How Much Can You Pay For A Rental Property?
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Have you ever wondered how to determine what price you should pay for an income property?
Here’s an approach that I’ve used for over a decade:
There are 3 things that matter in the analysis are (1) the income the property will produce (ie. the rent) and (2) the estimated repair costs and (3) the neighborhood grade.
Let’s look at each one and at the end, I'll summarize the formulas to help you determine your target buying price.
Let's start with Income, or NOI (net operating income).
The income that matters in your analysis is the net operating income or, said differently, it's the Gross Rent minus your TIMMV (Taxes, Insurance, Maintenance, Management, Vacancy).
Although you should plug in actual numbers, your TIMMV can be estimated at 30% - 35% of your Gross Rent, giving you a net rent equal to approximately 70% of Gross Rent.
So, for example, if rents are $700/m, the NOI can be estimated at 70% x $700 = $490/m or $5,880/yr.
Next you need to estimate the cost of repairs.
For a rental grade rehab, you’ll want to estimate repair costs to produce a safe and functional property, but also to minimize maintenance and maximize cashflow.
You can get an estimate of all repair costs for any property nationwide, here:
And finally, you'll want to consider the type of neighborhood the rental property is located in.
Neighborhood grades are = A, B, C, D, War Zone.
The neighborhood grade is used by experienced investors to “price the risk” of owning and operating an income property in different types of neighborhoods.
To do this, investors use target CAP RATE’S (CR) for each different neighborhood grade, to calculate an offer price. The target Cap Rate by neighborhood grade can be summarized as follows:
A = 8 - 9% CR
B = 9 - 10% CR
C = 10 - 12% CR
D = 12 - 14+% CR
WZ = 14+% CR
Now, to bring all this together, your offer formula is to determine your offer price is:
(NOI / CAP RATE) - Repairs = Offer Price
Let’s run some real math. If we take a $700/m rental deal in a C neighborhood that needs $10,000 in repairs, here’s how much you might expect to pay:
Offer Price = ($5,880 / 0.10) - $10k
= $48,800 CASH <----- Your Purchase Price
One thing you’ll notice here is that the VALUE of the property has been essentially ignored.
That’s because, in this analysis of a long term buy and hold rental, the income is what really matters.
The value of the rental property (after the repairs) or the after repaired value (ARV), only matters if you want to refinance to get your cash back out and into another deal.
That's a discussion for another day, but for now...you know the right formula and the 3 things you should consider to determine the right buy price for your next cashflow rental property.
Now go create your freedom...