Out of all of the diversity found in the 1 percent — the most wealthy in history — the one common thread is that they owned real estate. Building a real estate portfolio and becoming a landlord can be one of the best wealth creation tools available. But, if you’re not careful it’s also one of the easiest ways to lose a lot of money.
Cash-on-cash. Market comparables. The 70 percent rule. It is easy to fall into “analysis paralysis” with the investor vocabulary. When it comes down to it, there is a shortlist to look at when choosing a good investment. This list begins with an honest look at your financial situation along with specific goal setting. Below, I’ve listed 11 characteristics that will help you filter out the money pits from the money pots either for yourself as an investor or for a client that is a potential real estate investor.
1. Face The Facts…
Before you can even set goals, you must take an honest look at where your finances are presently. Make a balance sheet and a cash flow statement for yourself. Though, this can be difficult, it presents a tremendous opportunity to advance your emotional health and thereby your financial health. I recently did this and found a loser property in my portfolio. With this new knowledge, I can dump the property and 1031 into another. Never stop reviewing financials. They will provide new insights and opportunities regularly.
Remember, a balance sheet has all assets in one column and all liabilities in another column. It will help you measure principal paydown over time, debt to equity ratio and net worth.
Remember, a cash flow statement looks at money going out and subtracts it from money coming in. I recommend you do this with each investment individually so you can measure individual performance. This exercise will help you set expectations for each new investment. It will also help you decide whether you should keep a property or trade it for one that will perform to a higher standard.
Remove emotion and take an honest look at your financial position.
2. Set A Goal…
Now that you are armed with the facts and you have taken on your emotional and financial health head on, set a goal. Keep it simple.
Increase net worth by 3 percent in the next quarter.
Increase cash flow by $4,000 over the next year.
Remember, the reason you are here is to increase financial freedom.
3. Know Your Financing For The Property…
Most small time investors begin with 30-year fixed notes that require 20-30 percent down. Talk to a couple different mortgage brokers or officers. You should be able to answer:
How much can I qualify for?
How much will payments be?
How much cash do I need?
This will save you time in your property search. Any properties that are outside your loan qualifications on the loan or cash available are automatically disqualified from your list of potential investment properties.
4. Perform A Proforma…
Whoa! That was a mouthful. In simple terms, you are going to estimate a budget next.
Before you buy a rental property look at what comparables properties are renting for in the neighborhood and then check how many of those properties are actually rented. This will tell you two things — gross potential cash flow and likely vacancy expense.
Next you will need to estimate expenses. Taxes, insurance, and maintenance will be the most common. You may have others to address such as utilities or homeowner association fees depending on the property. Do not get too overwhelmed with this section. Ask another investor in the area or talk to a property manager about expense ratios in the area. Age of the property will be a significant indicator of the likely expense ratio.
Now, shove this proforma into your balance sheet and cashflow statement that you already created. Ask yourself, is this property going to provide a step toward my goal?
Note: If your goal is freedom, doing your own maintenance to increase returns does not meet your goal.
5. Location Success Factors…
Real estate markets are constantly in flux. National real estate trends might set the overall tone, but it’s all about local conditions. In order to secure long-term rental demand, you need to make sure you’re buying properties near sustainable supports — hospitals, universities, transit hubs, shopping and entertainment.
Identify up-and-coming areas. These are areas that are likely to see above market increases in value (net value increases more quickly).
Identify areas that are likely to see below-average increases in value. Take a drive, and these areas will become more apparent to you.
If you want to go in-depth here, talk to your planning and zoning department. They will be able give you information on commercial and residential growth plan for your city. This information is invaluable when considering where the up and coming areas are.
6. Property Management…
Arguably, more important than the property is the management of the property. A great home in a beautiful neighborhood can yield horrible results if the management is poor. A property management company will take 6-10 percent of the monthly income. A quality property management company will return more than its cost in value add to the property.
If a property management company’s turnover and marketing procedures reduce vacancy by 10 percent and its screening process reduces property damage by 10 percent, then not only have you saved yourself time and a headache, you have increased your cash flow.
Refer to step 2: What is your goal? What management solution will meet the long-term financial goal?
7. Leapfrog Money Pits…
When looking at rental properties, check the age and condition of the expensive fixes: furnace, roof, windows and appliances. Repairs for these can easily set you back $5-$15,000 apiece. If you want to invest in flips or fixer-uppers, budget appropriately. Typically, you will need to budget 10-20 percent above what you project major repairs will cost.
I use a general rule of thumb. I want to see an equity increase of at least the cost of the renovations. For example, if I buy a home for $100,000, and I spend $35,000, I want to see at least a $35,000 increase in value reflected in a sale price or rent (the property value should be at least $170,000).
These deals typically present more risk and reward.
8. Private Parking…
When at all possible, buy properties with private parking. People will pay a premium for it. I’ve seen rents go $100 to $200 higher a month for private parking. Think about it, people in cities will pay at least that much each month for a monthly parking permit. Plus, it’s a convenience factor, too. People pay for convenience all day long.
9. Financial Criteria…
Learn how other successful investors buy. You will find some people are steadfast on the 1 percent rule. That is, monthly rent must not be less than 1 percent of the total purchase price. This is a form of the gross rent multiplier — the simplest type of ratio. Other ratios, such as a cap rate, will give you a more detailed look at the property but are also more susceptible to skewing observed in situations such as maintenance deferment or simple misreporting.
Most markets do not offer properties that fall within the 1 percent rule. Some markets do provide these properties, but they can be terrible properties to buy. Again, talk to other investors and ask what their investment criteria is. You will find many investors are in a niche. Talk to them, and you will begin to develop your own niche. Remember older properties = higher expense ratios.
10. Product Type…
Property types typically have advantages and disadvantages depending on the market. These are general and not absolute. I know many investors who have not followed these and been successful.
Condos and townhouses: They are typically difficult because of homeowners association fees. You might buy it for less, but the increased expense ratio is too heavy for your cash flow statement.
Homes: You will typically pay higher rent-to-purchase-price ratios, but on the flip side, there is typically more equity increase over time. Remember, you can sell a house to a homeowner or an investor. You can sell an apartment only to an investor.
Multifamily: You will typically see more cash flow and less equity increase. When you are buying, you are competing only with investors. When you are selling, you are offering only to investors.
Again, each market will be different, but this is a general rule. Larger multifamily properties follow a different set of rules. Value is heavily weighted on income of the property. Incremental increases in income due to value additions or management efficiencies impact the incremental value. Market conditions affect cap rates, but net operating income sets the tone for value.
11. Profit When You Buy Not When You Sell…
You make your money (meet your goal) on the purchase, not on the sell. When you overpay, you will find that you are always struggling with cash flow. When you try to sell it, the property will either sit on the market forever or sell at a loss.
A couple of ways to see if you are overpaying include looking at previous closings in your area. Review neighborhood conditions to indicate value, and determine whether the property will require substantial repairs or updates to make it marketable.
The most important step in this process is taking a look at your balance sheet and your cash flow statement to determine specific goals. If you keep these two steps in mind through the entire process, you will be better positioned to make smarter, more profitable investment decisions.