If only picking the right rental investment property came down to a magic formula, there would be fewer headaches for you and your tenants. But, the truth is, while you might have a knack for making good selections, nobody gets it right every time. It's almost always a bit of a gamble, but there are some steps you can take, like projecting your potential NOI (net operating income) and/or basis points, before you buy, to improve your odds of landing a good deal.
We are going to break down the simple mathematical calculation and explore other practical considerations.
Change Your Approach:
Experts say investors need to change their mindset and go into this type of property search looking for a keeper - buying this one for the long haul. It's a different approach from the sixty or ninety-day flip. So, not only do you need to find the right location, but the house itself should be inviting and in pretty good condition. No more worst house on the block mentality.
Know Your Potential Tenants:
Consider the type of tenant you want to attract. Are you going for professional singles or young couples? Perhaps older folks who are down-sizing after becoming empty nesters. If that is your target tenant, you might look for properties with large first-floor masters, nearby dog parks, and lots of great restaurants within walking distance.
If it's a family you are hoping to attract, consider the local schools, safety, parks, running trails and other recreational activities nearby. It's common sense, but it can save you time by significantly narrowing down your search area.
Positive Cash Flow:
Determining location is the easy part. The next few steps can be more challenging. Experts say select properties that are likely to generate positive cash flow almost immediately. Finding that type of property can be a tough proposition for many investors who are concerned about overpaying for a house, knowing that you make your profit when you buy, rather than when you sell. And just to be clear, positive cash flow means money left over at the end of the month after you deduct all of your expenses including any mortgage you may have.
Here is an example using one of my first rentals: If your rental income is $2950 and you deduct insurance, taxes, monthly management fee, mortgage (if you have one), and you still have $900 remaining per month, well done! I highly suggest that you resist the temptation to spend even a dime of that money and instead let it roll over into an operating account because as I learned, you may need it for unexpected repairs or future vacancies.
If you purchase a multi-unit property that needs work but has one unit that is suitable to lease, do so right away at a lower price and on a month to month basis. Don't think of it as a loss, as you will likely recoup that money later. Leasing that lesser unit will allow you gain some income immediately. You can do this while making improvements to the remaining unit(s) and getting them rented one by one, at a higher rate. Then, plan to update the remaining, low rent unit at a later date and adjust the monthly rate accordingly.
30 Day Window:
Another option that has worked well for me is to buy a property that is nice enough that quick improvements can be made, like adding granite or stainless steel appliance, while you are hiring a management team and marketing the property for rent. The goal is to complete the work by the time the right tenant has been located and locked in, which is usually about thirty days. It's a real juggling act which requires effective time management of your crews, but when it works, it works well, producing income quickly.
Deal or Dud?
The final step I take is considering if the rental property is likely to be a "deal," long-term. One area of consideration is appreciation or the properties likelihood to increase in value over time. While there is no way to guarantee that your property value will increase, I gather comparables or "comps" and examine how they have preformed over the last few years and factor in future development plans. (We will break down the math behind determining comps and how substitutions help, in a later blog.)
The other consideration is basis points, and that has to be calculated. The explanation I learned while in real estate school was a bit complicated, so I searched online for a simplified version and found one I like, on Zillow.
While I don't usually copy and paste, I decided to do so in this case, so you could see precisely how the Author (Prof. Baron) set up the formula.
*Simple analysis tool:
A simple way to do a quick analysis is to take the conservatively estimated monthly rental income and divide it by the purchase price of the house. You still need to pencil out your deal with rents and actual conservatively estimated expenses, but this back-of-the-napkin test is a quick and easy test to see if it makes sense.
Example of a good deal: If you can collect $1,600 per month in rent and you paid $200,000 for the property, you are collecting rent that is 0.8 percent of the purchase price (0.8 percent = 80 basis points in financial terms). And that’s probably a really fair deal.
Example of a bad deal: If you can collect $1,600 per month in rent and you paid $400,000 for the property, you are collecting rent that is 0.4 percent of the purchase price, or 40 basis points. And that’s not a really good deal.
Give It A Try:
Get it? Try inserting your numbers from a property you are considering. Based on Professor Baron's example, is it likely to be a good deal?
Frankly, when I tried it on a recent purchase, I ranked in the "not so good" range, but I expected as much because I didn't purchase that property as a rental. I renovated it for sale, then decided to keep the house, following an altogether different model we'll call the 1-in-5 investment strategy.
Following this concept investors should try to keep every fifth property they buy and turn it into a positive cash flow rental, especially if it carries no debt or good debt. So, what's good debt? As you might recall from an earlier post the author of the New York Times bestseller Rich Dad, Poor Dad defines "good debt" as any debt that someone else is paying off. And he uses rental properties as a prime example. You can read Robert T. Kiyosaki's book or listen to him online to get a full understand of his approach to rental properties and building generational wealth.
Bottom line, despite how much we might enjoy lifestyle TV shows, experts say real estate investing is a marathon for the hardcore, and those who have been successful at it for a while will tell you that long-term wealth takes patience, determination, and hard work! But, be hopeful- if your property appreciates while your tenants pay down your mortgage, and you have a competent team in place you will likely do very well. But it all starts with you doing your own homework and selecting the right rental property.
Read more about investing at thestablesgroup.com
*Courtesy: Zillow and Professor Leonard Baron University of San Diego per Zillow.com)