How to Select Investment Property?

by Krantcents · 37 comments

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Finding a good investment property is no easy task!   Many people buy a home to raise a family, a hedge against inflation or flip and make a quick profit.  There are still others who buy homes as an alternative to investing in the stock market.  It may be a vacation home or a rental property, but it is still an investment!  If you want to find a good investment property, you need to know what to look for in a property.  

When you are buying a personal residence, you need to consider how much you can afford, down payment and qualifying for a mortgage. Investment property is no different, but you won’t live there!  Since the residence is not owner occupied, you will pay a slightly higher interest rate.  Whether it is a personal residence or an investment property, you need to run the numbers.  Investing in real estate can be part of your long range strategy for having income in retirement  or saving for retirement.  Diversifying your portfolio to include real estate is a good idea to be less dependent on the stock market.

Every market is different, but you need to start with an estimate of the rent you can charge.  There are rules of thumb that you can charge 0.5-1% of the sales price which may be true for properties in certain areas, but not everywhere.  In my example, I will use the median price and rent in the Los Angeles area.  I think the best way is to do a little research.  That is exactly what I did when I owned apartments.  I would go around in the neighborhood and act as though I was interested in renting an apartment.  This is probably not possible for a home.

Trying to establish rental prices for homes is a little trickier.  Homes are different because of their particular amenities.  A three bedroom is not the same in size, location or amenities.  Apartments are more similar in a particular neighborhood.  A real estate broker who rents homes is a good resource as well as some online resources.  Just like apartments, home values are based on location, amenities, size, age, condition, quality of schools and services.  There is one more factor which is very powerful and is the marketplace.  Supply and demand will materially affect the price of a home.

Now that you understand what contributes to home prices, you may apply the same criteria to help establish a rent. The rental market in a particular neighborhood establishes the rent just like the market price for a home sale.  You have to make a decision what you can afford and what factors you identify will help your home make a profit when you sell.  Most people who buy homes as investment property want to earn a profit while they own it.  The goal should always be to have a positive cash flow from day one.  This is no easy task because it depends on a number of factors.

What are the factors?  They are price, down payment mortgage balance and expenses.  Let’s go through an example, you buy a home or condominium for $400,000.  In theory, you could rent it out for $1,850 a month based on median prices in the Los Angeles area.  You would normally come up with a 20% down payment of $80,000 and carry a mortgage of $320,000 at 3.5%.  Based on my example, the mortgage payment is $1,437 per month for thirty (30) years.  Real estate taxes alone are $417 per month.  Based on just these two (2) expenses, you cannot breakeven!  What should you do?

Real estate is expensive in Los Angeles, but so are rents!  You need to locate a property that meets your investment criteria and you can charge more rent.  I do not mean to sound flip because it is no easy task.  When I bought my first home I had to find a situation that met my criteria which meant buying a fixer.  A good house that needed some work in a good location and I would gain when I sold the property.  Using my example, you would have to able to charge a rent of roughly $2,100 per month.  You need to cover a mortgage of $1,437, real estate property taxes of $417, property insurance of approximately $150 and a reserve for vacancy and repairs of $100 for a total of $2,100 per month.  Is that possible?

Of course it is, but you will have to do some research!  You may have to look for the cheapest home in a good neighborhood which may mean a foreclosure  or short sale.  Maybe you should look for a neighborhood in transition.  Making money in rental property is never easy!  Remember, starter homes in every part of the country are always a good choice.  A starter home is a small home or condominium someone buys as a first home.  The cost is lower and the rent would be more reasonable.  The important part is it will always be marketable as a rental and a sale.  The only downside is there is always a demand which may push the price  up a little.  Any home priced right which includes setting an appropriate rent will do well.  Rents are increasing because of lack of supply and demand because of stringent credit for new loans.

This is not a get rich quick scheme, buying investment property is like any other investment.  You need to spend some time researching and finding the right properties.  About eighteen years (18) years ago, I rented out my personal residence.  It was a five (5) bedroom, three (3) bath home with a pool and view of the city.  It overlooked a private country club in the Los Angeles area.  I rented it out for three (3) years for $2,500 per month.  I included pool service and garden service in the rent.  It was important to maintain the property because I wanted to sell it after the three (3) years.  In the meantime, we downsized to a townhouse.  Unlike a new purchase, my mortgage was much lower and so were the taxes, but the rent was based on the market.  The Los Angeles market is more expensive than most of the country, but it is also a great rental area too.  The same principle applies for international readers. Some countries such as Australia have a huge number of mortgage providers, so it can be a good idea to call up a local mortgage broker..

Final thoughts

Finding investment property is a  numbers game!  That in itself is completely different from buying your personal residence.  When buying investment property you should not forget that you will still sell the property as a personal residence eventually.  You have to find the right property at the right price to have a positive cash flow immediately.  Remember, rent is not forever.  You can and should raise the rent annually to cover your costs and cost of living.  It is real important to maintain your property and you need the money to do so.  If you invested in a stock and you did not receive the desired yield, you would sell it.  The goal in rental property is to make a profit while you own it.  Some may take a small loss  because the value of the property is increasing and  tax advantages.  That is a different strategy although a good one.  It is up to you, it is your investment property!

Photo by: dbking

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AverageJoe March 12, 2013 at 5:09 am

How much weight do you think someone should give to the Zillow rent number on a property, KC? I’m thinking you’ve probably used it before with your properties. We set our rent right at the Zillow amount and I got it, but there was a lot of complaining by people that I’d priced my rental too high. Did I get lucky?

Krantcents March 12, 2013 at 6:51 am

My rental property experience predates Zillow! I found that home values on Zillow lag behind the market. It is true as the market goes up and down. I would use it as part of my research and understand that it lags behind a little.

Tony@WeOnlyDoThisOnce March 12, 2013 at 5:39 am

Great post. Thanks for the emphasis on objectivity in a real estate investment; so easy to fall into the trap of making “gut feeling” buys.

Krantcents March 12, 2013 at 6:55 am

Thanks, rental property has to make sense in the numbers or you lose money. That is the main difference between a home and a rental. A tenant will never become emotionally attached to your rental! If they do, they are a likely buyer.

John S @ Frugal Rules March 12, 2013 at 6:54 am

Great insight. Never being in real estate myself I can understand the desire to make money, but I agree that positive cash flow is immensely important. My wife and I almost ended up moving to LA a number of years ago. Knowing what the rent situation is I am so glad we didn’t. Our money can go much farther here in the boring old Midwest. :)

Krantcents March 12, 2013 at 7:22 am

Rents and real estate prices are higher, but so are wages. I think it evens it out.

Holly@ClubThrifty March 12, 2013 at 9:58 am

Great post and great advice! I love owning rental property because it is an investment that I can visually see, touch, and feel. Right now we are reinvesting our positive cashflow into paying off our rental properties, but I do look forward to the day when our rental homes are money makers.

Krantcents March 12, 2013 at 11:16 am

My favorite part of rental property was the local control of the investment. It was very much a business with all the pros and cons.

Brian @ Luke1428 March 12, 2013 at 10:03 am

I think you highlighted the biggest mistake people make in rental real estate – paying too much when they purchase the property. I would say the big money in rental real estate is made during the buying process. We paid too much for our first rental because we were eager to get into the business, didn’t educate ourselves well enough and fell in love with a certain house. I’ve learned more since then and have focused only on foreclosures for our other properties. It’s a tougher process to go the short sale or foreclosure route and patience is key. However, the discounted prices outweigh the hassle and sets you on a cleaner path to making profits.

Krantcents March 12, 2013 at 11:17 am

Buying is important, but managing it is equally important. Little things like tenant selection, maintenance and raising rents are important too.

Brick By Brick Investing | Marvin March 13, 2013 at 8:12 am

I’ve been wanting to get into real estate investing for a while now but haven’t had the time to sit down and educate myself on my current market. Not to mention single family homes in our area start at $650k

Krantcents March 13, 2013 at 9:31 am

I live in Los Angeles which is one of the more expensive areas of the country and I can find condominiums or starter homes for less than $650K. It may take some work to find and it will likely be a fixer.

Kim@Eyesonthedollar March 13, 2013 at 8:18 am

Unless it was a spectacular property, it would have to cash flow from the start. I’ve only done one residential rental, but we wanted a certain area, had a price in mind, and waited until a house came along. I think being too eager could make you buy the wrong property, but at the same time, you have to jump when the right one comes along.

Krantcents March 13, 2013 at 9:38 am

Very true! Real estate is one of those products that is very sensitive to the marketplace. The good ones that are priced right go quickly. The others more than likely are over priced because the market tells you by it sitting unsold.

Nunzio Bruno March 13, 2013 at 12:14 pm

Loved this post!! This is why everyone should take at least one finance class in their lives so that they can familiarize themselves with NPV, IRR, ROI and a few others. If you are just starting out it can be almost to easy to get lost in the research and if you don’t set up a criteria or expectations for each deal or your style you can really do some damage to yourself financially. Awesome job :)

Krantcents March 13, 2013 at 12:38 pm

Thanks. If you are not interested in finance, you would never think about taking a class. The sad truth is it will affect you whether you are interested or not.

Glen @ Monster Piggy Bank March 13, 2013 at 8:19 pm

Excellent post, My wife and I want to buy an investment house soon, but we are just waiting for the right one at the right price.

Krantcents March 13, 2013 at 8:25 pm

Don’t wait too long! Prices are going up in California and I expect it will be true in other parts of the country as demand exceeds supply.

Untemplater March 13, 2013 at 11:46 pm

Property is a good way to diversify income streams. It does take a lot of patience if you aren’t using a property manager as there will always be things that need repairing and renovating. It’s worth it to take your time finding good tenants who are qualified and responsible. There are too many horror stories in SF of squatters who refuse to leave and stop paying rent.

Krantcents March 14, 2013 at 6:56 am

I have had horror stories in my apartments, but when I rented my home, it was far less. Everything starts with the selection of the tenant.

Martin March 14, 2013 at 12:08 pm

When I bought my rental the process was simple. I wanted something new with lots of potential tenants. I bought a condo that was in development and I used Kijiji to determine what the demand was in that area. The demand was huge and I’ve never had an issue with finding a tenant since.

Krantcents March 14, 2013 at 12:12 pm

I never heard of that program, tel me more.

My Financial Independence Journey March 14, 2013 at 6:06 pm

The problem you described is exactly what I ran into where I live. Almost any descent house or condo would cost more per month than I could charge in rent. I probably need to do a lot more exhaustive searching, particularly among lower priced properties.

Krantcents March 14, 2013 at 9:00 pm

It is not easy! In Los Angeles, we are beginning a seller’s market. The low supply of homes for sale is driving up prices. It just means you have to work harder to find something.

KK @ Student Debt Survivor March 16, 2013 at 3:15 pm

This post comes at a good time for me. We’ve been thinking about buying an investment property and are working on saving up a decent sized downpayment. We plan on buying in Maine (my home state) because the housing there is so much cheaper and because my step-dad is pretty handy and would be able to watch over the property for us when he retires.

Krantcents March 16, 2013 at 4:41 pm

Sounds good! How is the rental market in Maine? Would you take advantage of the college towns or the summer rentals? Remember the numbers need to make sense. Good luck.

Jim March 16, 2013 at 9:18 pm

Great post, I totally agree that rental property is a total numbers game. I have 2 properties, one that I manage myself and the other managed by a management company (property is located in a different city than where I live). The one that I don’t manage, does cash flow but it is difficult to get everyone to pay on time! The expenses are higher, due to the age of the building. My hands are tied, I have to have the management company, but with one property, I have very little leverage and so I am not getting top-notch service. Anyway, still believe it is a good investment, if nothing else for the tax bene’s!! Great post

Krantcents March 17, 2013 at 6:55 am

Thanks, you may want to discuss some of your concerns with the management company. They are providing a service which should be better than if you did it yourself.

Shawn @ PipsToday April 12, 2013 at 11:01 pm

Great post, I have invested money in stock and forex market. I am agree with your point “If you invested in a stock and you did not receive the desired yield” But most of the investor chose this field first. I am also planning to invest money in real estate for earning purpose, I just forget maintain the property section yes that’s very important part, Thanks for the tips.

Krantcents April 13, 2013 at 7:38 am

Thanks, investing in income property is much more hands on than the stock market, but it can be more lucrative.

Shawn @ PipsToday April 14, 2013 at 9:45 pm

Yes you are right, Thanks for your response.

Krantcents April 15, 2013 at 6:51 am

Another choice can be REITS. Similar to the stock market and less hands on!

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