When you look at a residential property, how can you tell if it will be a source of recurring income and make a worthwhile investment for you? There are some techniques that can help you do that, but when I was first starting out as a part-time real estate investor—as many of you are today—I sure didn’t know what they were. I can recall many times, as I was pursuing a full-time corporate career and just beginning to invest in real estate, asking myself whether I knew how to identify properties that would become profitable rental houses. Looking back, I think I was rather lucky because I don’t think I really knew what I was doing prior to making those purchases. What I mean is, I don’t know if I was engaging in the proper due diligence that ultimately would tell me whether they were going to be good long-term profitable rentals.
There were several myths to which I fell victim in those early days. To be honest, I don’t even know where I got some of those notions. They probably stemmed from simply not understanding real estate investing as I do now that I am a full-time investor and HomeVestors franchisee in Dallas.
For example, believe it or not, I actually believed that every house makes a good rental house. My thought process was: You find a house, you take out a mortgage to purchase it, and you rent it out. Maybe I thought there were some unwritten laws of rental economics stating that as long as you rent out a house, you are always going to be able to cover the mortgage and expenses, and it will be profitable. But I can now say, from experience, that is not at all true. I didn’t know it at the time, but I do know it now.
Another mistaken belief I had was that if I bought a house with the intent of wholesaling it but then perhaps didn’t end up doing that, then maybe it was not as attractive to other investors to purchase. Or if I were to buy a house with the intent of rehabbing it, and perhaps after the rehab it didn’t sell to a retail buyer, then that must be because it was not as attractive to those retail buyers as I thought it might be.
I believed the myth that in cases like that, there was always a fallback or a Plan C: You could just keep it as a rental. But again, through my own experiences, I have learned that is not true. Just because a house did not sell as a wholesale property, or just because a house didn’t sell as a retail rehab property, does not mean that you can comfortably fall back on it and make it a rental.
I can tell you from real-life experience that many times, the economics simply will not work. You will not be able to generate the rent off that property to cover the expenses you have already incurred or the expenses you are going to incur as you buy and hold it.
Then finally, I believed the myth that as long as the rent was greater than the monthly mortgage, everything was going to be just fine. I can tell you from personal experience once again, that is not true.
The good news is that all of these myths—as well as many others, I am sure—can be debunked through the proper due diligence. What I mean is, not all real estate investment assets are created equal. You have to figure out, prior to purchasing them, which are the good ones and which are the bad ones when it comes to buy-and-hold or rental properties.
I am going to fall back on the old adage,“the numbers don’t lie.” You are probably wondering, “OK, well what does that mean? Which numbers don’t lie? And how do I find those numbers?” That’s exactly where I was when I was a part-time investor.
OK, then, if I have to do the due diligence to determine whether a property is a good rental investment before I buy it, how do I do that? What measures, what calculations, or what analysis do I need in order to give me the confidence that it is going to be a profitable rental property?
Unfortunately, this is where things get even more confusing. You are going to find that there are endless numbers of measures that can offer you some help in determining the future performance of a rental property. No matter what you read, listen to, or who you talk to, you are going to see a barrage of different measures. Some people are going to tell you to calculate return on investment (ROI). Other sources may say that what’s important is cash on cash (COC) return. Some people will mention using the debt service multiplier (DSM), an analytical measure of the future performance of a property. You are going to hear that cash flow (CF) is king; that’s the most important. Some may tell you that all that matters is net income (NI). The list—and the number of acronyms—goes on and on.
Once you do get your head wrapped around all these measures, you will find that if you talk to 10 investors, they are going to list 10 different measures. And if two or three of them list the same measure, those two or three investors probably have a different value for that same measure that they think indicates future success.
So at this point, it becomes even more and more confusing. So let’s try to clear it up a little bit today, at the risk of oversimplification. Let me share with you just some of my observations on a few good measures to look at before you purchase a property in order to determine whether it’s going to be a profitable rental.
Debt Service Multiplier
Let’s look at the first one, and I mentioned it earlier: DSM, or debt service multiplier. The calculation is simple. You want to look at a property and determine if the net income is at least 1.25 times service on the property. Net income is simply your rent, minus your vacancy assumption, minus your maintenance, minus your taxes, minus your insurance. Debt service is simply your principal and interest payment.
All you are trying to do with a debt service multiplier is determine whether or not the monthly net income on a property will be at least 1.25 times the debt service, or monthly payment on that property. If it is, there is a good chance you have a profitable rental property on your hands.
The reason I like debt service multipliers is that when you ask most banks and lenders for a loan to purchase a rental property, they are going to use a DSM, or debt service multiplier. A lot of them are going to ask for a DSM of about 1.25. Some of them may ask for more, some of them may ask for less, but it’s a good measure in pre-diligence on a property so that when your bank goes to look at the deal, you and they are on the same page.
Monthly Cash Flow
Perhaps one of the most simplified measures, or maybe the one that’s most important to you, is monthly cash flow. The calculation is simple. You take your monthly rent, minus your principal, interest, taxes, insurance, vacancy, maintenance, property management fee and HOA fee, and whatever is left is your monthly cash flow.
This is going to vary tremendously among individual markets, but in Dallas, a good rental that has a 15-year mortgage on it, will typically cash flow about $300 a month. Now I caution you, your market may be very different, or your goals or objectives may be very different, but I share with you how it looks here in Dallas so that you can get an idea relative to your own market.
Why do I like cash flow? Well, bottom line, it’s the money that you are going to make in your pocket each month. Knowing your cash flow, and having a good cash flow that meets your objective, is your ultimate goal with that rental property. So if all the other measures confuse you, then do your due diligence and do it very well with respect to your cash flow. If you meet your monthly cash flow off that property after doing your due diligence, then you probably have a good investment property.
The 1 Percent Rule
Let’s look at another measure, which I call the “1 Percent Rule.” This is one that I commonly use to quickly analyze a property’s potential of being good solid buy-and-hold or rental investment property. Here is what the 1 Percent Rule is. (Once again, I caution you, this measure—as with any of these measures—will vary in terms of how different investors interpret, use and value them.) They may not work in your market, depending on your market conditions. In my world here in Dallas, you have to be able to generate at least 1% rent compared to the purchase price of the property.
Here is an example. Let’s say I see a property that I can purchase for $60,000 but it needs $20,000 of work, which ultimately means that is going to require an $80,000 investment to buy it and rehab it to get it rent-ready. The 1 Percent Rule says on that $80,000 property, it has to generate at least $800 a month in rent for it to even have the potential of being a good solid investment. If that $80,000 house can only generate $700 a month in rent, I know right away that I need to move on to the next property. (This assumption is based on a 15-year mortgage.)
My point here is that this is a great way to quickly look at a property on paper to determine if it’s even going to be something you should pursue any further at all. If the rental rate is not at least 1% of the money you are going to have to spend on it, it’s probably not a good property to invest in.
As I have said, there are so many more measures that we could look at and use. And all will have varying interpretations by different investors. The point is, there is no one right answer. It’s going to depend on your objectives and the opportunities you have and your market and whether you buy with cash, or whether you leverage your properties with mortgages.
Don’t Rely On Only One Measure
What I will tell you is, use more than one measure. Find the measures that you like, that you are familiar with, that you are confident with, that you know how to calculate, and that you know how to interpret. Find more than one measure.
I like to use at least three measures. I find that when I do that, if they have all met my objective, I have a high level of confidence that I have a good investment there. If only one of the three meets my objective, it’s a pretty good indicator that perhaps I need to do a little more due diligence on that property.
Pick the measures you like. Pick the measures you can use. Pick the measures you know how to interpret. Go with those, but go with more than one measure just to make sure you are looking at that investment from all possible angles.
In conclusion, just remember, do your own due diligence. You have to model and measure your assets. Don’t assume every house is a good rental.
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