Many people lost money in real estate in the last few years because they did not follow some fundamentals. Typically, they spent too much for the property or bought it under the wrong terms such as an adjustable rate loan. And, if you acquire a property at the wrong price or terms, its unlikely to get better over time. So, the most important step in real estate investments is the first one, getting the property at the right price and the right terms. Before I talk about determining the offer price for an investment property, I want to mention how most people buy their first rental property which is illustrated below.

The Typical Method

Basically, make and offer at what they think is a good price and hope that they will come out ok after rent plus income tax benefits. This is how I started and I lost a lot of money with this approach.

The problem is that the rent is not under your control, the market determines the rent. If you set the rent even $50/mo. above market value, the unit will likely be vacant for a long time before you find a tenant. This is where most first time investors get burned; over paying for an investment and the rent will not cover all the costs. Some people get so badly burned that they never consider real estate investments again. The problem was not with real estate, the problem was not having a successful process for evaluating a property as an investment.

Work Backwards to Make Money

I started consistently making money when I turned the process around; I based my offer price on the net income the property would likely produce. I call the this the "break even" price. If you get the property for the break even price are you guaranteed to make money? No! But if you pay more than the break even price, you will almost certainly lose money pre tax (post tax you may still be ok as you will see later). So the break even price is as much a sanity check as anything else. Note that depending on the property and other factors, you might choose to buy a property that loses money. The key word is in the last sentence was "choose". As long as you know what you are doing and it fits your financial goals, its fine.

How do you do this when there are so many unknowns? Actually, there are only two unknowns (rent and rehab costs) and they can be relatively accurately estimated. Of the two, rehab cost is not as critical because it is a one time cost and can be accurately estimated during the due diligence period (when you can back out of the deal without losing your earnest money) so the key element is the rent. I will cover how I handle rehab costs later and only focus on rent for the moment.

So, let's walk through the following illustration.

Once you have a good estimate for the rent, you can calculate the management fee which is typically about 10% of the collected rent. (Note: My clients receive a special rate of 7% with my preferred property management company.) In Las Vegas, I use 1% of the purchase price as an estimate of the property taxes (they are usually lower but this is a safe estimate). What you want to do is calculate all the other cost elements based on the estimated rent. Manually, it is a bit of trial and error but it's not too hard. Let's run the numbers based on: estimated rent of $1,000/mo. (or $12,000/yr), interest rate is 5%, 20% down and the HOA fees of $35/mo (or $420/yr).

On the fourth try we got close enough. So, only considering pre tax cash flow, you should not pay more than $170,000 for the property. This is what I call the break even price. What happens if you can not buy the property for $170,000 or less and you are depending on making a pre-tax profit? You walk! This is where investors get into trouble, they don't listen to what the numbers are telling them.

Calculating the break even price manually is a bit time consuming so I wrote a program which does the work for you and embedded it into this webpage just below the following table. Try entering the following numbers from the 5 cases into the calculator and you should get the answers at the bottom of each column.

Using the calculator you can see the impact of even small changes in periodic expenses like HOA fees. This is one reason I tend not to recommend communities that have exceptionally high HOA fees. You might be thinking, "What about condos?" On the surface, condo's do not appear to be as good an investment as a single family which typically has a lower association fee. However, many of the exterior maintenance costs are covered by the condo association so your maintenance costs will typically be less. Also, condos typically cost less than single family homes so you may be able to buy two condos instead of one single family property thus spreading your vacancy risk.

Call me today for your real estate investment needs, you will be glad you did.

Eric Fernwood
702-358-8884
EricFernwood@Gmail.com