Make Sure Your Rental Property Always Has a Cash Flow Using the Correct Formula Before You Buy!Posted on October 9, 2013 by
I spent the last weekend attending a training event put on by one of the premier real estate teachers in the country today. As I listened to her teach phenomenal content, I kept hearing her talk about the MAO formula to determine the most that anyone should pay for any property. The basic MAO formula is… “The After Repaired Value of the subject property X 70% less Repair Costs = the most you should pay for any property” when using institutional or private financing.
As she talked, I kept thinking to myself, what if the buyer can’t qualify for institutional financing? What if private financing isn’t possible either? What if the buyer doesn’t have someone lined up who can get institutional or private financing? If that is the case what good is the MAO formula to the buyer?
Sure, I know the buyer could use a Hard Money loan to fund their deals and there is a formula for getting a Hard Money loan too. The basic Hard Money formula used in my area is… “The After Repaired Value of the subject property X 65% less the Lenders points and fees = the most that can be borrowed on that property”. The biggest problem I see using Hard Money loans is if the borrower can’t get the property they are buying resold quickly. Most hard money loans are short term, usually one to two years in length and if the property hasn’t sold and the Hard Money loan becomes due and payable, the borrower may find it impossible to find other financing to replace the Hard Money loan and could lose the property.
Many of you know I buy property from people who do not live in the properties they own that are completely paid for and have no debt owed on those properties. The beauty of what I do is the property owners and I can make a deal because the properties are Free & Clear with no debt owed to pay off. This allows us to put together a deal that will work for both of us. I buy properties with no debt on them and I pay the seller every month instead of paying a bank. When buying a free and clear property you are buying the sellers equity in monthly installments. They are not making you a loan. If you plan to keep a property long term and you won’t ever need to get an appraisal to get institutional financing, or if you plan to wholesale the property to someone who will need to get an appraisal, the price you pay for that property is far less relevant. If a rental property is purchased correctly, it should never cost the investor who is buying the property one red cent. The tenant should pay enough rent each month to cover all costs of owning that property and also give the investor a cash-flow each month.
Let me show you a simple formula I use every time I am buying a rental property to make sure I never pay too much for any property. The formula looks like this.
I always start with what the subject property will rent for each month.
Here is an example.
|$1,200||What the property will rent for each month|
|–||$100||1/12th of the Annual Property Taxes|
|–||$50||1/12th of the Annual Property Insurance Cost|
|–||$120||10% of the monthly rent for Maintenance Costs|
|–||$60||5% of the monthly rent for a Vacancy Cost|
|–||$120||10% of monthly rent for Property Management (if used)|
|–||$200||How much I want as my cash-flow each month|
|=||$550||Which is what you have remaining each month to make a payment with.|
This type of property should never cost the buyer one penny to own simply because the tenant provides the money they give you each month as rent to make the monthly payment. I am less interested in how much I pay for most income properties because (as in this example) if the seller is willing to accept as a monthly payment how much remains after all costs of the property (in this example you shouldn’t pay more than $550 each month until paid in full) we can make that deal work. This example would be 0% interest financing. When using this formula you should pay less attention to what the seller is asking for the property and concentrate more on what you can pay the seller each month from the rent the property generates each month. It is possible to pay what the seller is asking for the property if the seller is willing to accept a payment of what you have remaining after all costs of the property (or $550 in this example) as the monthly payment for that property. This formula can tell you exactly how much you should ever pay for any rental property.
If you use this formula when buying income property that you plan to keep for the long term, you will never over-pay for a rental property again. Remember, the tenant pays for the property from the rent they pay each month and if all of the above costs are not covered you shouldn’t buy that property.