The Deal Analysis Funnel- Single Family Rentals

July 24, 2020

Find Multifamily Part 1 Here!

If you invest in real estate you are going to look at, and pass on, a lot of deals. The only way to filter deals efficiently is to develop an analysis funnel. 

The analysis funnel has a simple principle. You will not accept most deals and thus need to eliminate quickly at the top and as you move down the funnel you review more refined criteria. You will look at a lot more deals than you buy so you need a quick way to eliminate deals without too much work.

Here are my levels of deal analysis. If you have any additional steps let me know. I’m always open to improving:

Market

The first criteria is the market you are looking at. Sometimes that is determined based on where you live or where you grew up. For new investors I recommend to start out investing where they know. Other times it’s based on a detailed analysis of national markets talking in market criteria. This is a whole ‘nother post but let me give you a quick list of things to consider:

  • Population growth
  • Job growth
  • Upcoming development projects
  • New business and business density
  • Avg income
  • Income growth
  • Crime rates
  • Industry type
  • Rent to purchase ratios
  • Distance to other major metros

For me I invest in Houston, because I grew up and live here. It’s the third largest city in the US and has good deals within the many submarkets of the city. I also manage, educate, and partner with investors in the Houston area. All of these factors will make it unlikely I ever completely leave this market. I will give one word of warning. You are much more likely to lose substantially if you go into an unknown market. 

Once you have decided on a market you no longer need to revisit this step every deal.

Property Criteria

The first part of your filter is typically created on your online alert. Use a site such as Zillow or Har.com (Houston MLS) to set up an alert to send you deals that meet your criteria. For single-family homes we recommend that you find 3 bed 2 baths or 2 bed 2 baths with room to add a bedroom. Three bedroom homes are the highest in demand in Houston.

Once you have established your market and your criteria then reach out to agents specializing in investment properties in your markets and wholesalers. There are many local wholesaling groups on Facebook where you can look at a lot of deals.

Back of the Napkin

Now that we have our market and property criteria we will receive leads. The first analysis we will do is what I call my back of the napkin calculation. These are quick calculations that can be done in a few minutes. This will eliminate the majority of deals.

Rent to Price Ratio 

For single family homes I look at the current rent to the purchase price of the home. Let’s say a home currently rents for at least $2500 a month. I want to try and find at least 1% rent to price ratio. For this deal I would want the price to be $250k ($2500 / 1%). If a house is priced at $180K I would want the rent to be at least  1,800 (180,000 * 1%).

Massive Rehabs

This is the number one way new investors lose money. They want the homerun deal on their first property. Don’t make this mistake. It will always cost you more money and time than you think to get your property remodeled, even when it’s minor cosmetic repair. I’ve done over $3M in real estate improvement projects and I just now am starting to feel comfortable about timelines and cost. It’s very difficult to get right. For these types of projects I look at my return on capital. How much money am I going to have to put in and what will be the increase in property value and rent. These formulas are a bit more complicated 

Cash in the deal (purchase cash plus rehab, and holding cost) / new after repair value = Return on capital

My criteria is going to change based on how much rehab work is required. The more work, the higher return I need to justify doing the project. I like for light rehab to be 15-20% return and major to be 25%+. The more inputs you have into your formulas the easier it is to fudge the numbers to get the outcome you want. I recommend that you own at least 3 houses with no or very light (carpet, cabinet paint, backsplash, etc.) rehab work before getting into major projects. Or work with someone who is experienced.

Quick Pro Forma

If the property is within my back of the napkin calculation or within 10% then I will move on to the rental calculator. If you are new, I recommend that you do the Bigger Pockets rental calculator at first. This will show you items to consider for the cash flows on your property. Note that every area is limited and thus you need to talk to local investors or look at a lot of properties to know what is standard in your market.

The calculator does a good job of explaining the ranges to expect for your numbers. Here is a quick rundown of some points to consider

  • Estimate your repair budget (<$10k if new investor) on the high side by adding 25% 
  • Vacancy I like to assume 7%
  • For capex (capital expenditures) if it’s >20 years old I use 10%. For newer houses I will use 5%
  • Maintenance expense I use 5%
  • Management fees I use 8.9%
  • Assume your expected rent 15% lower than you estimate
  • Get an agent to run comps and also look at what is for sale in the area 
  • Never buy in a neighborhood until you have done the numbers on at least 5 properties
  • Get your loan information from a lender of your choice and preferably get pre-approved
  • Get actuals for:
    • Property taxes from the local appraisal district. (ex. HCAD)
    • Insurance from an agent
    • Loan from a lender
    • Utilities from current owner and tenants
    • HOA fees from agent

Make Offer

Once you calculate your cash flow then make an offer at 1.25% of the expected rent less rehab costs expected. So if I expect rent to be $1,400 then I will offer $112,000. This allows you to come up a bit on price if you need to. Note that more often than not your first answer will be no. I’ve now gotten three properties that were all a “No” to start with. Just keep kindly following up every 30 days. My longest negotiated deal was 13 months!

Conclusion

Your first deal is not going to make you rich. Your second deal isn’t going to make you rich. What you are learning is a long term process to true wealth. Your first house will be the hardest. Your 10th house will be immaterial in acquisition and cost. Your 30th house will make you a multimillionaire. Patience is the name of the game.

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