How to Find and Buy Rental Properties

The hotter the real estate market, the lower the percentage (leaving more money to pursue more “flip” properties). In a market such as the one today, the percentage is higher. While there is always money to be made in flipping properties, no matter the market condition, the profit margins become more slim in a downturn market. To insure against these narrower profit margins, an increase in rental property holdings solidifies our company’s financial position until the inevitable rebound of the cyclical real estate market. This approach to long-term real estate investing isn’t new. It’s the exact same approach the general market takes towards stocks and bonds. Stocks and bonds hold a directly inverse relationship. With stocks go up, bonds go down, and vice versa. This is because bonds are safe investment vehicles, while stocks are not. Correspondingly, however, bonds have relatively low interest rates, making them much less attractive than stocks. This combination is what causes the direct inverse relationship. When the stock market is in a downturn, the market as a whole (that being basically a conglomeration of millions of individual and institutional investors) has a tendency to move its money into bonds to insure against the waning stock valuations. Similarly, when the stock market is doing well, the money moves back from the bonds into the stocks. The real estate investment strategy I announced above works the exact same way.

When the real estate market experiences a downturn, like now, as well as in the early nineties, and late nineties, an increase in your holdings of income generating properties is the way to insure against the lower real estate market. There are some ancillary benefits as well. Take a look at any of the numbers coming out across the country today regarding the housing market. In general, this media related panic has caused an increasing record number of homes to be on the market. While I’ve discussed this more in detail here, for the purposes of the subject of rental properties, the effect that this market downturn has is that more people avoid buying a home, and instead rent. Uniquely, the current credit crunch occurring thanks in part to the subprime meltdown has lessened the availability of financing for the average homebuyer, thus even further increasing the pool of possible renters. On top of the general investing strategy, these additional factors make owning rental property in a real estate downturn a very profitable venture.

So that’s the why, in a nutshell. Now let’s talk about the how. There are a million different things to take into consideration when evaluating properties to buy as rental properties: the condition of the property, the location, the going neighborhood rental rates, desired target renters, etc. These vary so differently for each investor, it’s nearly impossible to attempt to generalize an approach as to what to look for and what not to look for. Luckily, these factors are actually some of the smallest aspects of the decision. Once you establish a certain criteria for the type of property you’re looking for, there’s a good chance you’re going to have a plethora of properties to choose from. What advice I can give, however, is regarding the most important aspect of scouting rental properties for value: price.

First and foremost, when you run the numbers on a potential rental property, it must cash flow. In simple terms, that means that the rent covers the mortgage payment and all other out of pockets costs for the month, with money left over. It’s a no-brainer that a property must cash flow, but you’d be surprised how many investors I run into that seem to have forgotten this “golden rule,” and pay additional money out of their own pockets each month just to own the property. Now, I  do understand that there is an argument to be said that a property doesn’t have to actually cash flow as long as it cash flows on paper (meaning that, since a part of your monthly mortgage payment pays down principal, this additional amount should be taken into account) however it’s my personal opinion that, with so many properties available to purchase, especially today, splitting hairs with a determination like that is just a waste of time and resources. This argument is actually irrelevant, however, once you get into the second determination of return on investment. We’ll get to that in a second, but back to the golden rule. Let’s take a real world example of a property I scouted for our company just last week. It was a 5 bedroom, 2 bath property in a decent neighborhood. Average rental rates in the area for a 5 bedroom were around $1,300-$1,500. The debt service on this property (i.e. mortgage payment, insurance, and taxes) was estimated to be around $1,100. We always require our tenants to pay for all utilities, except for city sewer and water. The city sewer and water bill is was estimated to be around $30 a month. Finally, our company uses a property management company to manage our rental properties, and they charge $50 a month per property. So, let’s run the numbers on this property:

Rent:                        +1,400 (the average of the neighborhood rental rates)

Debt service:             - 1,100 (principal, interest, taxes and insurance)

City utility bill:         - 30

Property manager:    -50

_____________

Net result:+ $220

So that property cash flowed. At the end of each month this property will yield an estimated surplus of $220. That might sound like a good deal, but we didn’t buy that property. I’ll explain in a bit, but the property did at least meet the first and foremost barrier. It must must must, absolutely must, cash flow. Check.

Ok, so that on to the final determination. When you strip away all the other extrinsic factors, deciding which rental properties to invest in is really a simple determination of desired return on investment. The same way that you would evaluate a money market or mutual fund, for example, applies here. Think about your retirement portfolio for a second, if you have one. When you’re evaluating what and where to invest, it all comes down to return on investment. That is to say, how much interest you will earn on your money. For example, right now a Certificate of Deposit (CD) with the bank typically yields around a 2 or 3% annualized return on your investment. Not that great, however CD’s are pretty much the closest thing you can come to a sure thing, so you pay for that lack of risk by the lower return. Anyway, evaluating rental property is the exact same thing. It’s simply a calculation of how much a particular property will cash flow over a year, and what percentage of your initial investment that represents. Let’s discuss your initial investment in a rental property for a second. Although it is still very possible to buy property with no money down, it’s difficult to find a property in good enough shape, in a good enough area, with good enough renters, to cash flow when you purchase it with no money down. This is because your debt service will typically be too high. Therefore, your best bet in investing in rental properties is to allocate a small amount of funds for the purchase of each property. It doesn’t have to be much. Just enough to make a meaningful difference in the mortgage payment, because, obviously, the lower the mortgage payment, the higher that property will cash flow. As an illustration, our company typically reserves enough cash for a 10% downpayment on any rental property. You may decide on a different amount, depending upon considerations such as available financing, and etc., but I offer that as a benchmark. This isn’t to say that if you find a property you can cash flow with no money down, that you shouldn’t do it. Simple math proves that a property cash flowing on no initial investment has a return of investment of infinity (because 1 is an infinity percent of zero), and there isn’t a market investor in the world that wouldn’t jump at an infinite percentage return on investment. However, since it’s not likely, we’ll continue on discussing your desired return on investment.

This is where the rubber hits the road, and not surprisingly, it’s again necessary to utilize an equation. The calculation of return on investment in rental properties isn’t just a simple comparison of annual cash flow versus initial investment. When looking over the long term regarding rental properties, there’s an inevitable conglomerate of factors that you must plan for. One of those is maintenance and repair. Just like your own home, there is a percentage that needs to be set aside for repairs. This percentage most certainly varies depending upon the age and condition of the home, however it must be considered nonetheless. Let’s say, simply for illustrative purposes, that percentage is 10% of rents each year. So if the annual rent a property will bring is $10,000, then $1,000 should be set aside each year for maintenance and repairs. That may be low or high, depending, again, upon the age and condition of the property, but for examples sake, let’s say that’s accurate (our company typically uses 15% to be conservative). The second thing to take into consideration is the inevitable result of deadbeat tenants. It never fails that no matter the pre-screening you do of your tenants, some eventually don’t pay, and have to be evicted. Although the eviction process differs in each state, it’s typically worthwhile to account for two months worth of rent per year as a reserve for such an event. In the event it doesn’t happen to a particular property, that’s great news and extra cash to you, but either way, if it does happen and it wasn’t planned for in the beginning, resources may have to be diverted from more profitable ventures, which you should try to avoid at all costs.

The Equation

Now that I’ve explained it, here’s the equation:

[(CF * 12) - (AR * X%) - (MR * 2)] / [Initial Investment] = ROI

Legend

CF = Cash Flow (from earlier)
AR = Annual Rents
MR =  Monthly Rent
X = the percentage of annual rents set aside for maintenance and repair
ROI = Return on Investment

(CF * 12) represents annualized cash flow.
(AR * X%) represents the dollar amount set aside maintenance and repair
(MR * 2) represents the vacancy/eviction reserve

Example

Let’s revisit the example I discussed earlier, the property I evaluated just last week. The cash flow on the property was $220. Monthly Rent was $1,300. Since we typically put around 10% down on a rental property, let’s assume the purchase price was $200,000, so that would be $20,000. Here’s it is in the equation:

[($220 * 12) - ($15,600 * .10) - ($1,300 * 2)] / $20,000 = -7%

After running this potential property through the equation, you can see that what seemed like an excellent deal before, at $220 a month cash flow, actually isn’t. In fact, it yields a negative return. I have to note that this is a very conservative equation. A more common form of it does not include the reserve for vacancy/evictions, however in removing those aspects, you must make sure to independently have those reserves available just in case. In that situation, the filled in equation for this example would look like this:

[($220 * 12) - ($15,600 * .10)] / $20,000 = 5.4%

With the less conservative equation leaving the vacancy/eviction reserve out, the annualized return on investment for the example given would be 5.4%.

Conclusion

Once you run the equation, the only remaining thing is to compare the estimated return on investment to your desired return on investment. Your desired return on investment is entirely personally. It will play into your overall investment portfolio, complement your other investments, and take into account your level of risk. Our company’s desired return on investment is 10-15%. It’s been set as a range simply because other factors can come into play such as growing neighborhood, or a forthcoming upswing in the real estate market that would make it beneficial to own more properties in the short term with less return that normal. Either way, we do not purchase rental properties that will result in a return on investment less than 10%. To work this equation backwards would mean that for this property to meet our requirements, it would have to cash flow $296 per month.

Now that you know how to evaluate the financial aspect of potential rental properties, I have one final comment. The current state of affairs in the real estate market means that now is an absolute fabulous time to acquire rental properties and grow your overall real estate portfolio. People are so panicked by this market that they are almost literally giving their property away. Surprisingly, even other investors are doing the same (blatantly ignoring the buy low sell high mantra, and instead selling as possibly low as they can). All this means is that there are phenomenal deals out there, everywhere. Since acquiring properties to hold for rent does not require any concern over having to sell, the worse the market for sellers, the better off for acquiring rental properties. Thinking long term, when the cyclical real estate market does make it’s rebound, you’ll be holding a large portfolio of properties which you can either continue to hold, or liquidate and move on. Either way, you’ll be in very good shape, considering the great price you acquired these properties for during the down market. The time is now. Get started, and good luck!