You worked with your real estate agent that identified a property that you like and are ready to make an offer. The big question is how much should you offer? Your real estate agent should provide you with comparable sale prices in the immediate neighborhood. Typically they will only include properties that are similar (i.e about same number of rooms and similar square footage that have sold in the last three months). This is a good way to determine comparable sales but I recommend that you ask them for additional comparable data. For example, ask them to include all homes (large or small) in the neighborhood and ask them for sale data for the last two years. You want to compare the subject property to a wider set of criteria than is typically used. Once you determine the fair price of the property, you can test by offering a slightly lower price. I don’t suggest you to offer 15 to 20 percent lower price. I don’t’ suggest you to offer 15 to 20 percent lower than the asking price but it does not hurt to offer say 5 percent below the fair market value. Remember that you are buying this property as an investment and not for personal use. If you don’t succeed in reaching a deal after a couple of times then you will know the true value of properties in the neighborhood. Your real estate agent should be understanding if he realizes that you are trying to get the best price but are still sincere in your offer and commitment to buy a property. Remember your agent gets paid only when you buy a property so you have to balance their time and effort as well. Also, when making an offer you can agree to other terms such as a fast closing to make your offer more attractive to the seller.
Example of cash flow calculation
While evaluating properties we realized the 1 percent rule. Basically if you can rent a property for 1 percent or more of the purchase price of the property, you will be cash flow positive.
Let’s take an example of a typical property with a purchase price of $140k. Lets assume you put a 20 percent down payment and take a 15 year fixed loan on $112K at 4 percent (please note that the interest rate for rental properties is slightly higher than for personal properties). Let’s assume you will pay a monthly HOA fee of $25 and manage the property yourself. Going by the above mentioned 1 percent rule, let’s further assume that you are getting a rental income of $1400 per month on this property. Your cash flow calculation will be as follows:
Monthly Rental income = $1400
Monthly Mortgage payment = $828 (Principal + Interest)
Monthly HOA fees = $25
Monthly property tax = $145
Monthly insurance expense = $75
Monthly Cash Flow = $1400 - $828 - $25 - $145 - $75 = $327
This example translates to a yearly cash flow of $3924 assuming the property is rented throughout the year. The key is to always be cash flow positive. In this case, the investor is in the safe positive cash flow zone. If the investor can get a higher rent, his cash flow will rise but for the purpose of calculation, I would advise you to use less aggressive numbers.
Let’s do the same calculation with a 30 year fixed mortgage.
Monthly Rental income = $1400
Monthly Mortgage payment = $534 (Principal + Interest)
Monthly HOA fees = $25
Monthly property tax = $145
Monthly insurance expense = $75
Monthly Cash Flow = $1400 - $534 - $25 - $145 - $75 = $621
The numbers look much better on a 30 year fixed loan. Of course I have not accounted for property management fees and any vacancies that may vary depending on you situation. At worst you are cash flow even. After fifteen years or thirty years, depending on your loan, you no longer have a mortgage and you own the property free and clear. Your property may or may not appreciate during this time.
The other thing to note is that a big chunk of your mortgage payment is going towards the principal of your loan. You need to understand this key real estate investments fact that you are paying down your principal and over time your property will be all paid off.
Your cost is mostly fixed during the life of the loan since it is a fixed loan. The rental rate may increase in the future due to inflation and should help improve the cash flow. If you fast forward five years, your payments are still almost the same although now a bigger portion of your mortgage payment is going towards principal. In the above example, most probably your rental income can increase in the future to $1550 or more, hence helping increase the cash flow.
