For the past several years there has been high demand for investments in single family homes as rentals and the large supply of foreclosed homes has helped to feed this demand. Having worked with hundreds of these investors, we have seen great success stories as well as great failures. The difference between the successes and failures typically comes down to two things, deferred maintenance of the home and replacement reserves.
Deferred maintenance is defined as items that need repair or have needed repair for some time but are not being addressed. Many times when an investor buys a single family home for a rental investment, they fail to look at the cost of getting the home where it is in rent-able condition and keeping it there. This is especially true in older, lower dollar value homes, where there is a limit to the amount of rental income a tenant is willing to pay. Additionally, rental homes that are in high crime areas tend to have more vandalism issues and therefore higher costs to maintain the home in rent-able condition.
The key to determining the deferred maintenance of a potential rental home investment starts with a good home inspection before the purchase, but it does not end there. Once the deferred maintenance items that need immediate repairs are identified and quantified, the next step is to determine the life expectancy of the other major items in the house and begin to reserve money each month for their ultimate replacement. These funds are called replacement reserves. If, for example, there is a an HVAC unit in the home that is 10 years old and the life expectancy of the unit is 15 years, there needs to be enough money put away each month for the next five years to have that money available at the end of the life expectancy. These replacement reserves need to be factored into any calculation when determining if a rental property can be profitable. Here is a simple formula to use when trying to factor in deferred maintenance costs and replacement reserves into the profit and loss of a single family home:
Cost of purchase of the home + Cost of Deferred Maintenance items to make home rent-able multiplied by 1.1%. This is the estimated monthly number that you will need in rent to cover the servicing of the debt (if there was a loan) or the cost of capital + taxes + insurance + replacement reserves. If the market will not bear that much rent for the home, then you probably should not make the investment, as the property will not cash flow. Here is one final example with actual numbers filled in:
$50,000 home purchase +
$10,000 in deferred maintenance
$60,000 X 1.1% = $660 per month in rental income.
$6000 to replace the roof in 5 years = $100 per month for replacement reserves
$6000 to replace HVAC, carpet, and water heater in 5 years = $100 per month
$1800 per year in taxes and property insurance = $150 per month
This leaves $310 per month to either service the loan on the house or to have a 6.2% return on the $60,000 that was initially invested.
One other helpful hint is to use a real estate agent to assist with your purchases. Typically there will be no cost to engage a buyers agent, as they will receive their commission from the seller and their expertise can often times greatly assist with making good purchasing decisions.