Calculate cash flow for second home

A winning formula for investment properties

By Inman News Feed
Add Comment Add Comment | Comments: 0 | Posted Jul. 1, 2010

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A winning formula for investment properties

Tom Kelly
Inman News

Let's assume home values are down in the area where you like to vacation. Truth be told, you wouldn't mind retiring there one day.

If you bought an investment home now and rented it out, is there any way of knowing if it will appreciate?

And, is there a break-even formula to use when considering annual cash flow?

One of the better second-home rental formulas now used was developed by Christine Karpinski, author of "How to Rent Vacation Properties by Owner."

Karpinski's definition of the break-even point is when all of the income (rent) from your vacation rental property is enough to pay all of the bills associated with ownership of the property. In other words, your vacation home should not cost you another dime after your downpayment.

According to Karpinski, if your monthly mortgage payment is equal to or less than one "peak" week rental rate, and if you rent for 17 weeks, then you should be able to achieve positive cash flow.

Consider a property that rents "by owner" for $2,000 per week during the peak season, with a monthly mortgage payment of $2,000. There are 12 peak weeks, most or all of which are generally occupied. Then 12 weeks rented equal one year's mortgage payments.

In addition, you'll need to rent five other weeks to pay for incidentals such as power, phone, association dues, minor maintenance, etc. If you handle the rental yourself and have 17 weeks booked (33 percent occupancy), you will have an even cash flow.

Rent more and you have positive cash flow, according to Karpinski, who serves as the director of HomeAway.com's owner community.

When analysts look at stocks, they often focus on the price-to-earnings ratio as a measure of whether the stock is overvalued or undervalued. The higher the number (especially relative to either the market as a whole or to historical averages), the more likely the stock is to decline in price over time.

University of California, Los Angeles, professor Edward Leamer proposed that real estate be considered in a similar light. In this case, though, the ratio is the price of the investment property to the annual rent it will earn.

This calculation will give you a standard by which you can judge the relative potential for appreciation of different properties in different neighborhoods and even in different cities. In other words, it helps to make sound investment decisions by giving you a tool to measure alternative investments against each other.

Here's how it works:

Suppose you're looking at a $255,000 property that will rent for $1,500 per month, or $18,000 per year. (We can assume no vacancy, but you can figure in whatever you deem to be reasonable.) You are also looking at a $120,000 property that will rent for $850 per month, or $10,200 per year.

The price-to-earnings ratio for the first property is approximately 14 (255 divided by 18), and the second is approximately 12 (120 divided by 10.2). The second property appears to be a better candidate for appreciation because it has the lower price-to-earnings ratio.

For a truly effective comparison of the two properties, you need to make a second calculation. You need to look at the price-to-earnings-ratio average for both properties relative to those properties in the same neighborhood.

If the ratio for the neighborhood of the first house is 20 while the ratio for the second house is 10, then the first property might be the better buy. It is underpriced relative to its surroundings, while the second property is overpriced.

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