Over the past several weeks, I have been following property listings in the markets where I own rentals, waiting for a great deal to pop up. I asked my agent to look into countless single family homes, duplexes, and small apartment buildings, but invariably there was something not quite right about each of them. Finally, a duplex which met my requirements for price, needed improvements, and cash flow popped up. I put in an offer right away. Today, my agent informed me that the offer was accepted! The next several months will be a flurry of activity as we work to close on the property, get it fully occupied, and add the rents to our monthly cash flow. With that in mind, I wanted to document the experience so that readers of the blog can learn the process of finding great rental properties, and the steps necessary to purchase them.
This article will address some of the specific challenges of buying in a market where you don’t live, but all of the advice is applicable even if you’re buying property in your area.
Consider Your Niche
Everyone has a different idea of what kind of properties will give them their ideal mix of income, problem-free tenants, and long-term viability. Perhaps you want to own student housing. Maybe multi-family properties are your thing. Or single-family homes. The point is, have an idea of who your ideal tenant is based on your risk tolerance, and then consider where that ideal tenant wants to live.
I don’t buy property in warzones (higher returns, lower tenant reliability) and I don’t buy property in upper class neighborhoods (lower returns, higher tenant reliability). For me, the mix I am comfortable with is right about the middle. I buy low-to-mid-priced homes and duplexes in working class neighborhoods. I try to rent to blue collar professionals with families, and I am looking for average to good credit and three times the rent in monthly income. This is my niche.
The important thing to remember is that there is money to be made at all levels. It’s okay to start in one niche and find that another is more suited to you.
Determine Your Budget
Your budget is determined by a number of factors. Some considerations when setting your upper limit for a single investment are:
- Cash or Financed Purchase – Each has advantages and disadvantages. A rental that you own outright belongs entirely to you, and is much more difficult to take away. A financed purchase is owned, in part, by the bank. However, leveraged (financed) properties have the potential to produce far higher cash returns. Consider this example: You have $100,000 to invest in real estate. In your market, a $100,000 property returns $2,000 a month. Assume that approximately 50% of your rents will go to expenses like repairs, insurance, etc., and that you qualify for a 5% interest rate. If you purchase the property in cash with these assumptions, you would have $1,000 in cash flow a month. Now let’s assume you finance four $100,000 properties, each with 25% down and 30 year fixed mortgages. Four properties would pull in $8,000 in rents a month. We subtract $4,000 for expenses, leaving us with $4,000. After paying the mortgage of $537 per property per month, we are left with $1,862 in cash flow, or $862 more per month than buying in cash! If your goal is cash flow, leverage can be extremely powerful… but it pays to be wary and not get stretched too thin. My advice is to avoid exotic, low down-payment financing for rentals.
- Long Term Real Estate Investment Plans – If your goal is to own numerous investment properties, and you plan to purchase those properties at a certain interval, your budget is the maximum cash you can save towards property purchases after all expenses and other investments in that time. If you only plan to purchase a single real estate investment, then your budget may simply be the cash you have on hand. I invest in properties between $60,000 and $80,000 which bring in from $1,300-1,500 a month in rents. I put 25% down on each property. Currently, I am able to save enough for a down payment in this price range about every six months, so I buy about two properties per year, give or take.
- Willingness to Renovate– If you are able to manage a rehab project, it is possible to buy properties needing repairs at deep discounts and put in “sweat equity.” The total cost of purchase and renovation can be far less than the market value of the repaired property. This can be a dangerous venture for the unprepared, as if your estimate is too far off, you might save nothing at all (or even spend more than you would at retail). Also, homes which are not habitable do not generally qualify for financing, so you might need sufficient cash reserves to purchase and improve the property. It is possible to buy and rehab a property, then seek a mortgage on it, financing your cash back out.
When you are done considering these factors, you should be able to express your budget in a few sentences (sort of like an investment policy statement for real estate). Here’s mine:
I will purchase one property with a purchase price of $60,000 to $80,000 every six months. I will finance the property with a 25% down payment. I will budget for up to $3,000 in closing costs and $5,000 in repairs maximum. The maximum all-in cost including down payment, closing costs, and repairs should be no more than $28,000.
Choose Your Market
Okay, now you know how much you can spend and what kind of property and tenant you’re looking for. Whether you know it or not, you’ve just eliminated many markets from consideration. Where do your budget and niche intersect? You may have some answers right away, or you may have to do some research.
Properties which cash flow at the expense of fast appreciation are somewhat common in the US midwest and south. Properties which cash flow less, but which attract more wealthy tenants and appreciate more quickly tend to be in US coastal areas. There are exceptions to every rule, but these are general observations to start your search.
When you think you have a good target market in mind, check into recent changes in demographics and economies. Is the city or town growing in size and investment? Check out the MLS listings for the area using Trulia or Zillow. Are properties in your niche selling for at or near your budget? Check Rentometer or Zillow for current rentals. Are properties in your niche renting for at or near your expected rent?
It may take a few (or many) rounds of this kind of critical analysis before you settle on your most promising markets. Take your time, this is a decision you might end up living with for 30 or more years!
Find an Agent With Investor Experience
Though all Real Estate transactions follow the same steps, the hunt for a rental property and a home are two very separate beasts. Ideally, you want to be working with an agent who has extensive experience in buying and selling investment properties. Your agent will be your eyes and ears, as well as your counselor when it comes to expected rents, neighborhood quality, and confirming whether a property occupies your niche.
I find that a great place to meet and learn from all sorts of people working in real estate investment is BiggerPockets. Do a search on the forum there for your target market and you are likely to turn up wholesalers, agents, lenders, contractors, and tons of other valuable resources. Then (and this is important), wait and observe. In your target market, who gives freely on BiggerPockets? Who seems most knowledgeable? Who has satisfied clients giving testimonials as to the quality of their work? These are the people to start talking to.
Shop Around for Your Loan
I’ve bought enough property now that I realize that with the same credit and income, an investor mortgage will vary widely from lender to lender in terms of closing costs and interest rates. It pays to shop around.
You will need to have a pre-qualification letter in hand before making an offer if you expect to finance your purchase.
There are a few important things to remember when shopping for your mortgage:
- You may request quotes from as many lenders as you like within 14-45 days, and it is only counted as a single inquiry when calculating your credit score. The range of days depends on which version of the credit scoring model is used. To be safe, you may want to focus your efforts to find the best mortgage rates to 14 days or less.
- Mortgage, student loan, and auto loan inquiries for the 30 days before credit is pulled are ignored. This means your search for a mortgage won’t affect your score while you’re searching for it, and you’ll get the best possible rate.
- In today’s rising interest rate environment, you will probably want to lock your rate. This means you will have a fixed period of time between gaining pre-approval and closing on the property to get the quoted interest rates. To avoid extra costs, you should gain pre-approval as close to making an offer as possible.
- Investment loans are more expensive than owner occupied loans. Though you may find an exception, plan for a rate 1% over the best rate you could qualify for on your own home.
I’ve discussed it elsewhere, but I’ll say it again here: You should always budget for property management. Even if you’re not sure which property manager you’ll be using, you should request property management agreements and fee schedules from several well-regarded property managers in your target market. The analysis you do in the next step needs to include not just the monthly property management fees, but also the “one-off” fees like tenant placement, lease renewal, and others.
Picking a property manager is equal parts intuition and information. At the very least, you should thoroughly vet your property manager using this Bigger Pockets blog post as a guide. I also strongly advise speaking to multiple references and requesting some example bills for repairs and rehabs to see how they align with local averages.
In the end, you need to feel comfortable that your property manager has your best interests at heart. A truly good property manager knows that everyone wins when the property manager and the owner’s priorities align. A poor property manager sees both the tenant and the property owner only as profit centers. If your property manager doesn’t put you at ease, how can you expect them to handle things if you are traveling, busy, or have a medical emergency?
Analyze, Analyze, Analyze
I’ve already written a pretty comprehensive post on analyzing a rental property. Read that post in detail before making any offer on a property. The gist of the post is that most people drastically underestimate the cost of doing business. They’re willing to guesstimate things like vacancy without looking into local averages. Worse still, many people neglect to take recurring expenses like tenant placement fees and landscaping (where applicable).
You should be somewhat conservative in your analysis. Your agent, the seller, and even your property management have a vested interest in showing you best-case scenarios for cash flow and appreciation. It is incumbent upon you to take a more realistic view of a potential property. You must put money away every single month to pay for replacement of capital items like roofs, water heaters, furnaces, and even the structure itself. Don’t be cynical, but don’t assume that everything in the property will perpetually operate under ideal conditions. Things will go wrong, and then you’ll be happy you budgeted for them.
Identify Properties of Interest
Once I know my approximate costs of doing business, I usually set up a copy of the analysis spreadsheet tailored to the market I am shopping. I have a property manager in mind (or at least an idea of average costs across several PM companies), so I plug those numbers in. I have an idea of the terms of financing, so I pre-populate those values too.
The goal is to have a template for the market where the only items I have to change are purchase price, improvements needed, and monthly rents. This allows me to very quickly evaluate properties to decide whether they merit someone actually getting in the front door. You are the one who has to determine what return is acceptable to you. I always consider the long term average return of an index fund (7-9%) and the additional risk taken on when renting property. For that reason, I look for a cash ROI of at least 12-13%. I also try to get at least $100 of monthly cash flow per $10,000 in up-front cash invested.
Put more simply, after plugging all my costs, vacancy, and saving for reserves into my analysis, my next property has a cash ROI of 14%, and $332 in bottom-line cash flow per month on $28,398 of down payment, closing costs, and improvements. Thus, the property met my bar for further investigation. You should apply your own minimum standards to any property before expending any more effort.
Once you have a property that looks good on paper, you, your agent, or both of you should get access to the property itself. If you do not have extensive construction experience and the property obviously needs repairs, bring along a contractor, or ask your agent to bring one. Don’t just guess or assume that the properties will be a certain cost. Rely on an expert.
I don’t visit my rentals in person before purchase. I am not a contractor, and I am not aiming to live in them. I do a number-based analysis, then I rely on my agent for an assessment of the property’s viability as a rental and my property inspector for an assessment of the condition. I am not scared of this, because I trust my team. Do what feels right for you.
One of the most difficult steps in evaluating a property is depersonalizing. Most of us walk into a home and cannot help but apply our own desires to it. If you are buying in a niche above or below your own standard of living, you must put yourself in the shoes of your ideal tenant instead. If you were your tenant, is this the kind of place they would want to live, and pay the rents you think you could get?
If, after estimated repairs, a property is within your budget and would be an appealing home for your target renter in your target niche, it may be time to make an offer.
Make An Offer, and Know Your Limit
Negotiating price is more or less the same when buying an investment property as it is buying a home. It’s just far more important to remain unemotional and not become a motivated buyer.
When you make your offer, you should know the absolute maximum you are willing to raise that offer before walking away. During negotiations is not the time to try to determine this, as you have likely already become compromised. If the asking price is $85,000, and you know that you must pay no more than $78,000 to achieve your required return, then you don’t offer one penny over your maximum asking price. You’d be surprised how often people capitulate when you turn down their “best” counteroffer outright.
The Property Inspector is Your Best Friend
Once you have an accepted offer, the first thing you will likely do is employ a property inspector to complete an inspection of the home within seven days. Most sales contracts should include a clause about being able to back out of the agreement with no penalty based on the results of the property inspection.
The property inspector is one of the only completely impartial people involved in the whole real estate transaction. They are more impartial than your agent, and even more impartial than you, the buyer. Their job is to give a complete assessment of all structure, mechanical, and cosmetic issues on the property. You will be furnished with a complete report of issues, large and small, and it will be up to you to decide whether to do anything about it.
The property inspector is not superhuman. They cannot see through walls or foundations. If an issue cannot be seen with the naked eye, it is unlikely that the inspector will find it. Still, they are trained to find most issues that could be a nasty surprise after closing.
Remember that all properties have some issues. You should be comfortable when you remove the contingency on the sales contract, but you don’t need to have the seller address every (or even most) issues, and many of them don’t need to be immediately addressed by you as the buyer. It’s tempting to see each issue as a dollar sign, but they’re not. Many minor issues can be ignored if they don’t impact the safety, comfort, or enjoyment of your tenants.
Once you’ve removed the contingency on the property, the following month or two will be filled with the straightforward process of closing the property. On the day of the closing, you or your agent will pick up keys, and the title will be recorded under your name with the local municipality.
Finally, you need to get your investment occupied and producing income! You may have inherited tenants from the previous owner. If so, you will be obliged to honor the terms of their existing lease. If the lease is long term, you can only replace it with your own when that term ends. If it’s a month to month lease, you may be able to require the tenant to sign a new lease of your choosing. If you have an existing and reliable tenant, consider whether it is worth moving them out to gain a small amount of rent per month. If you have to pay a tenant placement fee, you could actually end up losing money by upgrading tenants. Rather, it may be worthwhile to explain to your tenant that you want to bring the unit to market rents, but that you are willing to raise the rents over a year or two in recognition of their status as a good tenant. Some warning and some empathy go a long way.
If you need to find your own tenants (or have your property manager do it), you’ll again need to formulate a policy for what tenants will meet your standards. You may opt to have your PM use their best judgment, or you might set the standards yourself. Once again, BiggerPockets has a great guide on this topic.
Finding Great Rental Properties: Conclusion
I hope that this guide has given you a more solid understanding of how to turn your dreams of rental property into reality. I’m looking forward to adding two more units to our cash flow by early next year, but I’d also love to hear about how you select rental properties! Alternately, if you’re just getting started and have some questions, let me know in the comments and I (and others) would be thrilled to try to help!