the property as well,

like rehab costs. If you have to paint the property or put new floors in or replace windows, maybe replace the appliances or countertops or whatever you do to actually rehab the property, that would go into the amount of money that you put in as well, which is extremely important. And then also any other miscellaneous items that you have to contribute to purchasing that property.

And then you're going to total that up because the amount of money that you put in the property is all those pieces totaled up. And then you're going to take your yearly cash flow and divide it by that total investment number that we just came up with. And that gives you your cash on cash return. So for cash on cash return, anything above 8.5% makes the property worth looking at in my opinion. anything less, you might as well just invest in an index fund. But if it's above 8.5%, then it's worth actually looking at the property because there are different ways that you can make money that factors outside of cash on cash return, things like appreciation, the tax benefits.

So there's unforeseen things that are actually baked into some of these numbers that will actually help you build wealth. That's why real estate is such a wealth accelerator because there's five, six, seven, eight ways that you can truly make a lot of money in real estate. It makes money in so many different ways. and it's so positive in that regard that so many people build a great amount of wealth because of real estate.

And then the cap rate is the next number you want to look at, which is your purchase price divided by your net operating income. And remember, net operating income is just your yearly cash flow. Then what you want to do is just you want to analyze your total return. And analyzing your total return, we can do a whole episode on how to analyze your total return, which we will most likely do here in the future. But to put it simply,

it's just when you're factoring in the value of the price, property and factoring the cash flow and putting both those pieces together. I mean, you could spend an hour analyzing a total return after you make an offer on a property. So this is usually something that you would do either that generates in a spreadsheet automatically, or it is something that you would actually look at and say, hey, what is this property worth? If I buy it at this price where I get a 20% discount, all of a sudden I have 20% equity already in the property in addition to the cash flow coming in every month. And you'll figure out how to run your total return. So stay tuned. Make sure your subscribe so that when that episode comes out, you're notified right away. One big tip is when you

get these total return numbers and when you actually run your numbers, you want to set your minimums for everything because this removes the emotion out of the equation. So for example, for me specifically, I want anything over a 10% cash on cash return and I want $200 to $400 per door. So if it's a duplex, I want at least $4 to $800 in cash flow every single month. If it's a single family, house, I want at least $200 in cash flow every single month. Having these limits will allow you to make quick decisions because what you want to do is you're analyzing properties because if you're really serious about this, you're going to be analyzing a lot of properties is you want indicators to give you quick decisions.

That's why I'm talking about doing the 1% rule, making sure that at least cash flow is 1% of your purchase price every single month. Because if it doesn't, throw it out. Why would you continue to look at a property which most likely just won't fit your criteria? And this is how you run the numbers on rental properties. Because it doesn't have to be overly complicated, but you have to make sure that you account for everything.

Because if you miss something, it's just going to cost you money. And just remember, you make all your money when you purchase real estate. You don't make your money by adding value later on. You make all your money with the purchase price. So one thing I always try to target is try to get the property for 20% less than I think it's actually worth. Now, that's very difficult in certain markets. But if you can do that consistently, you will build tremendous wealth.

If you have any questions about this episode, hit me up on Instagram at Dollar A-F-T-R-Dolar. And follow us on Spotify, Apple Podcasts, or whatever podcast player you love listening to this podcast to. And please, if you want to help out the show, leave a five-star rating and review on Apple Podcast. Thank you guys so much. I appreciate each and every one of you, and we'll see you on the next episode. Thank you guys so much for listening. And if this is your first time listening, consider subscribing so you never miss an episode.

And share this episode with a friend. And don't forget to leave a rating and review on iTunes as well because our goal is to bring as much value to you as possible. And we're trying to spread this message that money can buy freedom. That's what money is there to do is to buy more freedom. So thank you again so much for listening. And I hope you have a great day. Rosen lasagna, medium power, 15 minutes.

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