The 2 Biggest Mistakes Made in Calculating Rental Property Returns

Calculating Rental Property Returns

Not only should you avoid these mistakes when you run your own numbers on a property, but you should also be on the lookout for anyone else who is making these mistakes when they try to sell you a property that is supposedly a great investment.

For anyone newer out there who doesn’t understand what I mean when I say “the numbers,” I am referring to the numbers used in calculating the projected returns on an investment property.

You’ve probably heard the term “cap rate” and “cash-on-cash return” and likely some other ones. More or less, they are all measures of the return you will get, or are getting, on your investment. “The numbers” are what are used in calculating those returns. For a more detailed breakdown of these numbers and formulas, check out Rental Property Numbers So Easy You Can Calculate Them on a Napkin.

So what are the biggest mistakes people make when running numbers on an investment property? Are you ready?

1.) Using Estimates Instead of Actual Numbers

There are actually three different ways I see people using estimations when trying to project returns on an investment property.

a.) The 50% rule

I hate this rule. I don’t know why, but I just don’t like it. Actually, I do know why. I don’t like it because it can steer new investors (and even some experienced) along a path of believing it should be used for actual evaluation rather than be used as a guideline.

However, I know a lot of people advocate this “rule”, so I’ll leave my opinions about it at that and look at it factual. The 50% rule says that, in theory, 50% of the rent you collect from a property will go towards expenses.

People use that as a guideline for whether they want a particular property or not…does it meet the 50% rule?

Here’s what you need to understand about this rule. The term “rule” is a hugely misleading term. Technically the “rule” should have been labeled “the 50% guideline.” It should absolutely only be used as a guideline when you initially glance at a potential property.

If it meets the 50% rule, great, go ahead and pursue it. But at that point, drop the “rule” from you mind and actually calculate the real expenses and don’t assume they equal 50% of the rents. If you were to pull that on a FL property for example, you could be setting yourself up for a major loss when you find out how much the actual insurance and taxes are down there. So much for that 50% safety net!

Never decide on a property solely because it meets the 50% rule. Use it only as a guideline (or if you’re like me, don’t use it at all) and then drop it.

b.) Calculating expenses

Oh MAN does this one drive me crazy. I hear it more than I could ever imagine; someone is evaluating a property to buy and they share the numbers associated with that property and they say things like “insurance is usually around $300/year”, “the taxes should be about $179/month”, “I should be able to get $1100/month in rent”, “I think it will be about $8,000 for the rehab”…

You get my drift. Please stop doing this when you evaluate a rental property. Yes, there are some numbers that will require your best guesstimate but those numbers are few.

If you are looking to buy a rental property, you can expect to have the following monthly expenses once you own the property: taxes, insurance, property management fee (if applicable), homeowners’ association (if applicable), mortgage (if applicable), vacancy, and repairs. Of all of those numbers, the only ones you can’t know for sure are the vacancy and repairs.

You do have to estimate those. The rest of the numbers, however, you can absolutely get actuals for.

Ask the current owner what they pay in taxes or look it up on the county’s tax assessor website, get a quote from your insurance company, ask your property manager how much they charge, call the homeowners’ association and find out how much they charge, and get a quote from your lender on what your payment will be. Easy!

And for the rents, because people love to guess on these too, find out how much the current tenants are paying and if there are no current tenants, have a property manager or a real estate agent run comparables in the area and determine what they deem to be a viable rent for that property in that area.

Lastly, if you are rehabbing the property to any extent, don’t just get one quote for the rehab. Get two or more to be safe. I’m telling you, there are so many unknowns and estimates required in real estate investing, get actuals in every single place you can find them. Because trust me, the numbers that you are forced to estimate can end up stressing you out enough by themselves.

Never use an estimate when you can use an actual!

c.) Projecting and speculating

Planning on raising the rent on your rental property by 3% in the next year is crazy. Almost as crazy as projecting appreciation. Guess what, you don’t get to choose when you raise the rents.

That is a common misconception, which even I had when I started, that should be thrown away. Raising rent on a property is not done just because you want it to. It’s done when the market supports it.

You can try to raise the rents but if that puts your rent over market rent, who will want to rent your house? No one, because they can rent a different property for cheaper (market rent). Same with estimating appreciation.

You have no idea how much, if any, a property will appreciate in the next 1, 5, 10, 30 years. Ask anyone who bought solely for appreciation prior to the most recent crash. Do you realize how many speculators went under in this last crash? Too many to count.

Why did they go under? Because they bought assuming appreciation rather than buying on solid fundamentals (i.e. buying for cash flow and taking any appreciation as a bonus). You are more than welcome to run a separate side sheet and add in raising rents and appreciation to see what hot shot returns both of those will get you, but don’t use that sheet as your primary motive to buy. Use only today’s (actual) numbers to evaluate a property.

2.) Thinking Numbers are Everything

Guess what, they’re not. Yes, numbers are critical in evaluating a property and they are really the only non-negotiable of all the factors that go into what makes for a good rental property. They are not, however, everything. I’ve mentioned a couple times these other “factors”, well what are they?

Keep in mind these points have room for maneuvering.

  • Location. Is it in a growth market? Is the population there on the rise or declining? Is the area safe? How are the schools? What kind of tenants will want to live there?
  • Property condition. What is the age of the property? Does it need any rehabbing? If so, what? What kind of tenants will want to live there?
  • Property management. Is there access to a good property manager to manage the property? Even if that is you because you plan to landlord it yourself, are you available to handle it?

There may be others that can be added to this list. The most important question of those, in my opinion, is what kind of tenants will want to live there? (if you didn’t notice by my italics there).

It comes down to “quality” of a property. Quality of the market, quality of the property, quality of the management. If any of those are lacking, you may hit some trouble.

Not always, and a lot of people make serious bank by investing in bad areas or by buying old, ratty properties, but be aware of the implications of those things before you buy a property should they be applicable.

You will always see returns get higher and higher (on paper) the more you go into less desirable neighborhoods and older properties. Always! And the returns may show substantially higher than of nicer properties!

Remember though, those numbers are only what is written on paper. They are not a sure thing. As soon as you get in a position of having bad tenants (especially if on a consistent basis) and an older property needing repairs, those phenomenal returns you projected could easily end up being more realistically much lower than you projected, if not even negative.

Numbers themselves are non-negotiable, but once you find a property whose numbers work, you must assess the viability of those numbers. They are far from guaranteed, I promise.

Any stories of actual returns turning out to be so far from what you originally projected you could barely believe it?

 

Source: BiggerPockets.com By;  ON FEBRUARY 8, 2014

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2 thoughts on “The 2 Biggest Mistakes Made in Calculating Rental Property Returns

  1. Lori H. says:

    Thanks for an interesting and informative article. We (www.lookatmyhomes.com) are seeing lots of people in our neck of the woods (western Pennsylvania) considering investing in income properties as a second or third stream of income. Your article will keep them grounded in reality. Right now you can buy relatively cheaply in our area and rent for a good profit, but markets can change.

    I’m curious. Which do you think is the MOST important factor beyond the numbers – location, quality of the property or management needs/skills?

    Liked by 1 person

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