What Should You Pay For Rental Real Estate?
Through my 20 plus years of experience with investing in real estate, I have learned that purchase price is where you make your money. Now, I realize that sounds so obvious that you may not even think it’s worth mentioning, but I see people overlook this simple statement so often that I’ve decided to write an entire article on just this subject. Real estate can be an emotional purchase for many people. When you fall in love with a particular property for any reason other than the cash it can generate for you, it is likely you will overpay for this asset. Real estate should be valued just like any other asset. Is the price your paying reasonable for the risk you are taking? Typically, this is a matter of simply running the numbers. There are complex real estate valuation tools, and volumes of books on these valuation techniques. I say don’t waste your time reading them. The simple rules work best. Below, in order of importance, are the tools I use to value real estate, and thereby formulate my offering price:
1. Calculate your cash on cash return and be sure you feel this return is sufficient for the property and risk you are taking. This calculation is fairly straightforward to make. Simply take your net cash income after debt service, including principal and interest payment and all expenses on maintaining and running the real estate, and divide this number by the initial cash you put down on the property. This will give you a simple annual return figure. For my taste, if its not at least 10% per year, then you’re paying too much. Many people will tell you to make an IRR calculation, or other sophisticated calculations to determine your real return. I say hogwash. Simple cash on cash return is all you need to do. For example assume you purchase a property for $1,000,000. You put down $250,000 (typically banks will require 25% down). Also assume your net cash income annually is $30,000 (always assume at least a 10% vacancy rate in making this calculation). Therefore, your annual cash on cash return is $30,000/$250,000 = 12%. Please be conservative in your estimates and understand each and every expense associated with managing the property. Always build in an annual 10% of rents reserve for maintenance as well. Conservative calculations will be key in your success. Don’t pay for future expected growth or increased rents. If the occupancy is currently 50%, and rents are low, then these are the figures you need to use.
Why should you pay someone else for your future revenues that you created through your hard work?
2. 1% of purchase price should be your minimum gross monthly rents. Believe me, I have run the numbers many times and if your not getting at least 1% of the purchase price per month in rents, then you are overpaying for the real estate. Purchase price $1,000,000, then minimum gross monthly rents at current occupancy levels needs to be $10,000 per month or you’re over-paying.
3. Don’t be timid or afraid to make a low initial offer, and put your offer in writing. So many people worry about offending the seller. Who cares? Make a low offer, around 10% to 20% less than what you’re willing to pay. Put it in writing so seller knows you’re serious. Don’t put too many contingencies but be prepared to close if accepted. If seller doesn’t respond, you can always make a higher offer or look for another property. There is always another deal, even though you may feel the deal you are working on is the best and greatest deal ever.
4. Remember you make your money on a property when you buy it, not when you sell it. What I mean by this is that you must pay the right price otherwise all the appreciation that you worked so hard for will go to the original seller because you will just sell the property for what you paid, or very little above this.
5. Finally, pay a price that you believe will enable you to have appreciation such that you are doubling the rate of inflation on your cash down payment. For example, if the current inflation rate is 3%, then you should take 6% of your initial down payment and this is how much, at least, the property should be able to appreciate each year.
Don’t be emotional, follow these five simple rules, and I assure you that real estate can be one of the most rewarding investments you will ever make.