Decide how much to pay for a property... while sitting at your computer

Today, we'll talk a little bit about investing in Single Family Homes (aka Single Family Residences). I bought my first Single Family Resident (SFR) in Jacksonville, Florida, in 2014.

Why buy a single family home?

While there is lots to talk about, I'll just cover two big factors:

  • The argument against: If your house is vacant, you won't earn any money - the main reason you buy rental properties.
  • The argument for: A 3 bedroom / 2 bath single family home is the most common type of real estate purchase. A multifamily home (a duplex, a triplex, or an apartment building) are largely only purchased by investors. But both investors and retail buyers (someone who is just looking for a place to live) buy SFRs. Therefore, if you buy an SFR, it'll be easier to sell later on and some would say this makes SFRs safer.

How do single family homes earn money?

Today, I'll just focus on rental properties. This is where you buy a property and rent it out.

Rent - Expenses = Profit (also known as Cashflow)

How much do you want to earn?

How much cashflow do you need? How about $5,000 / month? Sound good?

Only one problem - not many pay that much per month in rent.

How about $1,000 / month? That's closer to the average rent paid in the the U.S.

Now comes the tricky part: How much are you going to pay to get that $1,000 / month in rent?

If you could pay $50,000 to get that $1,000 / month in rent, that would be a fantastic return. Why?

$1,000 / month x 12 months = $12,000 Year

$12,000 / $50,000 = 24% Return on Investment (ROI)

What if you had to pay $200,000 to get that $1,000 / month in rent?

$1,000 / month x 12 months = $12,000 Year

$12,000 / $200,000 = 6% Return on Investment (ROI)

Not as good, right? So what you pay for a house is very important.

And what did we forget? Expenses, of course.

If the rent is $1,000, we can't expect all of if it will be profit. There will be expenses to pay: Property management fees (typically 10% of rent), maintenance and repairs (typically 10% of rent), insurance, marketing costs, vacancy loss (when your house is empty and not collecting rent) and capital expenditure (the cost to replacement items like your roof or HVAC when they wear down. And let's not forget taxes.

(Ben Leybovich will be discussing CapEx at our Oct 17 Meetup and what he learned from talking to property managers with over 10,000 units under management). 

So one metric investors use is the 50% Rule, which says that roughly half of your rent will go toward expenses.

So let's do that calculation again using the 50% Rule.

Instead of $1,000 / month, let's use $500 / month.

$500 / month x 12 months = $6,000 Year

$6,000 / $50,000 = 12% Return on Investment (ROI)

Let's put this in action now!

So let's do some quick computer research to find out how much we want to pay for a property.

Go to Zillow. Choose a property. I chose a house at random in Milwaukee.

Milwaukee rental homes
Milwaukee rental homes

Looks like a decent house from the outside.

  • It's a 3/1.
  • It's a bit small - only 948 sq ft. (Typically, where I invested in Jacksonville, the 3/2 started at 1,200 sq ft. My parent's home in Costa Mesa, CA is about 1,800 sq ft. A nice, new 3/2 in Class A neighborhood will be about 2,500 sq ft.)
  • There are a lot of pictures to look at, so that's good to get a better sense.

Let's look at the schools really quick (also available through Zillow).

Know the schools before you buy an investment property.

Know the schools before you buy an investment property.

These are not great ratings which tells us something that the price already let us know - this is not a Class A neighborhood. In a Class A neighborhood, you'll get ratings of 6 or higher. In Irvine, the highest rated school district in the U.S., the schools are usually 8s, 9s, or 10s.

Let's check out the rents comparisons.

  • Go to Craigslist Milwaukee (type it into Google and you'll get a link).
  • Go to Apartments.
  • Type in the zip code: "Milwaukee 53222"
  • (You can refine your search by checking "3 bedrooms / 1+ bathrooms.")
  • Check out the map feature.

Now look at how much people are charging for rent to get a sense of how much you could charge: $995 for a 4 bedroom.

Be sure to know much your rental is worth.

Be sure to know much your rental is worth.

Let's check out list view.

Screen Shot 2015-10-13 at 1.23.59 PM
Screen Shot 2015-10-13 at 1.23.59 PM

The closer the house is and the more similar the house is  (in terms of number of bedrooms, bathrooms, size, etc.), the better you can compare rents.

In addition to Craigslist, here are other rent comparing websites:

From Rentometer

Rent comparison in milwaukee
Rent comparison in milwaukee

So if $951 is average, we'll use $900 to be a bit conservative.

Apply the 50% rule:

$900/ 2 = $450

$450 x 12 months = $5,400

Now here's how you decide how much you want to pay:

Divide $5,400 by the Return on Investment you'd like to get.

Want to get a 10% Return?

Then:

$5,400 / 10% = $54,000

So, if all the above is correct, then the maximum you'd want to spend for this house is: $54,000.

But wait!

It's listed for $101,000?!

That's because the house prices are determined by comps (what other houses are being sold for) and not based on how much an investor might earn.

Also, keep in mind that if you were to finance this house using money from the bank, you'd have to spend a lot less (maybe 20%) to buy the house. And while your overall profit would go down, your % return on investment would go up.

So there you have it!

A quick way to decide how much to spend on a house using sound finance principles.

Keep in mind this was a quick and easy way to get a sense for a neighborhood and should not be used as a determining factor to invest. This is just one way to begin your analysis.

You'll have to get much better at estimating expenses, get to know the neighborhood better, etc. (A savvy investor would also look at exit price and all the other "cashflows" but that's a lesson for another day!)

But now that you have the tools to start, go ahead. Start looking at areas and asking yourself: How much would I pay for that house?