In economics, the term “rent ratio” has a very specific definition and use. It is a macroeconomic measurement used to determine whether it is more efficient to own or rent in a specific city. Economists divide the Average List Price of homes in a city by the Average Annual Rent of two-bedroom apartments, condos and townhomes.
That’s all well and good for economists, but it’s not a very useful number for property managers. Most of us use the same term for a different application and formula. We use it to determine how much we should pay when purchasing a rental property. The formula we use is the likely Gross Monthly Rent divided by the Rate of Return we want to see.
Each investor has a different level of expectation based on their own desires and needs. According to Chris Clothier of Memphis Invest a provider of turn-key rental investment services, his criteria is between 0.8% and 1.2%. At a Memphis Invest event this Spring, Paul Shively (Director of the Fortunebuilders Passive Income Club) agreed with that goal. In fact, when another rental owner asked why he didn’t want a higher number, Paul answered succinctly, “Because those deals generally don’t exist.”
How the Formula Works
I’ll get into how that ties into today’s title in a moment. First let’s look at applying the formula to a real deal.
I like to go for the middle of Chris and Paul’s range. If a quick look at the numbers shows a 1% return, it’s worth a closer look. In fact, I refer to this formula as my 1% Rule. Here’s how it works:
A few years ago, I looked at a potential rental. Before I asked the price, I asked Carol what the property should command in rent. She said I should be able to get about $1200 a month. Quick calculation: 1200/1%=$120,000. The asking price was $110,000, so we were on. After walking through the property, I estimated it would need about $10,000 to get it ready to rent. That put my total in at $120,000, exactly what I wanted. But that didn’t include closing costs and overages. I was able to negotiate down to $105,600. The actual repairs came in at roughly $12,000. My total investment was about $117,600, yielding a rent ratio of 1.02% because Carol’s rent estimate was spot on, as usual.
That was a very good deal. They are hard to come by in the Austin Market. (I won’t go into what my current return would be if I hadn’t sold it a couple of years ago.)
What If the Numbers Look Too Good?
So now we come to today’s title.
I got an offer from someone wanting to sell six duplexes as a package. The asking price was $275,000, and each duplex was “fully leased” at $375/door. That means the properties should produce $4500/month in gross rents. Applying our rent ratio formula, I should be willing to pay $450,000 for the package, not the $275,000 asking price. The rent ratio was 1.6%. Remember what Paul Shively said? That’s a red flag. The deal is just a little too good to be true.
But I’m human. So I drove 75 miles to take a look in the vain hope that a 1.6% ratio was possible. Nothing beats using your own eyes to scope an investment.
While the town the duplexes are in is impressive and growing, the area around them appears to be in decline and overdeveloped with rental properties. Two nearby apartment complexes with blocks have large banners touting “Move-In Specials” and “Free Rent.” And even though there were nice single-family homes nearby, the blocks immediately surrounding the properties were filled with other decaying duplexes, Class-C apartments, and empty businesses.
Taking all that into consideration, my instincts were to flee. Given that better maintained properties were offering “free rent” as a move in special, my gut told me that there was no way these properties was generating stable rental income. Even if they were “fully occupied,” I have trouble believing everyone is actually paying the rent every month. Why should they? They could just move to a nicer property and get free rent.
All that means is that this package wasn’t a good investment for this hermit. It doesn’t mean someone who was willing to actively manage the properties—someone who didn’t have to travel 150 miles to collect the rent or deal with other issues—could turn these duplexes around and make a tidy profit over time while providing safe, affordable housing to people who need it. That someone would have to also buy up most of the surrounding properties to be successful.
I’m not going to go as far as one of my previous managers, who said, “Figures don’t lie, but liars figure.” But I am going to say you should never take on more risk than you are comfortable with, no matter how good the figures look.
So what good (other than not buying a bad investment) came out of driving 150 miles to look at a property I don’t want to buy? I have a much better opinion of the the economy of the town, and I’m more likely to buy properties in other neighborhoods there.