A reader asks; How do I determine if a real estate investment makes sense?

SFR investing is not emotional; it all comes down to the numbers

Hello Chris,

Hope you are doing well. I’ve followed your advice and invested most of my sideline cash before and during the early stages of this rally, so thanks again for your financial advice.

Just wanted to ask you how do you estimate or value an investment to decide if it’s viable?

I’m somewhat familiar with the idea of discounted cash flow and obviously looking at rental comps or rental history and property tax rates is not complicated, to get a rough idea.

However, I find it difficult to estimate maintenance, insurance, and vacancy rates in advance, since those can be more variable, so those often end up as question marks on my spreadsheets. Do you have basic formulas that you use for that, based on the property value and type?

Regards,

P

I generally do not heed the predictions of the well-paid, but financially compromised real estate economists, for they are, by definition, incorrect. Most of these market shills are not involved in the residential market they way we investors and property managers are on a daily basis. We active investors are better able to feel the pulse of the marketplace than any well-paid analyst. Savvy investors who directly own their properties will generally come out ahead over time.

As long-term investors, we only care about the numbers; specifically I prefer analyzing what’s behind the discounted cash flows of a particular real estate investment. The easiest way for me to determine if a property is overvalued/undervalued/fair market is by determining an investment’s capitalization rate (cap rate) and internal rate of return (IRR). I then attempt to compare these current values to its historic norms to see if the price is too expensive or still offers value to me. Thus, the current market value only tells us part of the story. We need to see how the rental market has performed over this time frame. While we may not be getting full market rent, other investors will price real estate off this potential amount.

A house

I recently rented out one of my single-family houses, and the table directly below shows the specifics. I did not charge full market rent, but only have four people living in this 5 bed/3 bath house. However, I was easily able to increase my rent $1,400 a month after a sizeable rehab and three months of my time.

Take a look at the change in the capitalization rate; it actually increased over the four-year time frame. Based on these numbers, the price of the house actually offers me a better value than that of four years ago!

A condominium

Let’s take a look at another property I recently rented out. In this instance, it is a 2 bed/2 bath condo. I now receive $1,950/mo., yet full market rent is now about to $2,200, which climbed about $200 in the last six months.

As we can see in the above example regarding this condo, while the capitalization rate has declined, this property still offers an investor an ample cash flow and rate of return. While the cap rate has declined over the past four years, it has not dropped to the lows observed in the real estate bubble of the mid- to late-aughts. During the height of that real estate bubble, the cap rate on this property fell to as low as 3.5%. As we can see, there is still a lot of room for prices to rise before we call it a day on this cycle. If the cap rate dropped to 3.5%, the condo’s price would have to effectively more than double in price, while the rent stayed the same.

How to determine your other costs

Vacancy costs – If your rental properties are located in more rural or less competitive areas, a property manager may have to increase the allowance for vacancies. In some parts of the Greater-DC area, vacancy rates can be as low as 5%. In less populated areas, I generally place a vacancy rate of 10%. The circumstances depend on you and your abilities to quickly turnaround properties. This take some experience.

Rehabbing costs – If you have an advanced understanding of repairs and rehabbing, your repair and maintenance costs will be much less than those who choose to defer these activities to others.

Professional management costs – When I determine my costs and calculate my financial ratios and rates of return, I do not include professional management fees, unless the property has more than four units. When I determine regular maintenance costs, I devote a fair percentage to self-maintenance, but allot a certain amount to typical HVAC and roofing.

While your personal experiences may be more or less than others, I consistently account for what the typical pricing models include, and they include what I just mentioned. While your personal costs could be much higher if you decide to not get personally involved, price potential SFR investments based on market norms.

Please note that I did not address the concept of the IRR in this article, since it wasn’t necessary to illustrate the main thrust of my post; residential real estate in many parts of the United States still offers investors (and homeowners) some compelling value. This determination, of course, is  based on the growth in market rents.

I predict that the capitalization rate on the single-family detached house could approach 4% if bond yields do not move up much higher from here. If they do, cap rates will probably escalate to compensate and house prices could be under pressure. The upshot is that rents will probably rise, since higher bond yields imply higher price inflation. The capitalization rate on the detached house described above in the mid-aughts RE mania was as low as 4%. Moreover, given the trajectory of rent rates, I look for more rental rate increases over the years as more immigrants pour into the local area.

If the cap rate on the house falls to 4%, this would imply a market value of $745,000. If the cap rate on the condo fell to the same level, this would imply a market price of $479,750.