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How to analyze an investment property

Nov 07 2016

                Over the past several years of being in business I’ve met a lot of different people at various stages of their real estate investing careers.  Whenever I would deal with a newer, or uneducated investor (Note:  by uneducated I’m referring to their lack of real estate education, not traditional school education) I noticed that a lot of them do not accurately know how to assess an investment property for cash flow and expenses.  Most sellers feel that if they do not experience the expense on their end that they should not have to account for it such as a property management expense or if they are currently fully occupied they will not factor in an expense for vacancy even though historically the property does experience vacancy.  So, in this blog I’m going to break down the basic areas needed to properly assess a property whether you are a buyer or a seller so that you can help make accurate investment decisions.

                Before we can get into analyzing a property I’m going first go into what areas are needed.  A property has what are called fixed expenses and then it has variable expenses.  Fixed expenses are items that are fixed in cost such as management fees, taxes, insurance and trash.  Then you have variable expenses such as water and sewer cost, common area utilities, landscaping, maintenance, vacancy, turnover cost, reserves for capital improvements (this is like a savings plan) and misc. cost such as evicting a tenant or running an ad for a vacant apartment etc.  All these expenses are called operating cost which are separate in and of itself from debt servicing, which is also the known as loan or mortgage payments.   I’m going to go into each type of expense and how to account for it so that you can make a property analysis.  For the example of this blog I’m going to use a $100,000 property that is a three-unit building that has a gross rent of $1,500 per month, or in this case $500 per month per apartment so that you can see how I calculate the cost and make a proper underwriting analysis. 

                First we are going to start with the fixed expenses and we are going to go into management fees.  Now most owner operators (Note: owner operator is a person who owns the building and manages it themselves) do not factor in any type of management fee expense when selling the building.  The problem with this is that if you are getting a loan on it most banks will factor in the same expense in underwriting the loan.  The key thing to remember when evaluating a property is to consider now how the seller operates it but how are you going to operate it.  Even if you are going to self-manage you should consider something for this line item as your time is worth something.   For a building this size in my opinion I would factor in nothing less than eight percent (8%) of the gross collected rents.  (NOTE: Gross collected means actual rents received before paying other expenses).   While most banks are going to factor in five (5%) percent it will be hard to find a company to manage a building like this for that amount.  So, if you factor in eight (8%) of $1,500 you get a management fee of $120 per month, because remember our example we are using a $100,000 property that grosses $1,500 per month in rents. 

                Taxes is another thing you must consider.  While most sellers factor in something for taxes since they pay them; however, they usually factor in what they pay which is far less than what you will pay as the new buyer.  Reason being is when the purchased the property some time ago it was probably for considerably less money and their value they are assessed at is much lower than what you will be since most municipalities will reassess the property on the new value.  So, if the seller originally bought the property for let’s say $50,000, and we will assume the tax rate for this example is 1.5%, then he would be paying $750 per year in taxes but since you are purchasing the property for $100,000 the amount of taxes you pay will double, since the taxing arm of the local government will reassess it on the new sale amount, making your taxes for this property $1,500 per year, or monthly $125 per month.

                Insurance is another tricky one that you cannot take the seller’s word on.  One of the main reasons is the seller may have the property insured for a lot less of an amount than you would give what they purchased it for.  Other factors to consider are if you own more properties then you may be subject to other discounts that the seller may not be entitled to or vice versa.  If you guys have different companies, then the rates can vary big time for investment property.  There are a lot of insurance carriers out there that do not even want to insure investment property for some reason or another so this is something you are going to constantly be paying attention to and shopping for.  In my market a property like this would cost about seven hundred dollars per year to properly insure, or if you break it down monthly it’s about $58 dollars per month.

                I listed trash as a fixed expense because typically you pay a set fee for it, unlike other utility expenses such as electric, gas, water and sewer.  For a small property like this the trash may more than likely be included in your property taxes, and if it is that is great.  If it is not however you need to factor in something and a property this small would be relatively inexpensive.  I would suggest about $10 dollars per month, or $120 per year would be a fair an adequate number to factor in for such an expense based on our above example.  Now if you are in a market and these prices seem low you can figure out what these costs are, this is to simply inform you of the different categories to factor in when deciding to invest in cash flow rental property.

                Now that we have covered our fixed expenses to operate a property we will go into our variable ones.  This is where you need to learn how to use a “proforma”, which is a fancy word for “best guess” on these expenses.  If you are a newer investor it will be important for you to seek council in your buying process and decision making from someone experienced in this arena.  This is where “not all real estate agents are created equal” mindset needs to come to play.  I know a lot of real estate agents who think they can sell rental investment property and while some do a decent job at it most unfortunately do not.  Most agents do not own property themselves and have little experience with it therefore cannot accurately help you calculate or project these expenses and if the seller is not doing it for you, because most of them do not, then you are missing the mark on the true operating cost and value of a property.

                The first variable expense I’m going to talk about is maintenance.  This is one where the seller’s numbers will always be different from yours, especially if they are an owner – operator of the property.  Remember even if they do it themselves to keep cost down your time is still worth something and if you are taking a loan on a property the bank will factor something in their underwriting.  This is where you must remember “it’s not how they run the property, but how you will run the property” school of thought comes into play.  For our example, I will use eight (8%) percent as the number.  Why eight? Because that is a common number to use for properties of this size.  Basically, what I’m saying is that you take the gross rents on any one given month and factor in 8% of them to be spent on basic maintenance, this is not turnover cost of big items but the basics.  The basics would be leaky faucets or sinks, doors off track, something wrong with smoke detectors or the stove element burnt out etc.  So, if our property is grossing $1,500 per month and we factor in 8% for basic maintenance cost we are allocating $120 per month for basic maintenance services to be completed.  Now you will have some months that you spend more than this and you will have some months that you spend less but overall this would be a monthly average if you look at it over the course of an entire year.  Now other things to consider are age and condition of the building.  If you have an older building that has never been updated before with all original plumbing and what not, then this expense could be higher but if you have a new building then it could be lower.  We are considering for our example of a building in decent condition.  On a 1-10 scale, it’s about 7.25 give or take so therefore we can assume that most of it is ok but this is something that you will need to look at during your due diligence before investing in a property.

                The next variable expense I am going to discuss is vacancy.  Now the argument can be made that vacancy is not an expense and it technically isn’t; however, when you are building a proforma on a property you typically will figure out what the gross rent potential is, which means how much money will the building rent for if it were fully occupied for an entire year, then back out a certain figure for vacancy.  If you are getting a loan a bank will surely factor this in.  Given the current market we are in for rentals and the demand being high a five (5%) percent vacancy rate Is about right.  Now a lot of sellers will say since they have been fully occupied for a couple years that they shouldn’t factor in that and I could not tell you how full of shit they are with that theory.  Chances are tenants will move or they will not pay their rent once you take over and when someone moves on unless you have someone the very next day waiting to move in you are going to experience some vacancy.  So, if you take five (5%) percent of our $, 1,500 rent roll model you get a vacancy of $75 per month, or $900 per year. 

                Now we are going to go into the water, sewer and common utilities.  I’m doing these together since they are so closely related.  Water and sewer, I put as a variable because it is tied to the usage of what the tenants consume.  Now if your property has separate meters then that is a bonus to you and the building could have more value; however, keep in mind that if the tenants are paying that cost then you need to consider the impact it will have on the rents as you need to look at it as a balance scale.  Meaning that if the rent is $500 with water included then if you make them pay their own water, and that is say $25 per month, then chances are the rent will need to be $475-480 per month.  Not an exact dollar for dollar trade by any sense of the word but you need to factor that in.  A lot of land lords make the mistake of thinking they will achieve market high rents and make their tenants pay their own utilities so do the due diligence on the market you are purchasing in before making that decision to invest.  For our example, we will assume that the water and sewer cost are $60 per month, this is an allotment of $20 per month per apartment and that is a fair cost to use given the market I invest and work in, and since I’m writing this post that is the number we will use J.    I also lumped in utilities here.  This would cover any utilities for vacant apartments while you are getting them ready to rent out, if there is light on the outside of the building or in a common hallway etc.  If it’s just lights for electric it can be cheap.  I always like to factor $5 per month per unit.  This usually puts me close on a yearly basis if my vacancy numbers hold true to form.  So, for this example we will factor in $15 per month, or $180 per year. 

                The cost to turnover apartments and set aside for capital reserves are often the most overlooked by sellers and buyers alike.  Often investors do not consider these expenses because they did not occur recently or they lump it into maintenance cost and never go back and do a full accounting of their expenses to realize that the 8% maintenance cost we set aside is nowhere near enough when you include these.  So, for these expenses I have a couple formulas that I’ve come up with over the years of my experience.  Now keep in mind this may vary a bit and there is no way to pinpoint an exact number but this will give you a pretty close number to plug in.  For apartment turnover, this is to make one rent ready again, I take half of the units and multiple it by $350 for the yearly budget.  So, for our example here I have 3 units so take $350 and multiple by 1.5 and get $525.  When you put that monthly for cash flow you come up with $525 divided by 12 months, which equals out to $43.75 per month, which then I’ll round up to $44 per month. This is for normal wear and tear on a property and if the turnover expense is high you will have a tenant’s security deposit to also add to the expense. 

                Now when it comes for capital reserves, or as we refer in the industry “Cap X” this is a different formula.  Before I tell you how I compute this let me explain what Cap X is.  Cap X is a savings account of funds you put away for that big-ticket item that may occur.  Such as a new water heater, new furnace or roof.  Chances are you will only do any of these things one time during the duration of your property. Banks will often refer to these as “one-time expenses” meaning they do not expect you to do them each year.   The way I factor cap x savings on my proforma is like the way I do my turnover.   I take $150 per unit per year.  For our example, here since we have a 3-unit building that comes out to $450, or broken down into months is $37.50, rounded up to $38.  The idea is you will not experience cap x expenses every year so if you can save this money up over the course of a couple years or so then you put the money in when needed.  

                With these variable expenses, it is good to know the condition of the property you are buying as much as you possibly can before be making the investment.  The age and condition of the roof, mechanicals (which would be plumbing, electrical, heating and air conditioning) are very important in forecasting these numbers.  IF you need a bunch of cap x up front then these projects are nowhere near enough.  If you are a newer investor it is best to seek the advice and council of someone who is an expert in investment property, and frankly if you can find an agent that has sold but more importantly owns investment property themselves then honestly that is the way to go to help get you the best advice in making the decision to make an investment.

                Now that you have factored in a more realistic picture of expenses let’s look and see how our example investment property shook out and if It’s a worthwhile investment or not.  On our gross $1,500 per month cash flow we have operating cost of approximately $665 per month, leaving us a net operating income (often referred to as NOI) of $835 per month. Keep in mind this is before we have taken a loan out and put debt on it and must pay a mortgage, this is what you would refer to as “NOI before debt service” in the investment real estate industry.  If you put that on an annualized basis, meaning multiply it out by 12 months to figure out the annual income, you get $10,200 of annual revenue per year, before you pay a mortgage.  In all honesty on a $100,000 investment that is a return on investment (called ROI) of just over 10%.  I will not go into calculating returns on investment and using loan to leverage in this blog, but I did do that in my blog titled “utilizing debt.”  

                Hopefully by now you can see that there are a lot of things to factor in when making an investment property purchase.  These percentages and numbers are not an exact guide as each property is a little different given its age, size, location and tenant profile of renters but hopefully now you have enough information to know that there are a lot more categories of expenses you need to consider and why you need to consider them.   Of course, if you want to purchase any property in the Cincinnati Ohio or Northern Kentucky markets you refer yourself to the author of this blog for expert advice and opinions I was referencing above.  

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