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Buy Inexpensively. Fix. Rent. Become wealthy over time. Our parent and William Nickerson has a love affair with this thought process. We are in Houston for family reasons first, and secondly, because it is truly one of the great rental markets in the nation. And that was before Katrina filled all of the apartments. In evaluating a rental market, the investor needs to carefully weigh the monthly cost of owning a home versus the rental income he can expect to make. Unfortunately, the data that even a graduate level real estate education facility uses in Texas is flawed in this regard. PRICE TO RENT NONSENSE July 2005's Tierra Grande, the publication of the Texas Real Estate Center at Texas A&M, has the following table in this article that shows how Houston (and the rest of Texas cities) matches up against the rest of the nation in Price to Rent Ratios. Houston is really low on the list. All of Texas is really low on the list. Hmmm. We have low house prices and high rents. Sounds good to investors. But not so fast. The ratios might have something to do with higher carry costs in Houston. At higher interest rates, the price of housing goes down. At higher tax rates, the price of housing goes down. At higher insurance rate, the cost of housing goes down. Houston has higher tax rates and insurance rates than much of the rest of the country. To determine our real standing nationwide, we have to look at Cost to Own vs Rents. That will be saved for future research, when we look more in depth at the Houston market's rental characteristics. INVESTMENT GUIDELINE The "rent vs buy" title of this article is common real estate lingo for the decision facing the demand consumer of real estate. Should he rent or buy? As investors, we face the same decision. We buy because we buy "cheaply." Relative to what? Because real estate is both a consumable (someone can live in it) and an investment (it can be sold), real estate must be measured as for what you can rent it AND for what you can sell it. Investors like to be able to choose to either Rent or Sell depending on their financial situation. For that reason, buying a property needs to be measured for two factors: 1) Cost-to-Own vs. Rent 2) Equity MAO is about equity. The definition applies - you cannot get hurt too badly buying, remodeling and selling at MAO and stand a good chance to make money. But what if you rented the place out? Would that be even better? SELL VS RENT IS THE REAL CALCULATION Here is an example most remodelers face every day. An investor purchases a property at MAO. Fixes it up in three months and is ready to put the house on the market. The investor may be able to sell the property or rent it. Since this is a Basic Lesson, we will not get too Math intesive on return calculations. We offer the following guidelines. Take the expected listing price or appraised value and multiply by 90%. Subtract two more mortgage payments. Subtract everything you have into the project plus what it will take to complete. That is what we call the Cash Flow from Sale but is not the same as Profit, as defined in our Profit Calculation Lesson. ARV x 90% - Basis - 2 more payments = Expected Cash Flow from Sale Now, let's say you rented it out to a tenant. Rent x 90% (occupancy and maintenance) less carry costs (interest, taxes, insurance) of an 80% mortgage = Monthly Rental Income. To find your Return on Rental equity: Monthly Rental Income x 12/(Cash Flow from Sale + 1 rehab loan payment + refinance costs) = Return on rental equity To put numbers to the example: ARV/Sale Price = $100k Purchase Price = $45,000 Rehab Costs Rehab loan payment = $850 Rent = $1000 Taxes $175/mo Insurance = $50/mo Refi Interest = 7% Refi Costs = $2,500 Expected Cash Flow from Sale = $90,000 - $70,000 - $1,700 = $18,300 Monthly Rental Income = $1,000 x 90% - $467 - $175 - $50 = $208/mo Return on rental equity = $208*12/($18,300 + 2,500 + 850) = 11.5% So, you own a house, you could sell it, or you could keep it and earn 11.5% return on the cash you have in it. What do you want to do? That question faces investors with EVERY HOUSE YOU SELL. And take it from us, our parent sells houses for a living. LIMITATION OF CALCULATION AND SITUATIONAL FACTORS This calculation is only looking at investor rental expenses and not cash flow. That is a limitation but can be corrected by using monthly payment instead of interest, but then needs to be adjusted for a steadily declining principal balance and is a much more involved financial model, saved for Advanced Investing. Further, we ignore taxation and depreciation effects which can dramatically change these numbers, particularly if the seller is subject to high tax rates and short-term capital gains. Let us point out one dilemma investors will face time and time again. Should the investor be calculating returns based on loan balances or actual basis? Profit or Cash Flow? The answer depends on your particular financial situation. Our parent's initial objective is to maximize the return on cash that we invest, so we do that by using our Inventory Turns Method on our Sales. But it has a secondary objective - to preserve long-term equity through risk management - that is a fancy way of saying we choose 15 year notes instead of 30 year notes. More on that in Passive Income Investing. If you have questions and would like more dedicated and one-on-one/small group education, we can set up live in-person or on-the-job learning sessions - upon request or at a regularly scheduled time. Related Articles -BASIC EDUCATION OVERVIEW - Basic Investing ARV - After Repair Value Birddogging Contract for Deed Dealing with Contractors Estimating Profits Evictions - A Primer Executory Contract Foreclosure Overview Foreclosure Types Overview Hard Money Loans - a/k/a Asset Based Lending* Lease Options Leverage MAO - Maximum Allowable Offer Multi-Family Investing Basics as Presented by David Lindahl on March 4, 2006 No-Money Down Real Estate Investing Options Part-Time v Full-time Passive Investing For Beginners Pre-Foreclosure Profit Calculation Remodeling for Beginners Rent vs Buy Is Really Rent vs Sell Seller Financing as Investor Buying Tool Skiptracing Subject To Wholesaling Return to Listing Return to Investor Education |
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