So you think you’d like to invest in real estate do ya? Well congratulations. Real estate is one of the most powerful investment vehicles available. It’s also one of the most unique. Not only are you buying a structure with all the maintenance it requires, but you’re also buying the income stream that comes with it (the rent). When a rental property is bought right and in a good area, its tough to go wrong. Let’s discuss some of the factors to consider when looking into purchasing rental property.
LOCATION, LOCATION, LOCATION.
You’ve heard it before. Well, I’ll say it again. Location is number one when it comes to real estate. Getting a great price on a house nobody else wants to buy or rent is pointless. Home price appreciation (as well as rental appreciation) follows the rule of location more closely than any other. As it’s been said about real estate, “They’re aren’t making it any more.” This means if you’re buying in an area where people want to live, over the long-term you’re virtually guaranteed to see strong price appreciation and rental rates.
If only it were simple enough to buy a house in an area where people want to live and that was it. The problem with this is, prices in these areas are usually already pretty high. And the second rule of real estate governs when we can buy a property and for how much. It’s not just location we have to worry about, its also…….
For anyone but the most savvy, experienced investors, never buy a property that doesn’t make more in rent than all the expenses combined. The difference between the income the property produces and the expenses it costs to run it is your profit, or as we call it in real estate, cash flow. You may have heard the maxim, “Cash flow is king”. Well, it is. We are in this business to make money and it’s difficult to make money on a property that doesn’t pay for itself. While there are factors to consider such as price appreciation, loan pay down, and tax benefits, your meat and potatoes is still going to be cash flow.
(click here to link to an article on determining cash flow)
How does this compete with the rule of location? You’ll usually find that in general, the homes in the areas where everyone wants to live are priced too high to produce a solid cash flow. You’ll also usually find that the cheapest homes available often have the best cash flow. The problem is, cheap homes are usually cheap for a reason. Buying in the most undesirable areas brings its own set of headaches and I don’t recommend venturing into territory like this unless you’re very experienced and looking for a challenge. So if we want to buy in the areas where everyone wants to live, but we can’t make money unless we venture further away, what do we do?
Balance is the key to solving our location/cash flow problem. What I’ve typically found is homes in the urban/metro areas where the jobs are and everyone wants to live are usually priced too high to cash flow. Start venturing further away, often into the suburbs, and your odds of finding the right price to rent ratio start to increase. Regardless of the city or state, as a general rule, rental properties are typically going to be found in “bedroom communities”, or commute areas, where people live but commute to work. These are your hot spots where you’ll find the best chance of landing that perfect rental property. Once you’ve found your community where you can make the price work and the demand is still good, you’re going to want to look for….
SCHOOLS, JOBS, SOCIAL CLIMATE
Most people looking to rent a house have a family (single’s often elect for condo’s or apartments). Families mean kids, kids mean school. As I’m sure you can guess, the quality of schools will directly impact the demand for your property, which will directly impact the amount you can charge for rent. An often overlooked factor of buying in a great school district is parents won’t want to take their children out of the schools and will be more reluctant to move when rents are raised. Check out the school ratings online and see how well the local school system stacks up to other surrounding schools. Pursue properties in areas with an above average educational system.
Having a home in an area where people want to live is great, but if you want tenants to pay their rent, they are likely going to need a job. Jobs are important too. People follow jobs and want to live close to where they work. Once of the most profitable strategies in real estate is to find where the jobs are going and buy there early. As people move to the area for work they will need somewhere to live. This in turn will increase demand for your property which will drive up both the value of the property and the rental rates. Jobs are crucial. Follow the jobs.
When you’ve got people working together, and kids in school together, you’re going to get socializing. The social aspect of a neighborhood can have a huge impact on the direction the neighborhood takes. Buying in an area with parks, places for children or pets to play, and outdoor activities can foster a strong community that tenants will be reluctant to leave. The closer your tenants feel to their neighbors the less likely they will want to move across town to the new development that just went in with all the shiny bells and whistles. Conversely, neighborhoods with high crime, gang or drug problems, and very little socializing can lead to increased tenant turnover and vacancy rates. These factors also have a negative impact on home prices and rental demand. Avoid areas where there are no jobs and bad schools and you will likely be able to avoid areas with negative social climates in the process. In addition to the area where your home is located, you will also want to consider…
AGE/QUALITY OF THE HOME
Not only do you want to be in a good area, you want to own a nice, solid home as well! One of the BIGGEST detractors from rental income are repairs. Some repairs can be quite costly and the older a home gets, the more likely it will need more and more of them. While the foundation of most homes will stand longer than our lifetimes, homes are made up of many moving parts that will not. Hot water heaters, HVAC units, appliances, window seals, fences, roofs, and water pipes are all components that wear down with age and eventually need to be replaced. While home warranties can be purchased as insurance policies against unexpected problems, they are not a very reliable or cost-effective means of protecting your investment. As a general rule, the older a home is the more work it’s going to need to stay habitable and the closer it comes to functional obsolescence (this is a fancy word for a home that is so outdated and out of style it is slowly becoming unlivable). Examples of this are older homes with one bathroom or homes where you need to walk through one bedroom to get to another. While this may have been acceptable at one point in time, it is not something modern day tenants are going to want to pay for. Whenever possible, try to buy newer homes with popular floor plans that are less likely to need work for years to come. During market peaks, try to sell your older homes for top dollar and wait to buy newer homes after the market crashes. This strategy will ensure you are much less likely to catch any big surprises.
And last but not least:
LANDLORD FRIENDLY LAWS
The actual state where you are buying a home makes a difference in the experience you will have owning it. While some states are what we call “landlord friendly” (meaning they actually honor the contract and expect both sides to perform as promised), many others are not so much. California is notorious for siding with tenants even in situations where the tenant has clearly violated the terms of the lease. Research online and consult with a real estate attorney to get a better idea of the laws in your state. Don’t be afraid to invest in a different state if you feel the cards are stacked against you in your own. Like I say, make it as easy on yourself as possible!
So there you have it. The top factors to consider when purchasing rental property. While this is far from an exhaustive list, it’s enough to get you started and on your way to building wealth through the accumulation of cash generating assets.