When evaluating the investment potential of any income property there is one basic criterion that you must apply. That is cost versus income. Simply put, property income must exceed monthly costs by an acceptable amount or the property will not generate a positive cash flow. By definition an income property means a property that produces income. This sounds incredibly basic and simple but it is ignored by the vast majority of new real estate investors. I am speaking here specifically of cash flow, when I use the term income property. In order to be profitable you must purchase income properties at prices that allow you to generate a positive cash flow. One of the biggest problems among newer investors is the inability to accurately gauge cash flow potential. Today's higher selling prices, when combined with taxes and insurance costs have rendered many so-called income properties worthless as investments. Paying too much for a property means you cannot generate an acceptable positive cash flow. Excited but ignorant investors are plunking down big bucks for real estate without checking to make sure the real income will cover the costs. This has led to a drastic increase in the number of foreclosures of investment-grade property. When it comes to income property all you really need to know is what will a property cost you per month versus how much income can you expect from that property each month. My anticipated monthly income should exceed my total monthly costs by at least $200 or more for a property to be a reasonably good deal. Most experienced investors would consider $200 to be the minimum amount of positive cash flow that they would accept. If you cant get a reasonable cash flow - dont buy. Its that simple. It doesn't matter what the seller is asking for an income property. From the standpoint of an investor who is considering buying a particular income property the asking price is irrelevant. Income is the primary issue that drives my offer price. If there's not sufficient income Ive either got to lower my buy price to a reasonable level or just walk away from the deal. The last thing I want to do is pay too much going in. Therefore the sellers asking price is only valid to the extent that the property can generate enough income to justify the price. When you evaluate an income property you need to know how much income you can reasonably expect from this property each month. NOT what the seller tells me, NOT what my friend at the office is telling me, but what I can reasonably expect based on my own research. This is an area where you do not want to take the seller or anyone else's word. To protect yourself you must verify likely income for yourself. This is one of the most common mistakes new investors make. Making assumptions about income without verifying the real numbers can leave you with a negative cash flow and put you in foreclosure. So suffice to say it is critically important that potential income be verified before making any written offer. You do this simply by finding out what other similar size properties in the immediate area are renting for. Once I know what the likely potential income is for a given property then I am ready to determine what I can actually offer for the property by backwards engineering " based on the income. Let's say for example that a particular property rents for $1,000 per month and the seller is asking $139,000 for the property. Is this a deal or not? The simplest way to answer the question is to take a mortgage calculator and run the numbers. Sales Price $139,000
Down payment $13,900 (10% down)
Loan amount $125,100
Interest Rate 7.25%
Term in Months: 360 (30 year note)
Monthly Principal and interest $853.40 The calculation shown here is based on standard investment criteria which are generally 10% down, (or more) required for investment property. An interest rate of 7.25% is reasonable for an investor with better credit. (Your actual rate may vary, this is for example purposes only). I use a 360 month term simply because that is the longest possible time frame and therefore represents lowest possible full payment. So what do we have here? Basically we have a property we can rent for $1,000 per month. And we see from our quick calculation that this property is going to cost us $853.40 per month for principal and interest. We still have not added taxes and insurance. Taxes and insurance should easily amount to $150 or more per month. (Much more in some areas). The Principal, Interest, Taxes And Insurance are your PITI. Our payment (PITI) will be $1003.40 but our income will only be $1000. We are going to lose a minimum of $3 per month. Given that the object of the game is to make money we have to come up with an offer price that will allow us to do that. This is where backwards engineering" comes into play. Going back to my P I T I calculator in the Real Estate Investors Guide To Buying Right, I am going to begin to lower the sales price in increments of $10,000, until I find an amount that will allow me to earn a positive cash flow of $200 or more. I am working backwards starting with the sellers asking price and going down until I find a number that allows me to net at least $200 per month. If I lower the sales price in my calculator from $139,000 to $129,000 my P & I will drop to $785.18. I haven't changed the interest rate or the number of years. I am only changing the selling price. $785.18 added to my $150 per month for taxes and insurance now gives me a total cost of $935.18. Subtracted from our $1,000 a month rent we have now achieved a positive cash flow of $64.82. Still not what we're looking for, but we are headed in the right direction. Next I lower the sales price to $119,000, re-run the calculation and my P & I drops to $716.97. Added to our $150 taxes and insurance we now have a PITI (Principal, Interest, Taxes, Insurance) of $866.97. Potential positive cash flow now stands at $133.03 per month. I still haven't reached my target of $200 positive cash flow per month but again I am headed in the right direction. Next I'll drop the sales price to $109,000. At $109,000 my P & I is now $648.75. Added to my $150 for taxes and insurance, my total PITI will be $798.75 bingo! $1,000 -$798.75 = $201.25 positive cash flow. I have identified the maximum amount that I can pay in order to achieve my benchmark of $200 per month positive cash flow. Let's quickly review The seller is asking $139,000 for a property that will rent for $1,000 per month. If I pay the sellers asking price, I will lose money every month Using my P I T I calculator I have adjusted the asking price downward, recalculating the payment until I reach the point where I have achieved my desired positive cash flow. This is the essence of backwards engineering your offer price. As you can see from this example it is totally irrelevant what the seller is asking. It is only important to know what you can afford to pay in order to keep the payments at a level that will allow you to achieve your cash flow goal. In this particular case I would offer no more than $109,000 for the property. Of course the seller can refuse my offer price and try to hold out for more. But I know that I cannot exceed $109,000 if I want my cash flow to be at least $200 per month. It is not an emotional decision. I could care less about buying a property if it will not make any money. This is an easy way to determine how much you can really offer for income properties. Whether you're talking about single-family houses or multi unit apartment buildings, your cash flow must be higher than your costs or you will not make money.*** |
