Jorge and Rafi discuss how to evaluate rental properties, including cap rate, taxes, property management fee, vacancy rates, and classification of properties. They also discuss the difference between the 1st and 2nd years that you own the property, and the maintenance reserve.
- Consider the True Cap Rate When Evaluating a Potential Rental Property
- Don’t Be Fooled By A Phony Cap Rate! Verify These Key Components.
00:00 Rafi: Good afternoon, and welcome to… Oops. Oops. I moved it. Welcome to Graystone Investment Group Brown Bag session. I am Rafi, Chief Operating Officer of Graystone Investment Group.
00:11 Jorge: I am Jorge, CEO of Graystone Investment Group.
00:15 Rafi: I’m back.
00:17 Jorge: What do you mean back?
00:20 Rafi: It’s two weeks…
00:21 Jorge: Oh, yeah. You’re back…
00:22 Rafi: From vacation.
00:23 Jorge: From vacation.
00:24 Rafi: In the beautiful Puerto Rico. First, I wanna thank Raymond that helped us in one of the Facebook Live sessions. And also, thanks Stephanie back there. Hey, Stephanie.
00:35 Stephanie: Hello guys.
00:37 Rafi: Stephanie made her much awaited to debut last week. For some reason, it’s the most views we’ve had in any video. Whether I guess, they don’t like to see two ugly guys here.
00:48 Jorge: Yeah, yeah. They don’t like the ugly guys with sunglasses. [chuckle]
00:51 Rafi: Yeah, I know. I know. So thank you very much for holding fort for these last two weeks. And let me tell you, I think it’s a perfect example of why we do what we do. It was two weeks of recharging and one of them, no WiFi, no cellphone signal, nothing. But at the same time, man, the creative juices flowed, a bunch of ideas came out. So, I suggest to everyone, at least once a year, one week no cellphone, no WiFi, no checking Facebook status, WhatsApp notifications, nothing, and just detox your mind, and it works wonders.
01:41 Jorge: Rafi, that’s the beauty of real estate, there’s passive income. And if you do it the right way, and if you put the right processes…
01:48 Rafi: Absolutely. Absolutely.
01:50 Jorge: You could go and have your vacation and not worry about things breaking down.
01:54 Rafi: Absolutely. Absolutely. So Jorge, where can they find us?
01:58 Jorge: Rafi, they could always find us at homes4income.com. That is homes, the number 4, income.com.
02:04 Rafi: Excellent. And make sure that you please share this video in your timeline with your friends, that way they are aware of what we’re doing and all that kind of stuff. Today, we have a topic that has been also something that a lot of people have asked us in terms of, “I hear you guys talk a lot about cap rate”. And in one of the videos, we explain what cap rate is. It’s basically the appreciation rate, the return on your investment for rentals. But a lot of people have asked us, how do you calculate it? What factors, what variables do you use to calculate the cap rate? And that’s what we’re gonna be focusing on today. So again, cap rate, it’s the net return. Basically, the return on your rentals compared to the investment that you have made on that rental. But that means that hey, if you make a $1,000, you have a $1,000 rent on a property, that’s $12,000 a year. $12,000 a year if you made an investment of $120,000 is 10%, right? That’s how you calculate it. Rent divided by investment and that’s it.
03:22 Jorge: Well, actually, that’s a good question, Rafi. There’s two types of cap rates, actually. You have the gross cap rate and you have the net cap rate.
03:31 Rafi: Got it.
03:31 Jorge: And I believe the one that’s worth mentioning today is the net cap rate.
03:35 Rafi: Absolutely. Absolutely.
03:36 Jorge: Because that’s the one that calculates everything. And when you’re calculating the net cap rate, the idea behind it is for you to have a true number. And without true number, some people… So many different people calculate it differently. So a lot of investors come to me and say… Sellers come to me and say, “Oh. This is a great asset. The apartments we were looking at today, the eight units, is a great asset, it’s performing 13% cap rate.” But how are you calculating that? And that’s why I think, that’s why we’re gonna go over it today.
04:09 Rafi: And what you will see is that a lot of the times the sellers won’t quote the gross cap rate which is the one that I just calculated. You have the rent, the value of our investment, and that’s it. But at the end of the day, when you go to your bank, they never give you the gross amount, they always give you the net. It’s like your paycheck, you budget based on your net, how much comes into the bank, not based on the gross and then all that kind of stuff. So, it’s very important that when you are making investment decisions in terms of cap rate, you calculate your own net cap rate after that gross. So you can use the gross as a very broad way of looking at it, but if you want to get into the point of investing, you want to calculate that net cap rate, your net cap rate which again, like you said, some people add or take stuff away. Today, we’re gonna discuss the main expenses that should be part of calculating that net cap rate. Some people add other stuff like financing, stuff like that. It all depends on how you do it. So, what would be the first item, besides rent? So we have rent, that’s the gross. What would be the first thing that you’ll say, “You know what, you need to take into consideration to get to that net cap rate?”
05:31 Jorge: Okay. So obviously, we are evaluating a house, right? So, you have property taxes, is this something important?
05:40 Rafi: Taxes. Taxes.
05:41 Jorge: So, there’s a few things that we’re gonna discuss today. Let’s start with the taxes.
05:45 Rafi: Okay. Government needs to get paid. Uncle Sam, he’s greedy.
05:50 Jorge: And there’s the misconception that people can make mistakes calculating the taxes. They could think that, “I’m gonna calculate my cap rate using the, today’s taxes versus next year’s taxes.” Actually, when you do the cap rate Rafi, to make sure that you’re more accurate, you tend to use next year’s taxes.
06:15 Rafi: Why? I just paid the taxes last year, why use next year’s taxes?
06:21 Jorge: There’s actually a way of most of the series, you can go to their website, the property appraisal tax website whenever they go, and you could actually… There’s a guesstimate calculator there. But taxes, you always leave out this asset for a specific amount of money in the taxes. The new taxes are gonna be calculated based on the higher amount now, the amount that you pay for. So you might enjoy the current taxes for the next six months if you bought it in the middle of the year. But in reality, what you’re gonna be dealing with for the next 10 years, if you own the asset for 10 years is, the taxes on the year two. So you start to calculate it in year two.
07:05 Rafi: Okay. So let’s say that five years ago, the house was sold for $50,000. The taxes that you pay when you bought the houses are based on that $50,000. But then you bought it for $80,000. From now on, the taxes will be based on that new acquisition price of $80,000. So what you’re saying is, since you’re gonna be paying for the next x amount of years based on that new acquisition price of $80,000, use those taxes to calculate your land cap rate.
07:35 Jorge: Absolutely. Be conservative. And by the way, some counties calculate it differently. Actually, there are some counties that don’t care how much you bought the property for, they just take an average of everyone else. The point with the taxes is that you wanna be conservative, you wanna put a little bit of spread when calculating the taxes, 10%, 20%.
08:00 Rafi: And go to our website. Like Jorge said, most counties have their website where you can actually go there, get that guesstimate of how much it is, and then add a little bit of fluff, just to be sure. Just to be sure. So taxes, that’s the one that we always need to make sure that we include in our net cap rate calculations. What would be another expense that you would say has to be part of that net cap rate calculation?
08:27 Jorge: Absolutely. Insurance.
08:29 Rafi: Insurance. Absolutely.
08:31 Jorge: And this is a tricky one because they actually, the company, the insurance company that we’ve been using, Rafi, for the past two, three years, it took us years to find because it’s investor-friendly, not in areas that much [08:49] ____ always as investors the areas that we don’t necessarily need because those properties are not primary properties. And you need somebody, you need a partner in the insurance business to say, “Jorge, this is a 10-unit apartment building. Based on my experience, you should get this type of coverage.” Or, “This is a single family home. Based on my experience, you might not need to do lower deductibles, maybe you could increase them a little bit. It’s in a flood zone, by the way it flood.” A lot of investors don’t calculate flood within the cap calculations. That’s also important. So, get your numbers, and also put a little bit of a fluff there, just in case, when you’re calculating insurance.
09:32 Rafi: I think, again, insurance has to be part of your team, the same way property management has to be, banks, stuff like that. So make sure that again, it’s something that you already are getting the specific insurance that you need. But again, you are including it as part of that net cap rate calculation. And most of the time you pay it on a monthly basis but same as taxes, if you pay it annually, just divide it by 12 and that way when you’re making the net cap rate calculations, divide it by 12 so everything is on a monthly basis. But definitely include taxes and insurance. So we have…
10:08 Jorge: And usually rounded to the next hundred. That’s what we usually do. If it’s 875, 900.
10:14 Rafi: A hundred, yep. Exactly.
10:15 Jorge: 900 is the [10:16] ____.
10:17 Rafi: So, we have taxes, we have insurance, what another expense we should always include when we’re making this net cap rate calculations?
10:26 Jorge: Also property management.
10:28 Rafi: Property management.
10:29 Jorge: That’s an important one. That’s an important one.
10:31 Rafi: Absolutely.
10:32 Jorge: And when you look at the scale of things and look at your taxes, insurance, what you’re paying for that, we’re gonna go over research and all those stuff. The property management being just 10% most of the time is the one that you don’t wanna go cheap with is, the one that is… I don’t negotiate the 1049 as long as, meaning 10 plus what they’ve charged, 10% a month. So, I go with the better service because that’s where your biggest bang for the dollars gotta go. And you’re always talking about that, Rafi, the importance of having the right property manager.
11:07 Rafi: Absolutely. Absolutely. Property management, it’s one that you don’t want to skimp on. Again, I’m not saying, don’t shop around but make sure that you are getting as good a service as possible because you may save 1% but then you don’t get the kind of quality process that you need to be able to create that lifestyle passive income process. But definitely something that in this net cap rate calculations, you have to include property management. And remember, most of the time there’s a new lease fee, there’s a couple of initialization expenses. Right when you start, make sure you include those on that first year. And that’s one thing that… Remember that first year cap rate, most of the time is gonna be lower than the cap rate in the other year. The good thing about that is, if you’re conservative and the first year numbers work, then after that it’s gonna be a piece of cake, most of time. Because most of the expenses… Again, that first month deposit that a lot of property managers require and that kind of stuff, most of those are expensable on year one. Year two and above should be a better cap rate. So use that first year to make your decision because, hey, that’s probably most likely the lowest cap rate you’re gonna have in your property. After that, those numbers are gonna look better and better as the property seasons.
12:41 Jorge: Yeah, and just to repeat what you said about finding the tenant double fee, allocating the tenant fee that the property managers charge. 99% of the time when people are calculating the cap rate, they do not include the…
13:01 Rafi: [13:01] ____.
13:01 Jorge: We do. We base it on our percentage and say, “Okay, either half a month or a full month.”
13:07 Rafi: That’s big.
13:08 Jorge: But that takes a big chunk of your first year. But don’t worry about it, it’s like I said, the first year is your try out. Worry about year two, ’cause the first year there’s so many things that could come up that is not really realistic to count on that cap rate.
13:22 Rafi: Absolutely. I just saw Stephanie put there the website for one of the counties here in Tampa. Is that Hillsborough?
13:33 Stephanie: Yes, that’s Hillsborough County.
13:35 Rafi: [13:35] ____.
13:38 Rafi: Hillsborough County is there. So for those of you looking for tax information, you can go there.
13:46 Rafi: And we are back.
13:48 Jorge: You turned off the wifi… Alright.
13:50 Rafi: Yeah. Sorry for that, we had some technical difficulties here. I know Alan, I know. We have to find a way to connect to a better WiFi signal. I know. Working on it. [laughter] So we already talked about taxes, we talked about insurance and we talked about property management. I think those three are three that most people will…
14:13 Jorge: Get.
14:13 Rafi: Get. And I will say probably 80% to 90% of the time when we see, well, given those cap rates, they include those threes. But we will talk about two now that I think are the two most missed expenses to use when calculating your net cap rate calculator. The first one is one that, man… We have people fight on this one. We have people saying, “Oh, my property will never be vacant”, whatever. The next one is huge. I just gave it away. Which was the next one?
14:47 Jorge: It’s vacancy, the vacancy factor…
14:49 Rafi: Vacancy.
14:49 Jorge: Yes.
14:50 Rafi: But wait. They’ll say, “Wait, wait. Tampa is the best rental market out there. What are the vacancy rates?”
15:00 Jorge: Right now, I was checking 2.9%.
15:02 Rafi: 2.9%.
15:02 Jorge: So lets call it 3%.
15:03 Rafi: 3%?
15:04 Jorge: Yes.
15:05 Rafi: Why calculate vacancy on my net cap rate calculator? I’m gonna have my property rented all year. I have the best tenants ever.
15:15 Jorge: That’s not the way to do it. That’s not the way to…
15:17 Rafi: Period. Why?
15:19 Jorge: Well, that’s just like saying you’re buying a stock in the stock market and saying, “Oh, it’s been doing fine for the past five years and all of a sudden something happened and then…
15:30 Rafi: It will always go up.
15:31 Jorge: You’re crashing.” So even if it’s not relevant in 2017, let’s say you dodged the bullet in 2018, and it becomes relevant in 2020, then at least you can average it out by having a back-up plan and calculated from day one. That make sense?
15:54 Rafi: Absolutely.
15:55 Jorge: You calculated from day one and let’s say nothing happens, then that’s a cushion that gets rolled over. But you wanna calculate it before you make your investment. You wanna calculate that to make sure you get in the right investment.
16:06 Rafi: And besides that, there’s so many factors that influence vacancy. You can have the best tenants in the world, change of jobs, health issues, family health issues, mom and dad something happens to them, Dios bendiga a los mios. There are so many variables that impact vacancy. You can have again the best tenants, the best paying tenants, but something happens. That the market is great and you still have to factor that in. And by the way, just think about it this way, if you lose one month of rent, that’s 8.3% impact on your overall rent. 8.3%. So when we’re talking about 2.9% vacancy, I always suggest, even on markets like Tampa, where it’s 2.9%, to use at least 5%. Again, this is where your team has to be part of it. If you know that you live in an area where the vacancy rates are 5%, 6%, I would probably put 10%. I would double the market vacancy and use that as my vacancy numbers when calculating a cap rate. Do you agree?
17:22 Jorge: I totally agree. Obviously, Rafi, it depends on the area and what type of a property it is. If it’s a property that’s qualified, classified as an A plus property or B plus or B minus or C, you’re gonna adjust that a little bit because with the A plus properties, meaning higher end type of properties, tend to be a little better with vacancy. But in the worst case scenario? One month.
17:49 Rafi: I will say at least.
17:50 Jorge: To be conservative? One month.
17:52 Rafi: At least. And if you ask any property manager out there, they’ll tell you that it takes 15 to 30 days to bring in a new tenant. So remember, not only you’re gonna lose that month’s rent, you’re also going to lose that first month because the new tenant fee that the property manager is gonna take. So, vacancy is that one expense that can kill you. That can kill your investment.
18:19 Jorge: And some people say, “Well, I have the deposit, so I could always hold on to that.” But guess what? Guess what, guys? Sometimes the deposit is not enough, not enough to cover repairs, or…
18:32 Rafi: I was gonna say, forget the deposit for rent. 90% of the time, the deposit’s not enough to recover and turn that rental for the new… So, the deposit is out of the question. That’s fluff money that if you need to use it, most likely it will be to repaint, put new carpets and do some things, what they call turn the rental to the new tenant. So, vacancy is one of those expenses, guys, you need to make sure that you calculate, that it is part of your calculations of the net cap rate, because maybe not this year, maybe not the next, but you will be hit by that.
19:11 Jorge: Absolutely. Absolutely.
19:13 Rafi: The next one… So, again, to recap, we have talked about taxes, insurance, property management fees, vacancy rate, and the next one sounds like a no-brainer, but again, it’s one of those that we have seen people miss a lot. And it is maintenance reserve. Talk a little bit about maintenance reserve, Jorge.
19:38 Jorge: Well, this is a good one and we can say so much about this, but I will start with making sure from day one, Rafi, when you get the property that the rehab is done the right way. So, you could try to avoid it as much as possible. That’s a layer of protection, that’s your first layer of protection.
19:55 Rafi: Now, when you say don’t run away, again, and we talked about this in one of the previous videos, but when you’re rehabbing for a rental, what are the things that you want to make sure that that contractor is thinking of when they’re rehabbing a property for renting purposes?
20:10 Jorge: Well, we mentioned this before, the four point inspection. So, there’s four points that are extremely important, which is the roof, the plumbing, the electrical, and what is the last one, Rafi?
20:24 Rafi: AC.
20:25 Jorge: AC.
20:25 Rafi: In Florida?
20:28 Jorge: So, as long as you have those covered, you can see where everything else would be cosmetics, and you might be okay, but you gotta make sure those four are covered.
20:37 Rafi: And pay for a four point inspection. Four point inspection is $200-300, but it’s worth it. And the other thing that you need to make sure that when you’re rehabbing your contractor… Well, first, get a contractor who has done rentals. That’s almost a given, but get someone that has done rentals. And then, even on the cosmetic stuff, focus on long term usability. You don’t want the latest toilet that has the little button and this button for one, and that button for two. You want something that can be flushed a thousand times and it works. So, even the materials they use during the rehab, you’re looking at, not just cosmetically, but in terms of longevity, and that’s what you’re looking for in terms of rentals. You’re looking for longevity. Why? Because if that toilet flushes a thousand times that means no cost. No cost and that’s what you want. You want no cost, no expenses.
21:40 Jorge: You want a Tonka versus a Hot Wheel. That’s what I’m talking about…
21:44 Rafi: Tonka. I remember those. Tonkas, yeah.
21:48 Jorge: Even though they’re not the prettiest but they’re heavy duty and that’s what you’re looking for. So, with that said…
21:54 Rafi: But still, maintenance reserves.
21:57 Jorge: Maintenance reserve, I will say also 5%, 5% to 10%, but that’s the beauty about maintenance reserves in vacancy. That they’re separate, but at the same time, they could help each other.
22:13 Rafi: Impact each other.
22:14 Jorge: Impact each other. So, you could calculate it as a whole and say, “We’re gonna save 20% for both,” or you can calculate ’em separately. But guess what? If you don’t have vacancy, you still calculate it at 10% for the vacancy, you could use it for repairs. And if you don’t have repairs, but you do have vacancy, you could cover that, the repairs. So, they go hand-in-hand, and as long as you calculate it, you’ll be more safe at the end.
22:39 Rafi: And not only that, they go hand in hand because a tenant that has no issues with the property stays longer. So, of course, what we see is, oh this property has a high vacancy rate. Yeah, but the work was not quality work, so there were a lot of maintenance expenses. So, most of the time, it’s like that. The one with the highest maintenance expense have the highest vacancy. But that’s because you didn’t probably spend the money on the original rehab to have the Tonka approach. And that’s when things snowball. Now, in terms of maintenance reserve, what’s your recommended amount?
23:18 Jorge: I would say 10% of your purchase price or 0.10. So if you’re buying a property for $50,000, $500. If you’re buying a property for $100,000, $1,000. But like I said, that’s taking into consideration that you took everything else in account, including the vacancy and everything else, because you’ve been extra conservative on everything else and if you have to dip into the vacancy budget, you’re able to take some money out of there. But the same, if you want to be conservative, one month. So, one month for vacancy, and one month for maintenance reserves.
24:03 Rafi: Absolutely. And again, we can’t stress enough, that is assuming that you did a rehab focused on rentals. If you did a flip rehab and then you rent the property, watch out. Because you had that beautiful granite, and again that beautiful LED light hanging from the ceiling with the pendant, whatever, and that’s the first thing that breaks. And because you did it for a flip, you bought a $200 pendant and now you have to replace three of those, that’s $600 gone. So, make sure that that rehab, it’s a rental rehab. And then calculate for that one month, and like we said, every year, as the property seasons, things should go down. With maintenance, it’s probably the opposite. With maintenance, it’s probably one that you, the first year, because you did a good rehab, you know what, maybe maintenance expenses that first year are not that high, but then as things progress start inching up that maintenance because that A/C that had five years left, that means that next year it has four.
25:09 Jorge: Or roll over. Roll over the fault from year one to year two.
25:13 Rafi: And one thing that you can do is open an account for it. I think if you’re disciplined, just open an account and just put that month’s rent there. To your point, you leave it there. Next year, you put another month, so now you have two month’s worth of maintenance there. And the great thing about doing it that way is when it happens. When, not if. When it happens, you can go to account. It doesn’t hurt your cash flow at that moment, because you already were planning for it.
25:42 Jorge: Absolutely.
25:43 Rafi: Make sense?
25:44 Jorge: Absolutely.
25:45 Rafi: Excellent. So, to go over the five things, the first one: Taxes. Government needs to get paid. Insurance. Property management.
25:54 Jorge: Number three.
25:55 Rafi: Vacancy.
25:56 Jorge: Four.
25:57 Rafi: I like that. Four. And the last one. Maintenance reserves, number five. Now, those are the five that we’ll discuss today, but there’s a bunch of other little things that you can add to research. For example, if you decide to pay someone to keep up with the yard, all that kind of stuff. So, those are expenses that you know. Make sure you include them as much as possible. Those are the top five that we say every single net cap rate should have at least those five.
26:30 Jorge: Absolutely. And the idea about doing this video is that so you have the location, next time you get presented a property and you think it’s a decent deal, check it out again. Do your own calculations. By the way, there’s a lot of cap rate calculators you could find online.
26:47 Rafi: Absolutely.
26:48 Jorge: Google them, like you said. There’s thousands of results. So, make sure that you understand that what they’re saying that you’re getting is exactly what you’re saying. Now, you could confirm it by doing your own evaluation.
27:02 Rafi: Exactly. Stephanie, do you have any questions out there or anything that…
27:07 Stephanie: I don’t see any questions.
27:10 Rafi: We don’t see any questions. Guys, remember to share this video in your timeline with your friends, so they know that we are here every Friday around 1:00 PM-ish. Next Friday, we have to see because we are going to a golf tournament next Friday, so we have to find out if we can do it from there. We’ll let you guys know.
27:30 Jorge: Or we just let Stephanie do it.
27:33 Rafi: Ah! Stephanie by herself?
27:36 Jorge: She’s looking at us like, “I’m gonna kill you, Jorge.”
27:39 Rafi: Excellent. Well, let’s tell them where they can find us.
27:43 Jorge: They could always find us at homes, the number five… No. I got you. Homes, the number four.
27:51 Rafi: Homes4income. Homes, the number four, four income. Again, we’ll see you next Friday on our Graystone Brown Bag sessions. I am Rafi.
27:58 Jorge: And this is Jorge. See you next week.
28:00 Rafi: Thank you very much for your time and see you next week. Bye.
Graystone Investment Group
Graystone Investment Group is an experienced real estate wholesaler in Tampa Bay. We serve clients who flip homes in as little as 30 days, as well as clients who hold high cash flowing rental properties.
Unlike other wholesaling groups, we provide clients with a turnkey process at no extra charge. We find properties that we resell to investors at discount prices, while also connecting them with private financing. We also coordinate with rehab and management companies we’ve worked with for years.