We are taking an objective look at what makes a rental property a good investment and are analyzing a six-unit residential property I have for sale on Randolph Street in Napa as an example.
In Part 1, we found how income determines the value and placing too much significance on appreciation may prove to be speculative. We then briefly discussed determining gross operating income.
Let’s discuss operating expenses and how financing fits in.
Then we will wrap up with a discussion of cash flow and a few key financial indicators in Part 3.
Randolph Street expenses
In Part 1, we found the annual gross operating income to be $120,840. In analyzing whether this property is a good investment, we subtract the expenses it takes to operate the property.
Keep in mind the debt service (loan payments), cash reserves and leasing commissions are not a part of the operating expenses.
Our goal is to examine the investment property as it stands no matter who the buyer may be.
We may have an all-cash buyer or a buyer who puts the minimum down payment or a buyer who likes a large cash reserve.
Therefore, we leave the variable expenses out of this part of the analysis.
For Randolph Street, we have property taxes, property insurance, property management, repairs and maintenance, common area gas and electricity, water, trash service, sewer service, landscaping service and a couple of minor expenses.
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The total annual operating expenses to a new buyer will be $41,821. These expenses will not represent what the seller is currently paying—at least not in California.
In California, the value of a property is reassessed with every sale to determine the new property taxes. Prior to that, the seller was paying property taxes based on the value when purchased plus annual nominal increases.
The aggregate tax rate for Randolph Street is 1.1367 percent of the new assessed value. For this analysis, I used the market price of $1.7 million to arrive at a new annual property tax assessment of $19,324.
There may also be an adjustment in property insurance depending on whom the buyer uses and if they have a portfolio of other investment properties or a single property under their account.
There may be other adjustments as well to service contract providers.
After subtracting the total operating expenses from the gross operating income, we arrive at an annual net operating income of $79,019.
How do we handle financing for Randolph Street?
As I mentioned, financing is specific for each buyer, but in our analysis of Randolph Street, we will use a hypothetical loan for a typical buyer of 25 percent down payment or $425,000 at an interest rate of 4.5 percent amortized over 25 years.
This gives us a monthly payment of $7,086.86.
Financing is not included in the analysis to arrive at net operating income and therefore, specific financial indicators such as the capitalization rate, which we will talk about in the next article along with cash flow.