902: Does the cap rate matter? 1%, 2%, 50%, 70% and BRRRR
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Welcome to Episode Two of Season Nine of the Growing Empires Show. Today we're going to talk about how to analyze your rental property for an acquisition. So stay tuned.
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Welcome to Growing Empires hosted by real estate entrepreneur and trusted investment advisor Jennifer de Jesus. Growing Empires provides insight to building wealth through passive income producing real estate investments for those who want to build and manage a more profitable real estate portfolio.
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So you're starting to look at investment properties and you're thinking about how to analyze those properties. And I'm sure that you've read a wealth of information on the web. And trying to decipher which one is best for you could be a little bit of a daunting task. So today, what we're going to do is review some of the most commonly used methods, why people use them, what they're used for to analyze specifically, and what that should mean to you as far as analyzing your next investment deal. So we're going to jump right in, and we're going to talk about some of the most commonly used analysis metrics. And the first one most widely use is called cap rate. So the reason that people use a cap rate is because they're trying to analyze all the functions have a deal to figure out whether or not the purchase price of the property is going to fall in line with what the market averages are in a respective area. And the cap rate is a metric that is going to analyze your income, minus your expenses, divided by your sale price is how you actually acquire that cap rate number. And when you're going to look for properties, one of the first things you're going to want to do is make sure that you're talking to your broker, or your real estate advisor about what is going cap rates in a local area. So for example, in the Lehigh Valley, I can tell you that we commonly can find cap rates between 10 and 12%, for one to four units. So small residential multifamily units. And for five plus units, you will see cap rates anywhere from the 8 to 10%. Now if we're going into like Class A properties, you will see them hover as low as like 6%, on average, but ultimately, if you're buying value add properties, you're going to see five plus units or anything commercially zoned to be somewhere around that 8% cap rate as a current market average. Now, in my history of being in real estate, I've seen cap rates as high as 20%, for small multifamily homes. And I've seen the cap rates as high as 12, or 14%, for large multi unit homes, and they do fluctuate based on the market conditions. But ultimately, what you want to do is, whatever marketplace you're in, you just want to find out what is the average for that area, so that you can make sure you're kind of in line with you know, that marketplace, you're not buying too high or too low, and potentially buying a dud. Okay, so let's talk a little bit more about the functions of the cap rate. So income is going to be all of your gross income that you collect on the property. Now, when I analyze this, I do not typically use any kind of garage income, shed income, storage, utility, laundry income, or any of those other variable expenses, because they're not guaranteed. It's not like rent, it's not like somebody has to use them. They don't have to use your laundry facilities, they can go down the street and use a laundromat. They don't have to have storage. They don't have to rent a parking space or a garage. So I would suggest that when you're analyzing the income on a property, that you just choose to use things that are contractually based. Like leases, okay. So whatever income is actually being generated on that particular property is what I would use in my analysis. So income minus expenses. Now these expenses that you're going to calculate, are going to be anything that would be required to be paid by you, the landlord. And I find that this is the area where most people make the most mistakes, and it's because they don't take the time to analyze every detail. And they forget really important things like licensing fees or rental registrations or business licenses, you know, every municipality has different rules. And very commonly, there are business license fees that are a part of kind of like a privilege to operate a rental business in that municipality. A lot of times there's rental registration fees, and they are very different. So one is the municipality the taxing authority saying you need to pay a license fee to actually operate a business here and that's your rental business, a rental registration or a rental license. They're commonly called different things in other areas. But that is the town now saying not the taxing authority with the town saying you have to pay each year to get your rental property inspected, and to be able to have the right to run and operate a rental property. So they're not necessarily the same thing. Usually a business license fee at least in our area is about 25 bucks. Rental registration is usually an annual thing. And it ranges anywhere from like $35 to $100, a unit just again, depending on the municipality,. And then you may also have rental inspections that are required yearly. And again, this fluctuates, some areas can require it to be done every single year, some areas could require to be done once every four years. So you do have to figure out, and the easiest way to do that is to call the local municipality or the township that you're going to invest in and ask them all of those ancillary fees that you might have to pay if you wanted to own and operate a rental business in that municipality. Okay. So when you're calculating these expenses, back to what I was saying earlier, it's really, really important that you make sure that you know all of the functions of the expenses. Because if you're only going to cash flow 2,3, $400 $500 per unit per month, and you have to pay these fees that you forgot to analyze, your cash flow is quickly dwindling. And we want to make sure that for any investment that you buy, that it is always positive cash flow from day one. You never want to buy a property that does not have positive cash flow, unless you are using some type of 70% roll or you're doing a major rehabilitation where there should not be occupants in the property at the time of acquisition. So expenses, common ones, are mortgage taxes, insurance, okay? And on top of that, you have to also consider any landlord paid utilities. So do you pay for heat? Do you pay for water, sewer trash, electric? You know, those are types of expenses that you would have, you also need to pay attention to whether or not you're in an HOA, a homeowner's association or a condo association, because there could be HOA fees or condo association fees for the property that you're purchasing. Then you're going to want to bake in a vacancy factor rate. And again, it's really important for you to talk to your broker about what is the market average for that specific area so that you're not undercutting yourself. But typically, when I do an analysis, I will use a 5% vacancy factor, I also need to factor for general repairs and maintenance, because those are things that you're going to have to expect to have money for come your ownership of this property. So when I'm analyzing maintenance and repairs, I'm usually factoring in somewhere between two and 4% of the income for general repairs and maintenance. And again, that is a number that you really need to talk to your real estate advisor or your real estate professional to know what would be adequate for the type of property that you're buying. And that number will fluctuate based on the condition of the property. I've seen as low as 2%, I've seen as high as 10%. And it really depends on the class of property that you're buying, the condition of the property that you're buying, and the area that you're in, and then also how old that property is. So going back to our analysis, all of our income, minus all the expenses that I talked about, including a subtraction for vacancy, and including a subtraction for repairs and maintenance or reserve. And that's going to bring you to your net operating income. You're going to take that net operating income, and you're going to divide it by the potential purchase price. And that's going to give your capitalization rate or your cap rate. This again is the most widely used metric. And that's because it really analyzes a lot of the details that are necessary to find good cash flowing properties from day one. It is not the end all be all, but it is definitely something that I would suggest that you highly analyze and look at before making your first purchase or subsequent purchases.
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The episode will continue in just a moment.
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I recognize that as an active investor, you want to implement best practices that drive the highest returns in your properties. Everything we do at Empire is designed to make life a lot easier for you so you make sound decisions regarding your portfolio. Whether that's through this Growing Empires podcast, our company of services of property acquisition, construction and management, or by becoming an Empire Capital Fund investor, we want you to be as successful as possible. However, using the right methods is critical to achieving your ROI. There's a lot of advice out there and it can be overwhelming. Especially if you're using a method that isn't working. Don't take a chance on an approach that may not be right for you. If you want to be sure I can help you assess of your current strategies are fit to your properties end goals. Book a call with me today to see if there's a better way. Go to JenniferdeJesus.com and click book a consult and I can confirm that the method you are using is the right one for you or suggest a simpler, more profitable alternative. One quick conversation and you'll feel better about the choices you're making regarding your real estate investment portfolio and the value of comparing to long term.
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Now let's talk about another widely used method and that is the 1% rule. Okay, the 1% rule is a rule of thumb for rental property investors used to decide whether or not the property is worth taking a closer look at so it's not as in depth as the cap rate analysis. But it means that the gross monthly rental income should be at least 1% of the purchase price. And this is just a very quick metric to scan through data at a high volume to see if this property would potentially be a profitable or could be a profitable property. So 1% rule is something that is definitely use a more of a scaling basis so that you can look at and analyze a very wide variety of data very, very quickly. Because in this marketplace, a lot of times speed to lead is everything to get the best deal. So you want to be the first one out of the gate, you don't want to be in multiple bid situations if you can avoid it. So a lot of times people will use these benchmark rules to help them determine if the property is worthy of taking a second look. And that's the 1% rule. Now, the 2% rule, you may have also heard of. The 2% rule is a more conservative version of the 1% rule. And it means that the gross monthly rental income is at least 2% of the purchase price. These are very commonly used in that value add proposition. The 50% rule is also something that's out there. And the 50% rule states that operating expenses, excluding debt service, operating expenses, excluding debt service, will average out to be about 50% of the rental income. Now, none of these three metrics are something that I suggest are the only calculation that you use, because it doesn't factor in a lot of things. It doesn't factor in, you know, your general repairs and maintenance. Some buildings you may buy going into knowing that you have to put significant capital improvements into the building. These benchmark rules do not really analyze that information. And you really need to know what you're buying before you go and make that offer on that property. But they do give you a basis to understand whether this is going to be a potentially cash flowing property or a negative cash flow property. Of course, if it's a negative cash flow property, you just want to throw it out, it's not worth looking at and move on. Another rule that you're going to hear people potentially mention is a 70%rule. But this rule is very specific, because it really is about buying properties that needs significant amount of repairs, before it can be rented or occupied. And basically, it's a purchase price plus repairs should be 70% of the after repair value or the ARV, and again, that's only really used on properties that you're potentially going to buy and flip. So the 70% rule is mostly used for major renovation projects. And typically your flip projects is what you're going to use that for. You can also use that 70% rule for the BRRR method, if you really want it to to help you analyze that data. And that BRRR method is buy, rehabilitate, rent, refinance, and repeat. And that BRRR method which again, is really commonly used, and people are really drawn to it, because it's a great way to pull out equity, and still own the property. So it's a little different than you flipping a property because you're selling your asset, right. So you can't continue to make money on something that you sell. So when you're flipping properties, you're talking about big lump sums of cash that you're getting. And when people flip properties, they're flipping properties because they want to be able to take that boatload of cash and use it on another acquisition, usually a larger acquisition at that time. People that choose to use the BRRR method, over that flip method, are people that are looking to hold on to that asset. So the BRRR method is really, really good. If you've got the ability to rehabilitate a property very quickly, that BRRR method can be fantastic for you to be able to really progressively go after future investments. Because you're going to do it in a very quick method, you're going to pull that money out, you're going to reinvest that equity into another asset purchase, which is essentially duplicating or doubling your investment strategies very, very quickly. So it's a really great buy and hold strategy for people that want to very progressively go after future acquisitions. Now, the most important thing about the BRRR method that you need to know is that it is not one size fits all. Not every market is going to have properties or a real estate market that would make sense for that type of method. And why I say that is a couple of things. Number one, if you're going to do the BRRR method, make sure that you have an ability to renovate that property very, very quickly. Because the longer you hold it, the more it costs you and that is one of the most common areas that people fail. Is that they don't have a plan prior to the purchase of the property. Then they sit, they get in trouble with permitting issues, maybe because we're trying to find that cheap, cheap contractor who doesn't do things by the book. You get stopped work orders put on your building, you're sitting idle for many, many months and you're not able to capitalize on the equity in your property because you used it because the renovations took you far too long. Okay. The other major part of that that is usually an issue for investors, if it's, it's not successful, it's very wrong. And that is the refinance side of it. So just because you can buy properties at really favorable prices, using your 70% rule or even better, does not mean that the market is strong enough to give you that refinance on the back end, that is going to give you enough equity play for your next investment. So be very, very careful with that. I've talked about this in other episodes, but it is a really, really interesting type of investment strategy. It's just not for every area or for every person. So that, in a nutshell, are some of the most commonly used metrics for analyzing properties. I'm sure that you as the investor, have some of your own methods as well. When you go to make those investment purchases, you should review your metrics with your real estate advisor or broker and just see if they have any other advice for analyzing properties. I hope you got a lot out of today's show and until next time, take care.
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For more information about how Jennifer can help you plan, develop and manage a strong real estate investment portfolio, visit growingempires.com