How to Budget for Resale Profits When You Buy Rental Property

Since the point of real estate investing is to make money, real estate investors never lose sight of the fact that any rental property they purchase today must be able to produce a profitable gain when it is re-sold in the future.

In this article, I want to show you a simple formula you can use to determine what price you should pay to acquire a property based on a budget you create that includes an eventual future re-sale price, your total investment up to the point of sale, and your desired profit.

1) Estimating Your Future Re-Sale Price

When you plan for profits, start with a re-sale price that a reasonably well informed buyer will pay for the property. Remember, buyers dictate the price at which you can sell an income property, so avoid the temptation of estimating the property's future price by merely adding your dream profit or rehab costs to what you pay for the property.

Start this way. Locate other properties similar to the subject property in configuration, condition, and location that have recently sold. It might be difficult trying to compare an apartment complex to an industrial complex, so look for properties that are most similar to the subject property.

Next, calculate an average for the cap rates at which those properties sold and use it to estimate a value for the subject property. To be sure you're on the right track, call an appraiser or qualified real estate professional to confirm that the cap rate you're using is correct for your market area.

During this process, stay conservative. For budget purposes aim for a sales price somewhat below the highest-valued rental property in the area, regardless how much better-quality you think the subject property is to those comparable properties. The closer you approach the upper price limit of the area, the more difficult it becomes for you to get your price when you re-sell the property.

2) Estimating Your Costs

Okay, now that you've determined a realistic re-sale price for the rental property, you must now develop some estimate of what it will cost you to achieve that price.

During this process, you must not lose sight of the fact that investors will only pay you for the income generated by the property and otherwise will have little interest in how much money you put into units or grounds; only how much rent the tenants are willing to pay due to those improvements. So cost-plus pricing doesn't work, other than maybe with a structural issue such as a roof, electrical, or plumbing. It would be a mistake for you to expect an investor to pay you for excessive, unessential, and perhaps unneeded modifications to the building.

Now, budget your costs. The building must have a sound infrastructure (so you certainly need to account for those costs if required), but beyond a structural issue don't plan to spend money on the rental property (especially with mere window-dressing) unless it equates to more income stream (i.e., higher rents and occupancy or perhaps lower operating expenses).

3) Determining Your Maximum Acquisition Price

Before we give you the formula and an example, you need to consider how much of a profit you want to make. Once decided, you're ready to go. Here's the formula:

Sales Price - Costs and Profit = Acquisition Price

Say, for instance, you find a 10-unit multifamily apartment complex for sale that you estimate, after some improvements, can be sold in one year at $780,000. If we assume that you want to make a $25,000 profit, here's how you set up your budget:

Acquisition expenses and closing costs (to purchase the property) = $5,000
Cost of borrowed funds (interest paid during the holding period) = $20,883
Materials for fix-up = $42,000 Labor for fix up = $22,000
Re-selling expenses @ 6% = $46,800
Closing costs at re-sale = $7,800 Desired profit = $25,000
Total = $169,443

Next, deduct that amount from your estimated re-sale value to determine the maximum amount you should pay to acquire the rental property.

Your estimated re-sale value = $780,000
Less: Your estimated costs and profit = 169,433
Maximum acquisition price = $610,567

There you have it. Budget a profit into your next real estate investment acquisition and use it in combination with a serious real estate analysis to crunch the numbers. Here's to your real estate investing success.