Rental Tales – Part I: The Perfect Market

Today, I will sign the closing paperwork on my latest real estate investment, a duplex located in a midwestern state.  Little by little over the past few months, I have been writing articles sharing my methodology for finding, analyzing, and purchasing rental properties.  Still, people write me several times a week to ask the same questions:  How do I pick the markets where I buy rentals?  How do I assemble a team?  Even though I have been trying to answer these questions in my articles, I recognize that it is hard for anyone to feel like they ever completely get it without doing it themselves.

Since I can’t act on your behalf, I’m going to try to share the next best thing.  Over the next few weeks, I’m going to tell you the story of my latest rental property purchase.  I’ll release one post per week on the following topics:

  • Finding the Perfect Market
  • Assembling the Team
  • Choosing a Property
  • Making an Offer and Inspection
  • Finding Financing, Insurance, and Property Management
  • Closing and Rehab
  • Placing Tenants

Obviously, rehab and tenants haven’t happened yet since I’m closing today.  Still, if all goes well in the next couple of months, the property should be up, running, and producing cash flow by the beginning of April.

What are we waiting for?  Let’s buy some property!

The Hunt for a Market Begins

In order to tell the story properly, I need to take you back in time to the beginning of 2015.  I already owned good properties in the southeastern US, but I wasn’t completely satisfied with the cash flow, which I thought was a little low.  I also knew that by the time I reach FI, I want to own property in a minimum of three markets to protect us against localized downturns, disasters, and other possible issues.

As I mentioned in my post about finding great rental properties, before you even attempt to find a market, you’ve got to pick your niche and your budget.  You might be able to find the greatest rental market in the country, but if you can’t afford the properties there, then it’s of little use to you.  Here’s what I know about the properties I want to own:

  • Price should be between $50,000-$80,000
  • I want to finance with 25-30% down
  • When possible, I want to purchase multifamily units
  • Neighborhood should be a solid B-/C+ (Working Class)
  • I want to spend less than $3,000 on inspection and closing costs
  • I want to spend less than $5,000 in initial repairs and rehab
  • I want the property to cash flow $100/month per $10,000 spent on purchase and rehab

A few of these parameters are by choice, a few of them I developed based on my experience. First, I started with our goals:  In four years, when we retire, we want to have $3,000 or more in safe cash flow per month from rentals.  You may know that I am pretty picky and conservative about how I analyze property. I allow for vacancy, repairs, tenant placement fees, lease renewals, and every other cost that is bound to eventually hit me on a property.  When the monthly transfers come in, the percentages I allow for each of those items remain in the real estate account.  Only what is left after allowing for all of those things is what I consider true cash flow, which gets transferred to a separate account.  That’s why the cash flow we count towards our retirement income increases more slowly for us that many people might reckon it.

At my current rate, it will take about ten properties as good or better than those I’ve already purchased to hit $3,000 in safe income per month.  That means I need to purchase two properties each year over the next three years.  I can save up about $20,000-$25,000 every six months if I am saving as hard as possible (and putting all real estate cash flow towards new properties).  That means I can afford a down payment, closing, and repairs on properties roughly in the $50,000-$80,000 range at that interval.  So, by knowing my income goal, how much lenders require of me, and how fast I can save, I’ve established my budget and my rate of property acquisition.

I like multifamily units because they help mitigate risk of vacancy somewhat.  If only one unit is occupied, you can generally at least still cover the mortgage. Just as important, multifamily properties tend to produce greater cash flow.  The downside of multifamily properties is that there are two or more of almost everything mechanical (furnace, hot water heater, AC – though my properties don’t have AC), so repair costs can be higher.

Cash flow is proportional to risk.  The very highest cash flow is in the lowest quality neighborhoods, but tenants are unreliable and the risk of damage to your property is very high.  Conversely, the lowest cash flow tends to be in the highest quality neighborhoods, where tenants are reliable and respectful of your property.  Because I want good cashflow, but also respectful tenants, I fall right in the middle of this spectrum.  I want neighborhoods that real estate investors would call “B” or “C” neighborhoods (like a report card).

Closing costs, inspection, appraisal, and other costs can be shopped for to some extent, but title companies and inspectors tend to also be close in price.  I go in expecting to spend about $3,000 on everything from offer to close, including the cost of financing.

The $5,000 repair budget is mostly out of necessity.  I can’t come up with the cash to buy a distressed property (which cannot usually be financed) and do an extensive renovation, so any property I buy needs to be eligible for financing, and within a few thousand dollars of rent ready.

My “$100 cash flow/month per $10,000 cash invested” rule is just my own rule of thumb.  You don’t have to follow it, because it relies on you doing the same sort of strict and merciless analysis that I do. If you don’t budget for tenant placements, lease renewal costs, and stuff like that, this rule might seem very easy.  But trust me, when you’re setting as much aside for vacancy, repairs, and fees as I do, this is a very high standard.  Again, if you’re not going to analyze exactly how I do (or more strictly), then you should ignore this.

The Field Narrows

Alright, so I knew what my ideal property looked like, and I knew what I could afford.  I kept my budget in mind and started researching average home prices nationwide.  There are any number of ways to do this, but Trulia has a pretty good map.  It was obvious: If I wanted to spend under $100,000 per property, my best options were the midwest and the south.

The truth is that there are great markets throughout these regions.  I knew that I wanted to purchase in a city, and you probably will too.  I wanted to have lots of options for brokers, lenders, insurers, property managers, inspectors, and contractors.  There’s nothing more terrifying than the thought of finding out your Property Manager is cheating you, and he’s the only guy in town.

I knew that I wanted to buy in a city with low unemployment and a large population of renters.  I happen to believe that mid-tier urban centers in the midwest and south will become more popular in the coming years as millennials flock to cities (and away from high cost of living areas).  That said, in my price range, there will simply always be tenants.

I know that readers will want a quantitative way of picking a market, but the truth is, even after having established all of these criteria, you still just have to look at markets and decide on a couple to focus on based on your subjective opinion.  In the end, you may look at a lot of properties in a number of markets that you feel good about until one jumps out at you as a great deal.

A Choice Emerges

I have lurked for years in the Biggerpockets forums, so each time I looked at a new market, I would search for posts about it.  I would read, and read, and read.  Eventually, I decided to call up an integrated brokerage/PM in a city in Ohio.  They were one of several such companies that I spoke to (I also looked at Wisconsin, Michigan, and Indiana).  I had seen several of their brokers participating on BiggerPockets, and they gave the impression of both being very busy and very engaged.  I interviewed them fully, expressed my questions and concerns, and ultimately, decided to begin a more intensive search for property in the city.

The broker I worked with listened as I described my property parameters, and set me up with access to the local MLS system, and a custom search tailored to what I was looking for.  Every week, I would receive an email highlighting the new properties matching that custom search.

The hunt was on.

Join me next week as the team comes together!

This Post Series Continues in Part II.

14 thoughts on “Rental Tales – Part I: The Perfect Market

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  8. JJPint

    The above all sounds fantastic, but how are you determining the neighborhood “class”? Is it anecdotal, or is there a standard tool you are using?

    1. The Vagabond Post author

      Hi JJPint, thanks for your comment. Truthfully, it’s a little subjective, but this article does a pretty good job of articulating how I see the letter grades:

      In short, an A neighborhood is perfect in nearly every way and probably filled with luxury properties, B is going to be white collar tenants and mostly newly-renovated, C neighborhoods will be working class tenants with few amenities (while still being safe and reasonably maintained), and D or lower are what most people would consider a “warzone.” Tenants will be unreliable and while on paper the cash flow can seem better (because the properties are CHEAP), the unreliability factor makes them a difficult investment.

  9. cody weiss

    This information is awesome! The rating system is awesome and I am currently using your cash flow calculator.

  10. Ashley

    Just discovered your blog – LOVE! I’m curious though… have you considered purchasing a house for short term rentals? Airbnb or VRBO? We’ve been thinking about taking the plunge but was wondering your thoughts on this vs. long term renters. Thanks!

    1. The Vagabond Post author

      Hi Ashley,

      I’ll do my best to answer, but I should say up front that I don’t know the economics of short-term rental the way I know them for residences.

      Obviously at the present time there are going to be opportunities, but I’m not sure we’ve hit the bottom yet and it’s difficult to predict how long the tourism sector will be depressed. Get lucky and call the bottom and you stand to do well– but another totally plausible scenario is that you could buy a vacation rental and then see little or no income in the coming few years, and it could become a millstone around your neck.

      I have been looking at hospitality businesses with a partner in the past few months, but those are a little larger than single-unit vacation rentals- on those, we’ve decided to sit and wait a little longer. Even here in the city where we live in Spain, a city that thrives on tourism, vacation apartments are disappearing left and right. Obviously all of this is market-specific. Wherever you’re considering buying might have a tourism sector that is somehow immune to pandemic factors. For me, where we are, the risk of things going badly in the near term is too high to enter the market.

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