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Analyzing Real Estate Deals: Rules of Thumb You Need to Know

Hey, everyone! This is Kaylee McMahon with our Tea by Kaylee, joined by Jason Bible from Mr. Texas Real Estate. We’re diving into crucial rules of thumb for analyzing real estate deals today. These guidelines are essential whether you’re dealing with single-family, multi-family, or small multi-family properties. They help you sift through deals quickly and decide if they’re worth your time for detailed analysis.

What Are Rules of Thumb?

Rules of thumb are quick, general guidelines used to make decisions easier in various situations. In real estate, they help you determine whether a property is worth further investigation or if it should be discarded. Think of them as your first line of defense against a bad investment. When brokers or wholesalers send over deals, you can use these to quickly assess if a property is worth your time.

Vacancy

Understanding Vacancy

Vacancy refers to the percentage of all available rental units that are unoccupied at a given time. It’s a crucial metric because it impacts your rental income directly. To get accurate data, you can consult sources like CoStar, LoopNet, or your local MLS.

Rule of Thumb for Vacancy Rate

A general rule of thumb for vacancy rates is to assume anywhere from 7% to 10%. This assumption helps you project your potential income more accurately.

Economic Vacancy vs. Physical Vacancy

What Is Economic Vacancy?

Economic vacancy takes into account units that are occupied but not generating income, perhaps because tenants are not paying rent. This is different from physical vacancy, which only measures whether a unit is occupied.

Why Economic Occupancy Matters

Economic occupancy measures the percentage of units where tenants are actually paying rent. This number is more important than physical occupancy because it reflects your real cash flow.

Bad Debt

Defining Bad Debt

Bad debt is essentially unpaid rent or outstanding balances from tenants that you’re unlikely to collect. This often includes tenants who live rent-free or those with overdue rent that’s never going to be paid.

Accounting for Bad Debt

When analyzing a deal, it’s crucial to factor in bad debts as they can significantly impact your net operating income (NOI).

Lost to Lease

What Is Lost to Lease?

Lost to lease is the difference between the market rent and the actual rent you’re collecting. This can happen due to concessions or simply because rents haven’t been adjusted to market rates.

Rule of Thumb for Lost to Lease

A common rule of thumb here is to assume 3% to 5% lost to lease. This gives you a conservative estimate to work with before diving into the actual financials.

Concessions

What Are Concessions?

Concessions are incentives you offer tenants to sign leases, such as one month free rent or gift cards. These can significantly impact your effective rental income.

Rule of Thumb for Concession Levels

If concessions are over 3%, it’s a red flag. Excessive concessions can indicate a problem attracting tenants at market rates.

Closing Costs

Single-Family Homes

For single-family homes, you need to consider several costs:

  • Agent Fees: Typically around 6% of the transaction price.
  • Title Costs: Usually 1.5% to 2%.
  • Concessions: Budget around 2% for potential concessions, repairs, or seller contributions.

Multi-Family Properties

Multi-family deals have additional complexities:

  • Acquisition Fees: Can vary widely from 0.5% to 6%.
  • Legal Costs: Ensure you account for legal fees during the transaction.
  • Title Fees: Similar to single-family but can include additional administrative costs.

The 1% Rule

Understanding the 1% Rule

The 1% rule states that monthly rent should be at least 1% of the after-repair value (ARV) of the property. For example, a $100,000 property should rent for at least $1,000 a month.

Using the 1% Rule

Properties meeting the 1% rule are generally good candidates for rental investments. If the rent is less than 1%, the property may be better suited for flipping. However, remember to account for higher tax rates in specific areas, as well as differences between condos and townhomes.

Rent Growth Assumptions

Avoid Linear Projections

Rent growth isn’t a straight line; it’s often non-linear. Historical data shows that rent growth can be “lumpy,” with periods of stagnation followed by rapid increases.

Rule of Thumb for Rent Growth

Assume a conservative rent growth rate of 2% to 3%. Looking at historical rent growth can also guide your projections. Houston, for example, saw rent growth of 0.9% over the past year, despite a long-term trend of about 3% to 5%.

Expense Growth

Understanding Expense Growth

Expenses like taxes and insurance tend to rise over time. These need consideration when projecting future costs.

Rule of Thumb for Expense Growth

Estimate around 3.8% for annual expense growth. This figure helps account for increasing taxes and insurance, which have been on the rise.

Protesting Property Taxes

It’s crucial to protest property taxes every year. Utilize professionals who specialize in this to ensure you get the best assessment possible.

Cap Rates

What Is a Cap Rate?

Cap rate (capitalization rate) is a metric used to evaluate the profitability of a real estate investment. It’s calculated by dividing the NOI by the property’s value.

Calculating Cap Rates

The formula is:

Cap Rate = (Net Operating Income ÷ Property Value).

For example, if a property has an NOI of $1 million and is valued at $10 million, the cap rate is 10%.

Differences in NOI Calculation

NOI calculations can vary based on property types and the expenses included. It’s essential to standardize these calculations when comparing different properties.

Other Metrics

Debt Service Coverage Ratio (DSCR)

DSCR is another crucial metric, measuring a property’s ability to cover its debt obligations. It’s calculated by dividing NOI by debt service (principal and interest payments).

Why DSCR Matters

A DSCR above 1 indicates that the property generates enough income to cover its debt, reducing your financial risk.

Final Thoughts

Understanding these rules of thumb can significantly ease your initial deal analysis. They provide a quick way to filter out deals that aren’t worth your time, allowing you to focus on those with real potential. Whether you’re looking at vacancy rates, economic occupancy, bad debt, or cap rates, these guidelines will help you make more informed decisions.

Invest smart and always do your due diligence. Happy investing!

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