The Magic of Income Property Math

duplex

duplex

How Income Math Is Magic

Owning income property is the key to magic money. Don’t believe me?

Think of it this way. Let’s take a small income property, say a fourplex. A quick way to figure the value of a fourplex or a duplex or triplex is to take the NOI [net operating income] and multiply by 10 or 12, the going rate here in Southern California.

So for example, a fourplex has four equal units and each is rented for $1000. Monthly income is $4000 and yearly income is therefore $48,000. The owner pays water and garbage collection for a total of $300 per month or $3600 per year. The taxes and insurance amount to $5000 per year and repairs about $2000. Subtracting these expenses from the income of $48,000 gives us the net operating income of $37,400. Multiply that by 10 and the value of the property is $370,400.

Rents have been going up all over the country and especially here in Los Angeles, so it’s time to raise the rent to current market rates.  Each unit will now rent for $1100. Yearly income becomes $52,800 and, assuming expenses stay the same, the NOI  $42,200. Multiply that by 10 and the value of the property is now $420,200. Magic. Pure magic.

For every extra dollar in increased rent, the value of the property goes up $10. This is truly magic math. Almost all the gains are passive. This kind of math is much more favorable than paycheck math, small business math or stock investing math.

More Magic

In the above example, the owners have not only increased the value of their property, but are also receiving a monthly income of $3500. If the property also has a mortgage, not included in the NOI, the tenants are paying that mortgage, not the owner. 

Many owners of income property fail to keep their rents at market rates. Now you can see why this is potentially catastrophic in the event that they wish to sell the property, take cash out of the property or refinance. Unless the rents are kept at market, the value of the property does not increase.

What Is The Best Investment Property? Part 1

With the low mortgage rates and super-low housing prices, many investors who have fled the crazy stock market would like to invest in real estate. Most of us think we know something about real estate and, really, we do. After all, everyone lives in real estate of one kind or another. Owning your own home and owning a rental-producing asset are two different things, however. Let’s assume you are looking to purchase rental property for the first time. Let’s also assume that you will have the 30% or 20% down to invest and want to leverage your money to best possible advantage. What would be the best use of your money?

fourplex

Single-Family or Multi-Family?

Many first-time investors automatically gravitate towards single-family homes.  That’s what most people know best, so it makes sense. But, is that the best use of the available money? I would say no. On the same amount of land and  often for the same price, it’s possible to purchase a duplex, a triplex or a quadruplex. That means for the same money, you will get double, triple or quadruple the rent. It also means that if one renter does not pay, you still are receiving half the rent, two-thirds or three-quarters. This will make quite a difference because you have to pay the mortgage and the expenses of the property every month whether you have tenants or not.

Therefore,  all things being equal, which they never are exactly, my preference is to purchase a multi-family dwelling instead of a single family one.  A fourplex is probably the most units a first-timer can handle.  Beyond the fourplex also more complicated loans apply. An investor can even purchase up to a four-unit building with an FHA loan which requires only about 3.5% down plus another 3 to 4% in closing costs. Using such a loan puts the investor at a significant advantage due to the gain in leverage from the smaller down payment. fixer Fixer or Repaired?

Many first-time investors naturally tend to look at fixer properties because they are cheaper than properties in good condition.  If the investor is an experienced rehabber or in the construction business, then it might make sense to buy a fixer. As long as the buyer has experience, knows the cost of the needed materials, and can either do the work himself or can get it done at a reasonable price, integrated into the purchase price, then a fixer can be an ideal asset.

For everyone else, though, it’s really not a good idea. During the rehab, the investor is paying the mortgage but receiving no rent. Sometimes repairs take longer than anticipated. As a rule of thumb, rehabbing a property always costs more than anticipated. Besides the loss of rent, the investor should take into consideration the wear and tear on his personal psyche. Searching out reliable contractors and overseeing their work can be exhausting. For someone with a full-time job, the time lost to the new property can never be recovered.

Fully-Occupied or Vacant?

Another issue that investors have to consider is whether they want a fully-occupied or a fully- or partially-vacant building. Often, sellers are trying to get rid of properties which they have saddled with bad tenants or tenants not paying market rents.  Asking for the rent roll and checking it carefully will show if the existing tenants are paying or not. A smart investor also has a good idea what the rents for the proposed purchase property ought to be. The purchase price should usually be a multiple of the yearly rents. Thus, if the yearly gross rents amount to $26,000, then the purchase price should be about 10-12 times the rent, or $260,000- $312000, depending on the market.  In some markets investors will find properties for significantly less.

In the MLS listings, frequently the would-be investor will encounter “pro-forma” rents alongside the actual rents of the property. This means the seller has failed to keep his rents at market, so the potential  or “pro-forma” market rents are included.  That’s fine as long as the price of the property is calibrated on the actual, not the pro-forma, rents. Of course, usually sellers want to base their price on the pro-forma rents.

But, think about it. The new investor will have to approach the existing tenants with a hefty rent increase as a first introduction, not a good start. Some of the tenants will leave rather than pay more. Others will have to be evicted. Whatever happens, it will cost time and money for the new investor. Reasonably, then, the investor should not pay pro-forma prices.

If the investor feels confident that the current renters are paying close to market rents and have a good history of on-time payment, that is the ideal situation. On the other hand, there are good reasons  to purchase a vacant property as well. The new owner will be able to thoroughly investigate each and every unit, which is usually not possible with tenant-occupied, making any repairs or cosmetic updates required. Plus, the new owner will set the deposit amount, the rent amount and the qualifications for the renter. Don’t want dogs? Want to check credit and do a background check? Want to limit smokers? Any of these are possible with a vacant building.

How To Be A Landlord

Investing in single or multi-family homes and dealing with tenants isn’t for everyone.  For those with the intestinal fortitude to have tenants, now is a terrific time to invest in rental property. Loan rates are low and the deals are out there. For the first time in a long time, it’s actually possible to buy property with 20% to 30% down and get a cash flow right away. In the past, of course, SoCal real estate was so pricey that the best investors could hope for was appreciation of the property. Now, even in SoCal it’s possible to get a cash flow deal and make some passive income right away.

A few years ago, I invested in two fourplexes in San Antonio, Texas which are now supplying a tidy cash flow every month.  Attaining that income wasn’t easy. First, I had to renovate the properties, both built in 1940 and on adjoining lots. That took many flights from L.A. and about 6 months for both. My procedure was one at a time, so after about 3 months I had one building finished and full of tenants and then I started on the second building which took another few months.

Along the way, I have learned quite a lot about managing property and about managing tenants. Watching my clients who owned rental property also taught me a lot.  Here’s some of what I learned about tenants.

How To Be A Good Landlord

  • Know the rental laws.  This is elemental and vital. If you own a rent -controlled property, make sure you understand the ins and outs and follow them to the letter.
  • Have prospective tenants fill out a detailed application and pay at least $30 for a credit check. Paying for the application will screen out the insolvent and insincere applicants.
  • Thoroughly vet your prospective tenants-run a credit check, call the last rental and verify the income. Do not rely on your “gut feeling” as many nice guys make terrible tenants.
  • Make sure prospective tenants understand and agree to your rental terms before accepting them. Deal with some issues upfront: do you allow pets, do the tenants pay utilities, how many cars can they park, how long is the lease, etc.
  • Only “hold” an apartment for a tenant after you have a good deposit in the bank.
  • Make sure the empty apartment is pristine before turning it over to the new tenant. Finding a dirty oven or a leaky faucet or a malfunctioning A/C gives tenants the wrong impression.  Make sure everything is shipshape.
  • Make sure tenants have signed the lease and given you evidence of putting the utilities into their names before you give them the keys.
  • Fix or repair items tenants complain about immediately. If you expect good tenants, you have to be a good landlord. This includes dealing with other tenants who may make noise, not care properly for pets or park in the wrong place.
  • Treat your rental like a business. Never forget you have the rental to make money,  not to make friends.
  • Make it crystal clear to tenants that the rent must be paid on time or late fees accrue and/or eviction begins right away. This is where many landlords fail. Allowing tenants to pay late or not at all simply creates a crushing load of debt they will never be able to pay. Make sure tenants understand you need your rents to stay in business.
  • If tenants are late paying the rent, immediately find out why and when you can expect to be paid. Immediately send the tenant with an inadequate explanation, a 3-day notice to pay rent or quit. If the tenant does not pay, start eviction without delay. That way if the excuse is invalid and you do not get the rent, you will get the tenant out in the shortest possible time. Do not be a nice guy about this. 
  • Keep the property in top condition. This will guarantee you a constant flow of good tenants and a good sale price should you ever decide to sell.