How to Purchase Investment Real Estate, Part I
I wrote in my last Blog Post, “The Biggest Mistake Made by Real Estate Investors,” that most novice real estate investors make the mistake of purchasing real estate for capital appreciation rather than for income. In this post I will discuss my approach to deciding which properties make a good investment.
If you follow my advice in the “Lessons Learned” list from my previous post concerning my California real estate fiasco, you should avoid most major errors when selecting a real estate investment. However, to provide some additional understanding, I will discuss my approach to buying real estate in greater detail.
The Proper Way to Purchase Investment Real Estate
Before discussing my investment approach I should warn you about realtors. You may experience difficulty finding a realtor that will work with investors. Investors are looking for unique properties that contain the right elements to be a good investment. Realtors prefer working with people looking for a primary residence as homeowners are more emotional when purchasing property and tend not to be as price sensitive. Over the years I went through almost as many realtors as I went through properties. Once they see how serious you are about investing, most realtors will drop you as soon as it is politely possible. In retrospect I think it is best to seek out a real estate company’s principle broker and tell that person about your intentions of looking for investment property. The broker may save you a lot of time by directing you to the realtor in the company (if one exists) who is used to working with investors. However you do it, your first goal is to find a realtor that will work with investors.
How do you know if a property will make a good investment? There is a simple rule that I use. Assuming a 20% down payment and 80% financing of the purchase price (a minimum 20% down payment is required for all investment property purchases), I will only consider buying a property if, after allowing for all expenses and financing costs, 10% of the monthly rental income is left over as net positive income. Let me give you an example to better illustrate what I mean.
Let’s say you are considering a $300,000 property and you finance $240,000 (80% of the purchase) with a 30-year fixed rate mortgage at 5% interest rate which has a monthly payment of $1,288. You have estimated your other monthly costs as $250 for taxes and insurance and $150 for property maintenance. This means the total monthly cost for this property is $1,688. In order to have about 10% of the monthly rent left over after all expenses, the property must command about $1,875 gross monthly rent ($1,688/0.90 = $1,875).
Why do I want 10% of the rent left over after all expenses? For one it allows for a buffer in the event the property expenses have been underestimated. In the beginning underestimating expenses is a possibility until you get more experience at evaluating properties. But there are two other important reasons I have this 10% requirement. First, you should want some kind of immediate return on your investment. In this example, $60,000 has been invested in the property so the $187/month net positive cash flow ($1,875 – $1,688) represents about a 3.75% annual return on the initial investment (3.75% = ($187 x 12)/$60,000)). The second reason is things in your life may change. In the beginning you should always manage the properties yourself. However, you may move, your work may make it difficult to manage the property, or another reason may make it necessary to hire a professional property manager. The average fee to hire a property manager is 10% of the rent. Thus the 10% net positive cash flow will cover your management fee if you decide to hire a manager, even if on a temporary basis.
As the previous paragraph shows, the rental income the property can generate is very important. In fact, when I consider a real estate investment, I always assume that there will not be any property appreciation during the entire period I own the investment. If, based on the rental income, the investment still looks good to me then I will proceed with the purchase. This is all I do to determine if I should even consider entering into a real estate transaction with a particular property.
Reducing Investment Risks
Where are the risks in a real estate investment? The biggest risk is in not purchasing the property correctly up front. How do you reduce this risk? By being certain of the property income and expenses before you proceed with the purchase.
You will know in advance what the purchase price and all the details of the financing will be. You will also know in advance what the annual cost of the property taxes and insurance will be. The only things you will not know in advance of the purchase with 100% certainty are the capital and maintenance costs of the property and what it will rent for. When researching a potential investment, these two areas are where you should focus your effort in order to estimate them as accurately as possible.
Capital expenditures generally are not a surprise. You can plan for these costs well in advance. I always made a habit of saving all the net rental income in the early years of an investment to fund any necessary near term capital improvements. Annual maintenance costs, however, are difficult to estimate in advance because much of these costs are a function of how the tenant lives. For this reason I always make sure the tenant pays for obvious tenant caused maintenance/neglect such as clogged tub drains and clogged gutters (I actually write these things into the lease). However, after doing this for 20 years, I have found for an average single family residence, if you are willing to do the simple things yourself, annual maintenance costs seem to average about one month’s rent. So, if a property rents for $2,000 per month, I would budget maintenance costs at about $2,000 per year. Of course there are lots of exceptions to this rule. For example, if you are renting a lower cost unit for $800 per month, then your annual maintenance costs will be more than one month’s rent.
With my one month’s rent maintenance rule in place, the last area of uncertainty is the rental income. I usually have a good idea of the potential rent for a particular property, but the rental income is so important I want to be sure I get it right. Therefore examining the potential rent is where I spend most of my time when I am considering a real estate investment. In researching a property’s income potential, I take the time to call up every rental advertisement in the local paper that describes a property similar to the one I am considering. I make an appointment to see each property (usually I let the person showing me the property think I am a potential renter). I note each property’s rent and any major differences from the property I am considering, such as location, number of bedrooms/baths, parking, pets allowed, etc. After analyzing this data I am able to determine within about 5% what the property will rent for. I have to be honest this analysis, more often than not, causes me to move on to the next property. But the research is still helpful in evaluating future properties.
This investment process may take awhile to find the right property. However, never forget it is your money that is at stake. No investment is risk free, but when you consider how long it takes to save the funds for each investment, you want to be reasonably sure you are not making a big mistake. Once I started following the above process I never regretted purchasing any investment property after that.
I will end this long post with some words of wisdom an experienced investor told me early in my real estate investing career. “Real estate is a love-hate relationship. If you have to pay out money every month to carry your properties, you will hate real estate; but if each property pays you every month, you will love real estate.” I can tell you from experience that this veteran investor is right. So be sure that any property you buy pays you every month.
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