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 Mindset:
First, investors change your mindset. Experts say go into your property search with the mindset that you will be holding onto this one for the long haul. It's quite a different approach from the 60 or 90-day model, where you are taking everything out, making it all brand new and putting the property right back on the market. So, not only do you need to find a great location, but the house itself should be great too. No more worst house on the block mentality.
Next, think about the type of tenant you want to attract. Are you going for professional singles or young couples? Perhaps older folks who have become empty nesters. If so, you might look for properties with large first-floor masters or dog parks nearby 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. It's common sense, but a consideration that is sometime overlooked and that can effect your bottom line. Determining your target tenant is the easy part. This next step is more challenging.
Experts say locate properties that are likely to generate positive cash flow almost immediately. From an investor's point of view, producing cash flow quickly without overpaying for a property, can be a tough sell.
What Helped Me:
If you purchase a multi-unit property and one of your units is suitable to lease right away for a nominal amount, do so on a month-to-month basis. Meantime, make improvements to the remaining unit(s) and rent them out one by one, at a higher fee. Then, make plans to update the lesser unit at a later date and adjust the rent accordingly when it's complete.
The other option I have found doable is to buy a property that is nice enough that you can make quick improvements while you are trying to hire your management team and get it tenanted. Hopefully, you will complete the work by the time they are ready to move in. It's a risk, but most families need 30 days to prepare for a move anyway, and hopefully, that will give you the window you need to complete your improvements just in time, creating positive cash flow - quickly. By the way, so we are clear on the definition, positive cash flow means money left over at the end of the month after you deduct all of your expenses including any mortgage you might have on that property.
An Example : (from one of my first rentals)
If your rent is $2950 and you deduct insurance, taxes, monthly management fee, mortgage (if you have one), and you still have $900 per month, well done! I strongly agree with the experts and suggest that you save that money and let it sit in an operating account because, as I discovered early on, you might need it for unexpected repairs or vacancies.
My Final Step:
The final step I like to take is considering if the rental property is likely to be a "deal, " long term. One area to consider is appreciation or the properties likelihood to increase in value over time. While that is hard to determine, I look at comparables or comps from the past six months to two years.
The other area is basis points, and that has to be calculated. The explanation I learned in real estate school was a bit complicated, so ! searched online for a simple and clear example and found this one on Zillow.
While I don't like to copy and paste, I decided to do so in this case, so you could see exactly how the Author (Prof. Baron) set it up.
*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: Try inserting your own numbers from a rental property you'd like to buy. Based on his formula, is it likely to be a good deal? Frankly, when I tried it on a recent purchase, and I ranked in the "not so good" range, but I expected as much because I didn't buy 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 plan.
5-in-1 Plan: The concept being that investors should try to keep every fifth property they buy and turn it into a positive cash flow rental if that property 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 finance.
Bottom Line: Bottom line, despite how much we might enjoy the TV shows, 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 generational 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 legwork and selecting the right property.
*Formula courtesy: Zillow and Professor Leonard Baron University of San Diego per Zillow.com)