I am going to give you a very basic outline on how to screen and identify good rental properties. I’ll cover the fundamentals based on the assumption that you’re buying for a long-term wealth building strategy. I am also assuming that you’re buying with a simple conventional loan. For now, I will not get into any of the more exotic financing or low down payment strategies.
We’ve all heard the worn out saying that, when it comes to real estate, it’s all about location, location, location. Well, amongst real estate pro’s it’s also said that there is no problem that price won’t remedy. So, to be closer to the truth, location is important but so are things like price, condition, and financing.
When starting down the path of home ownership of any kind, you should identify your target area/s. So location does come up high on your checklist, even though in the end I think price is more important.
The first rule in finding a location is you do not have to limit your search to your immediate area. If the median home price in your area is $500,000 and the rent is $2,000 a month, that might be a bad invesgtment area and it just might be out of your price range. Do not rule out areas or properties just because you wouldn’t live there.
You want to identify areas that have good job and population growth. Some of the major moving companies publish information on population trends like this United Van Lines post and many of the financial magazines often write articles on things like Money Magazine’s famous annual Best Places to Live list. This general data can help you zero in on potential locations. I always pounce on articles on population trends and best places to live and share them on my twitter account.
Once I have a few general areas in mind, I can do specific location research. In general I want an area where the median home price is no more than about 3 – 3.5x the median household income, unless there is evidence that more affluent households are moving to the area. You can search most of this data by City, County or area code via the Census Bureau’s website.
Sexy markets rarely make good locations for bread and butter real estate investors.
I remember when everybody wanted a Florida portfolio. Back in 2006 I would have certainly considered most of Florida a good example of a sexy market. At the time premiums prices were paid on properties and capitalization rates (the rate of return on an investment based on the income) were dreadfully low. All of that contributed greatly to the collapse of that market. But, you just need to know that low capitalization rates mean it will be hard to make that property cash flow. Properties that do not cash flow can quickly become liabilities rather than assets.
Pro Tip: Do NOT buy your rental based on anticipated future value appreciation. That’s the sexy market trap. It’s seductive and it’s dangerous. Choose your property based on cash flow and fundamentals and you’ll be able to weather the ups and downs of the market. We’re playing a long term strategy here.
Avoid areas with high crime, especially violent crime. There are investors who specialize in these areas but it is not for the new investor. If families don’t feel safe in a neighborhood it will be difficult to find and keep good tenants. If it’s difficult to find good tenants then you have to take what you can get. When you take any tenant you can get, you end up with more turn over, more headaches and more costs.
Tenant Landlord Laws
Another big factor in your location choice is local tenant landlord laws. Be careful investing in areas where the laws drastically favor the tenant. For example, in the D.C. area you can buy a home in Prince Georges County, Maryland where it can easily take six months to evict a non-paying tenant. Alternatively, you can go over the river and buy in Fairfax County, Virginia where it will take just six weeks to evict a non-paying tenant.
If you do select an area with lengthy eviction periods, you’ll need to plug that into your potential vacancy rate costs. (I’ll cover vacancy rates next week.) For now, just know that it is a cost. And, you’ll need to be extra thorough in your tenant screening process when operating in long eviction process areas.
Buying an investment property is not like buying a home for your family. You normally cannot just go snap up any home listed on the market. You’ll need to find a better than average deal, keeing in mind the vast majority of homes listed on the market will likely be priced too high to serve as a good rental property.
Income is a major factor for investment real estate. It is the main factor for determining the max price you’ll be willing to pay. Professional investors use capitalization rates to determine their purchase price, but there is a good rule of thumb used by some real estate guru’s and discussed regularly in real estate investing online communities. It’s The 2% rule. I first heard this term on the website http://www.biggerpockets.com and I like it because it’s easier to use and explain than capitalization rates.
The 2% rule says that your monthly gross rental income should be at least 2% of the total price you pay for a home. Another way to say it is that your total costs (purchase price and fix up) should be no more than 50x the rent that property will generate in one month.
As an example, say you find a home you can buy for $100,000, it then needs to rent out for $2,000 / month. Or, if you find a home that rents for a $1,000 / month, $1,000 x 50 equals your max purchase price of $50,000. This is extremely difficult to find and requires a significant time commitment. If you can find a deal like this in a desirable neighborhood you’ve scored in a big way.
I’m assuming that you’re doing a 20% down payment and buying for the long term value. In this case, you’ll likely be in very good shape if monthly rent were about 1.5% of the total costs of the property. But, however, I do not recommend going below 1%.
Another factor in the price is the market value. When it comes to single family residential income properties, you can never ignore the comparable sales and the market value. Regardless if your potential home meets the 2% rule you don’t want to pay more than what nearby comparable homes are selling for at the time. Always make sure you get an independent appraisal.
Don’t use the 2% rule to identify a good location. You’re probably not going to find a neighborhood where the average rent is 1 or 2% of the average home price. You have to identify a good area and then go bargain shopping. You’re probably going to have to find a really good deal or a home that needs fixing up, or other opportunities to add value.
You must consider the condition of the home. If you have to make repairs or upgrades to a home in order to get it rent-ready, those need to be calculated into your total property costs and added into your 2% rule equation. At this stage, you’ll just need to calculate a rough number for repairs. In the next article I’ll talk about your final due diligence where you’ll get inspections and repair estimates.
There are a million ways to finance or in other words, use someone else’s money to buy real estate. I’m assuming for this article that you’re going to a bank and putting down the conventional 20%.
Financing is like any service industry. You need to get at least three bids, and, people (your actual loan officer) make a big difference. I have a preference for small community banks. They normally have better continuity with their customers and a more defined / streamlined decision making process. I highly recommend that you talk to at least two local community bank loan officers and maybe one of the big banking centers.
Technology is great. Make sure you download a mortgage calculator app with an amortization chart. If you don’t have a smart phone you can find the same thing on line through any simple search.
Unless you have a bunch of cash lying around financing will be critically important.
Even if you do, I recommend you get an 80% loan. Some might argue that financing should be at the top of this to-do list because if you don’t have the means to buy the home, searching is a moot point. However, I disagree – knowledge can be your down payment but that’s for a different discussion.
Example: You found a home that’s just not a great deal and you are inclined to walk. Let’s say the seller wants $100,000 and you’ve determined the home will rent for $950 per month. This income is less than 1% of the purchase price and there is nothing specifically attractive about the location.
A conventional break down of this deal would look like this: You would put 20% down and finance $80,000 with the local bank. A thirty year loan on $80,000 at 5% interest would cost you about $430 per month. There’s another handy rule of thumb for calculating costs. In most cases all your operating costs added up, not including your mortgage or debt service, will equal about 40-50% of your monthly rental income. Those costs include taxes, insurance, management, vacancy and maintenance. So let’s plug in a 45% for operating costs which would equal $450/month. This would leave you with a total cost of $880. That’s $430/month mortgage payment plus $450/month in operating expenses, and a net income of just $70. ($950 in gross income minus $880 in total expenses.) Not too exciting, right?
Now let’s assume the seller offered us 100% seller financing at 0% interest for a 30-year term. Why would she do this? I don’t know, but I’m trying to make a point here. Breaking this deal down with this new attractive financing option we’d determine that we didn’t need to bring any of our own money to the deal, or maybe just enough to cover closing costs. We keep that $20,000 down payment in our account to be used on the next deal that comes along. Financing would be simple: $100,000 divided by 30 years, or 360 months, for a principle payment of just about $278/month. We just eliminated a major cost: interest. Operating costs stay the same at $450, making our total expenses $728. Subtract our expenses from our same $950/month income and we get a net monthly income of $222 without putting up any of our own cash. This deal just went from a “probably not” to a slam dunk – just by changing the financing.
It is highly unlikely that you’re going to find a seller who will do this extreme level of financing, but if they or someone else offers you financing that drastically reduces your down payment or interest costs, it can drastically change the attractiveness of the deal.
This process is your first filter. It will help you quickly eliminate properties that will not make good deals, and hopefully identify a handful of good potential deals. Next week I’ll cover some of the steps needed to do your final due diligence and, hopefully, pull the trigger on your first rental home purchase.
Source: HotPads/Zillow Inc