5 Rules To Buying An Investment Property

Morgan Ellis
Morgan Ellis
Published on August 4, 2020

Are you considering buying an investment property? How do you know you’re picking the right one? Or that you’ll actually make a profit? Maybe you’re just getting started or maybe you’re a seasoned vet in the field and just need a refresher, but there are a couple of guidelines it is important to follow to ensure success. Much like anything else in life, you can’t just jump into things. You need to develop a plan and you need to know where you’re going and that all begins with knowing what to look out for before you dive in. Before you spend any money be sure to check out these 5 rules to buying an investment property.

Be conservative and patient.

One of the most important rules when investing in a property is to be conservative. You don’t want to dump a bunch of money into something you’re won’t see a return on, or worse, get a negative return. When looking at what rent might be for a property, don’t assume the highest rent in the neighborhood is what you will get for it. Even if you have the best or nicest house, we suggest using 80% of the comparable rent price. Why? Because as silly as it sounds, it is important to budget for the unexpected. Or to be cliche, expect the unexpected. It’s better to be conservative so when you come out of the other end, your return hopefully is better than what you planned for and if it’s not, itll still be good! 

Along with this is the importance of being patient. There are A LOT of rental properties out there. It’s so easy to get attached to a project that you’re putting money into but it is important to not make emotional decisions to make a wise investment. You may lose out on deals or cancel a couple of deals because in the end the numbers may not work out or the repairs are too expensive. Don’t fall in love with your investments or their potential. Be patient and find a property that will work for you and your budget. 

Know what kind of market you’re entering. 

You want to make sure that you’re getting a good deal.That depends on what market you’re in and where you are. You could be in a sellers market or you could be in a buyers market. Sometimes the asking price and what the property is worth does not correlate.Whether they are overpriced or underpriced you need to be aware of which party the market is going to favor. When buying an investment property a goal would be to pay 80% of the retail value. That way, if for whatever reason, you have to sell the property tomorrow, you’ve still made some money. Again, you want to be a little bit conservative by making sure you’ve got a good deal in today’s market. 

Know Your Rate of Return

What is an acceptable return for your investment? There are a couple of ways to calculate this, like gross rent multipliers or cash-on-cash return. However, taking rule number one into consideration, we want to find the CAP rate because it is conservative and consistent. If you’re in the St. Pete area then you might be looking at a 5-8% return.  If you’re in a good neighborhood it could be an 8-12% return. If you’re anywhere outside of the St. Pete area, those numbers might not apply. You might be in a totally different market where nothing under 10 % is acceptable, but in St. Pete it is acceptable. Those lower percentage returns will sometimes translate into higher appreciation properties. Good neighborhoods tend to appreciate a little faster, fringe neighborhoods could go either way so it’s a bit more of a risk but you might get a little bit more rent. Now if you’re in a struggling neighborhood, your rate of return might be really high because your acquisition cost is lower. Now keep in mind, you may have to deal with more repairs, or more collections, or more vacancies. Overall, you should have more of a return in those struggling neighborhoods. 

So how do you calculate the CAP Rate?

CAP= Net Operating Income/ Acquisition Cost

NOI

NOI is Net Operating Income. This is your income (in this case the rent) minus your expenses (can include tax, insurance, maintenance, utilities, landscape, management, vacancy)

A few key points in calculating your NOI is to take into consideration how often this income or expenses occur. Most of these occur monthly so you will need to multiply those numbers by 12. Also, you should have a plan for vacancy. Even if you have a renter lined up, after a year or two they might move leaving you with vacancy. Let’s assume your turn around is 2 weeks, you need to getting it cleaned up, get it rented, and evaluating tenants. Those 2 weeks account for 5% of what you could be making. If you have a whole month that’s 8% almost 10%. Another key point is to not plan on the taxes paid last year, chances are they are going to be different. If you have a well kept property your maintenance should only be about 5%, but if not it could be up to 10%-15%. You may or may not pay for any utilities, but make sure you’re calculating that. Landscaping may also be over looked. A lot of the time tenants are taking care of it but if you don’t want to chance that, make sure you calculate your monthly landscape costs. The last aspect to keep in mind is Management. If you’re not local you might want to have someone manage your property, estimate about 10%.

Acquisition Costs:

Your acquisition cost is not just the sticker price of the house. There are always some extra costs, even if you pay cash. Closing costs on cash may just be a couple hundred dollars but if you are financing it could be 5% and that can include maybe first year of taxes and insurance and the cost of the mortgage fees. It could also include improvements. You may think the house is move in ready but plan for at least $1,500 even if you think it just needs to be cleaned, at least that will give you a little but of a buffer but most places need painting, cleaning. If it just needs a light touch up, plan for $5,000. However, if you need to do renovations to make it move in ready you may need to spend a lot more than that. So, when you’re shopping for an investment property determine the improvement costs, then add another 20-25%.

Patience… Again.

Be patient with your return. If you go into a rental property, especially with a mortgage, and expect to be making money hand over fist you will be disappointing. If you want a quicker return, then you might want to flip a property. It is more risky, you may make a lot of money, you might break even or you may be negative. So when you’re buying an investment property as a rental it is important to remain patient with your return and remember your tenant is paying your mortgage and your expenses. All the while your property should be appreciating.

NEVER REFINANCE MORE THAN YOUR ORIGINAL INVESTMENT. 

If you spend $100,000 on a property and you put $20,000 into fixing it up if you refinance it, ideally within the first 2- 5 years, don’t take out more than $120,000. It is okay to take out your original cash, but don’t take out more than that because you will still have to pay taxes on it when you sell it in the future. If you decide to refinance at a higher price, your investment becomes more risky and its how a lot of people get into trouble.

I hope this article provided some value to you, if you want to hear more about buying an investment property this topic you can listen to our broker, Morgan Ellis, talk about it here.

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