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Spokane, Washington  Est. May 19, 1883
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Tom Kelly: Rules of thumb for judging future ‘rent-by-owner’

Sending your kid off to college had you mulling the “what’s possible” questions of a quiet return to your favorite vacation spot. Truth be told, you wouldn’t mind retiring there one day when all the kids have moved out.

If you bought an investment home there now and rented it out, is there a 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, including the mortgage and property taxes. In other words, your vacation home should not cost you another dime after your down payment.

According to Karpinski, if your monthly mortgage payment is equal to 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.

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.

UCLA 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 rental 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-earning ratio for the first property is about 14 (255 divided by 18), and the second is about 12 (120 divided by 10.2). The second property appears to be a better candidate for appreciation since 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.

Although all this might appear complex, it’s really quite simple. After all, you already know the prices being asked for the properties you are evaluating, and you should know what rent you can charge once you own them.

All that’s needed is to find out the averages for prices and rents in the immediate neighborhood, and you’re done. Check county records online, or ask a local Realtor or property manager to help you out with these two numbers. This is a helpful research process that could propel you to financial success.

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