Bread & Butter Properties

Bread & Butter Properties
Generate passive rental income

Friday, July 23, 2010

Determining How Much to Pay for the Rental Property

Here's what I do to determine how much I would pay for a rental property. And of course, needless to day, I would want to come to a price that is below market price (see my previous Blog on the importance of buying below market price).

  • Firstly, I would want to figure out roughly what the market price is: and for this I want to know, what the transacted prices are and also what the owners are currently asking for.
  • To find out what the transacted prices are, I would check with a few valuers, but be aware that these prices may be 6 months to 1 year old, as there is a lag in the data they compile. For the asking prices, it's quite easy to find out through checking with a few real estate agents, and also the owners directly. But note that these prices tend to be higher than what's actually transacted eventually as they tend to price it higher their asking price. Plus, owners would normally price in the commission that they pay to the agent, which can be 2-3% of purchase price depending on their arrangement.
  • Secondly, I would like to find out what the properties in the area are renting out for. For instance, what would a basic 3R 2B unit be renting out for? What's the difference in pricing for these units on different floors? Are there any particular blocks that are more in demand? (because they are nearer to the shops / public transport like LRT). What about the rental for smaller units? And the less desired units? (could be because it's further away from the basic amenities). You can find out this sort of information out by asking a few agents who farm in the area. Just record down the information you collect in a note book for review later. But, I normally would discount the prices they give by say, 5-10% as agents tend to inflate the prices a little.
  • The next thing, now that you have the estimated market price of the property and also what it can rent out for, you can work out what your yield is.
  • The yield is calculated as the annual rental income divided by the price. So, let's say that gross rental income for a 3R 3B unit is RM600 per month, and the asking price is RM100k, the gross yield is 7.2% p.a. (assuming that you are able to rent it out, for all 12 months in a year – i.e. no vacancies).
  • You should also calculate the net yield – which is the gross yield less the costs related to running the property like, maintenance, quit rent, etc. So, if your costs is RM50 per month, then your net rental income would be, RM550 (or RM6, 600 per year) which gives a net yield of 6.6% instead.
  • The next question is: whether you are happy to purchase the property given the yields? In this example, buying a RM100k property for a gross yield of 7.2% per annum? Or 6.6% net yield. Note: that there are some costs which can be controlled (which can improve your net yield) like how much you spend to maintain the property like repainting, and others.
  • At this stage I would take stock of how much I can finance my property for also, and hence how much my monthly installment would be. As indicated earlier, your rental income must always more than cover your installment for the deal to be worthwhile.
  • Once, I am satisfied with my estimate of the rental income i.e. it can be verified, and more than cover my installments, I work out how much I would pay for that property. I do this by working backwards to arrive at a price which I am comfortable with. So, let's say I want a minimum 8% gross yield, I would need to purchase the property at RM90k (RM7, 200 divided by 0.08). And, if I want a gross yield of 7.5%, then the price would be roughly RM95k. So, effectively I establish a price range for the property I am looking to buy.
  • Remember this is the price range I am willing to pay, but not necessary what the market is pricing it at. So, if the market price for the property is RM100k, and I am only willing to pay RM95k, effectively I would need to acquire it at below market price. This is where the numbers game and being able to identify the motivated sellers come in. Hence, this is where the work comes in: looking at least 100 deals, before I end up buying one or two units at below market price. (read my earlier Blog in this topic)
  • Of course, the other way to improve your yield is by increasing the rental income; but there are limitations to this, as you don't set the rental, the market does. I would normally err on the conservative side when it comes to estimating rental income, and place more emphasis on being able to buy them at below market price from motivated sellers. You make money in property when you buy, so the lower the price that you pay, the more chances you have of making money, in terms of the yield you get (and also from capital appreciation in the long-run).

Next: we will discuss the importance of your Return on Cash in finding the right rental property.

Chris Gan

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