Basic Guidelines for Rental Properties

I decided to finally try to purchase a rental to start trying to build up some cash reserves. I've read some books on the subject and the main thing people say is to make money using other people's money. They want you to get hard money loans for the down payments.

Let's talk about this a little. Obviously if you pay zero down, your loan will be larger and your monthly payments will be larger. And if your monthly payments are larger, there is a higher probably that you will default on your loan.

On the other hand, if you pay all cash for a property, there is virtually no risk (although you still have to pay taxes and the property is susceptible to damages). This is because you don't owe any money and there is no way to default.

So, perhaps there is a happy medium. As an investor you want to maximize your rate of return on investment. Here are the numbers with the property I am purchasing. I hope to buy a $55,000 property, and pay $11,000 to avoid mortgage insurance. This will allow me to have less risk since this is a first property. I shoot for a R/V ratio of 1% (1/100 of the value), meaning I want to rent for $550 per month. Most real estate people say to estimate 2 months of vacancy per year. If the mortgage payment on my $44,000 loan is $325, that leaves $225 per month or $2250 per year of cash flow. Placing $250 into the home might leave a $2000 return on my $11,000 investment which is 18%.

On the other hand, if I paid $55,000 cash, I would have $5500 per year minus $250. That would be a $5250 return on my $55,000 investment which would be a 9.54% return.

Now, these calculations lead me to understand how much a house should be valued at. Based on the paying all cash, you would see that a 5% or 10% return is reasonable, meaning you should pay between 100 to 200 times the amount you would rent a house for.

So, here are some quick rules of thumb.

1. Paying 20% down is the standard way to balance risk versus reward.
2. An investment rental should be purchased at a R/V ratio of 1%.
3. A home has intrinsic value of about 100 times monthly rents.
4. An ideal sale would be at a R/V ratio of .5% (200 times monthly).
5. Placing 20% down on a R/V ratio of 1% should earn about 18%.

Here are some other interesting tips.

1. Purchase cheaper homes that allow multiple people to afford rent.
2. Purchase multiple unit properties (easy to obtain R/V of 1%).
3. Purchase during down cycles (1%), sell during up cycles (.5%).
4. Make money based on R/V.
5. Don't purchase assuming an appreciation, let that be an added benefit.

This post was reposted from http://sizuservices.blogspot.com/2010/08/business-business-business.html, originally written on August 12th, 2010.