How do you know if a loan is a good idea for an investment property? I get this question a lot so I figured I would share how we do it.
I am going to write about how we evaluate our real estate investments, although the same rules can apply for an investment in a non-real estate asset too. But for simplicity sake, let’s say we are evaluating a rental property.
I’ve written a lot about using private money to finance investments. For the purpose of this post, let’s say it does not matter how you finance an investment. It could be with a bank. It could be from your Aunt Mildred. The point is that some of your investment is going to be financed and you want to know if it is worth it. So let’s run some numbers on what we will call “debt service.” Does it make sense for you to pay for money to secure a given investment? That’s what we are trying to get at here.
When you secure financing for your investment, you agree upon terms. Those terms are as follows:
How much money are you borrowing?
How long as you borrowing this money?
What happens at the end of that time frame? Is the loan paid off or is there a balloon payment due at the end?
What interest rate are you agreeing to pay to the lender to borrow the money?
Is there a penalty to you the borrower if you’d like to pay off the loan early?
Before you figure out these terms, you need to know what the property in question can make back. Presumably you know what it currently rents for or what it can rent for. If you do not, check Rentometer.com to get an idea of how a property in the given zip code can perform.
Now you’ve got an idea of what property can make per year. But of course you don’t keep every penny in rent. As the landlord, you will pay for taxes, insurance, and repairs, as well as any legal fees necessary. You also want to account for possible vacancy between tenants. And possibly debt service. So the question is: can your property make enough to pay for all of the above expenses and still make you money? If not, can it make you money in the near future?
In order to be conservative, we take the annual rent roll, which is the monthly rent times 12 months, and slice off 40% for taxes, insurance, legal fees, and vacancy. This is an industry standard and usually pretty safe. Now you’ve got a new yearly figure. Divide that by 12 to see what this property makes you per month and ask yourself: can I afford debt service in that number? Remember, debt service is not taken into account in this 40% slice. We are going to account for that next.
What will you pay to borrow this money? I keep a free and easy Loan Calculator app on my phone for when I’m toying with numbers on the go. But Bankrate.com also has a good loan calculator that allows you to play with the terms. This is important. Change the numbers around to see what works for you. Change the terms (time and interest rate) and see what happens.
It is important to note that loan calculators differ if they are interest-only or amortized. Make sure you are using the correct online calculator when toying with the numbers! Here is a good interest-only loan calculator. Here is a good amortized loan calculator. Bookmark them!
I use a spreadsheet to evaluate several terms against each other to see what works best for us. A spreadsheet which I will happily share with you! Click here to get it!
In this spreadsheet, you will have to input all the cells in green. Meaning you have to calculate your monthly payment on the loan yourself using the tools I describe above. The spreadsheet’s calculations should do the rest for you.
Next, simply see if you can afford any given debt service. In the spreadsheet I just gave you, you will see that an interest-only loan will cash flow for you nicely but you have to have a plan to pay off the balloon payment at the end of the terms. Maybe you save up for it with the cash flow or some other way. You’ve got to be pretty sure in your plan to do this because a balloon payment at the end of a loan is a rude awakening if you haven’t been planning for it.
Or maybe you amortize your loan. You’ll see that short-term amortized loan is expensive but a longer term, lower interest loan is not so bad. And of course a lower interest rate is always in your favor. Find the terms that work for you!
Now you work your magic to find this loan! That is the subject of a whole other blog post and the subject of one of my favorite books by Susan Lassiter-Lyons called Getting The Money.
Another way to “fiddle” with these numbers is lower the loan amount. Can you put some of your own money into the deal to reduce what you are borrowing? Play with that too.
My husband likes to say that you should invest in a property if it cash flows even $1 per month because it means that it is paying itself off and you will eventually reap many rewards. This is certainly how you build a portfolio: secure investments that cash flow above their cost. However, $1 per month in cash flow is hard to stomach. I’d say you want to get closer to $100 per month in cash flow for the deal to be worth it to you. Remember, you are trying to build a nest goose portfolio. This calculation is an important part of a larger plan. You have to be able to see it as a whole, as well as individually. That is what prudent investors do!
I hope this helps you begin to see your debt service as a moving target. Remember, debt service is not just up to the banks. It is up to you too. There is opportunity for creativity here. You are in control far more than you know!
As always, I welcome your comments, questions, and corrections too!
Disclaimer: I am not a financial professional. I just play one on TV. This blog is not to be construed with personal financial advice. It is my attempt to share with you what I have learned on my road to building my own family’s wealth. I hope you enjoy it!