Real Estate 101 – Investment Property

Whenever an investment is universally despised, it’s often a good time to consider investing.  And, no investment is as unpopular as real estate right now.  If I had a nickel for every article I’ve read lately that says, “A house is not an investment”, I could probably pay off my house.  The truth is that a house or other property IS an investment.  It’s a very large investment.  But, that doesn’t necessarily make it a good one.

This is the last in a series of four posts on real estate.

Real Estate 101 – Renting vs. Owning
Real Estate 101 – Market Dynamics
Real Estate 101 – Purchase and Finance
Real Estate 101 – Investment Property

Disclaimer: I’m not a licensed broker or a real estate professional and laws change and vary by state.  Before making any decision about buying a house, you should be aware of the laws or consult with a licensed professional.

The Economics of Investment Property

If a property is rented at a profit, or the mortgage is paid off, it’s an asset.
If a property is occupied with a mortgage, or rented at a loss, it’s a liability.

Monopoly Game

Image by Alan Cleaver

Notice this has nothing to do with the property values, appreciation or home equity?  What it has everything to do with is cash flow.  Real estate investment professionals look for properties that will provide a positive return on their investment.  The equity and appreciation are secondary.  A property that doesn’t return a positive cash flow is a poor investment and professionals will avoid it.  If it doesn’t “pencil out” they will look for another property.

Someone who buys a house to live in (retail customer) has very different needs and motives than someone who buys a property to make a profit (professional investor).  A retail customer should be much more concerned if this is a house they are going to enjoy living in for many years to come.  Is the neighborhood safe?  Are the schools good?  Are the neighbors friendly?  Is the structure sound?  Are there employment opportunities in the area?  If not, it’s probably a bad investment, no matter how much it costs or changes in value.

Finding Properties to Invest In

One of the most difficult things for a novice real estate investor to do is to find potential investment properties.  The network of real estate agents, brokers and mortgage lenders are geared primarily to serve retail customers.  And, they generally aren’t interested in looking through thousands of properties to find one that could provide a positive cash flow.  If they do find a house that is priced way under market and is suitable as a rental, it usually yields a pretty small commission.  And, it often comes with transfer hassles, such as a foreclosure or a short sale.  This doesn’t mean a real estate agent won’t help you find a good rental property.  But, they may be less than enthusiastic.  Or, they may try to convince you that retail-priced properties are a good investment.  Most of the retail properties will be money-losers.

Be prepared to a do a lot of the legwork yourself.  Look for FSBOs and talk to distressed sellers.  Check on Craigslist and look in your local newspaper.  Talk to banks and ask about their REO properties.  Ask around about agents who work as “bird dogs”.  These agents will look for specific types of properties for a finder’s fee.  Since, they are looking at properties all day anyway; they may spot something that meets your needs.  And, if sales are slow, they may be pretty aggressive in finding what you need.  Don’t get discouraged because you are going to have to look through a lot of properties to find a few suitable ones.  Then, you will discover the reason they are priced under market.  Patience and persistence are going to be the keys.

Money is Made or Lost in the Purchase

It may seem ridiculous to go through such a frustrating process to find a rental property.  But, the profitability is determined in the purchase.  If you buy an overpriced or unsuitable property, it could become a terrible investment that loses money every month.  This is known as an “alligator” because it will eat you alive.  If you don’t have the patience and the fortitude to find a suitable rental property, you should keep your money in the bank or a good mutual fund.  You probably aren’t cut out to be a landlord.

Here are the things you must know, before you buy a property:

  • Does it pencil out to a profit?
  • Is it a sound and suitable structure?
  • Is it the right size for a rental?
  • Is it in a rent-able neighborhood?
  • Is it within a short driving distance?

What Makes a Property Suitable?

Profit Potential – No matter how much you like a rental property, it must be profitable. This means the rent must be high enough to cover the mortgage, taxes, insurance, and some vacancy. Other costs such as routine maintenance, appliance repair, HVAC servicing, etc. should also be factored into the rent or be the tenant’s responsibility by contract. A good rule of thumb is that a property should rent for about 20% more than the mortgage, taxes and insurance. Every landlord should also carry a liability policy to cover unforeseen expenses.  Finally, before you buy a rental, you should know the comparable rents in the area or you risk extended periods of vacancy.

Location, Location, Location– There are two big issues with location and rental properties.  First, is it in a rent-able area?  The area should be safe and close to a large source of jobs.  There shouldn’t be a lot of vacant properties.  The area should have something that attracts tenants, such as a nice location, a college or a military base.  Second, is it within a reasonable driving distance.  The book Nothing Down recommends properties within the “Golden Hour”.  That way, you can easily maintain the property and collect the rent if necessary.  Unless you are going to pay a property manager, you shouldn’t buy properties too far away from where you live.

Size and Type– Obviously, you want a property that will rent easily.  These are 2-3 bedroom condos, 3-4 bedroom houses or duplexes and triplexes.  It is best to stay away from small or large rental properties.  The rental market mostly consists of young couples, small families or sets of roommates.  There is a demand for studio and single bedroom units, but these people will usually rent in an apartment complex a duplex/triplex.  Single bedroom condos are rarely profitable after the association costs.  And, the resale value on a 2 bedroom house is deplorable.  Large houses attract multi-family tenants or lots of roommates.  This leads to high maintenance costs and problems collecting the rent.  Vacation or luxury homes can difficult to keep occupied.

The Structure – The structure must be sound and the layout practical.  Unless you work in the construction trades, I recommend hiring an inspector prior to buying a property.  There could be huge liabilities from things like a cracked foundation, leaky roof, mold in the walls or substandard plumbing and electrical.  Properties that have been modified or converted into a duplex, should have layouts that make sense and all of the proper permitting.

Market Conditions

The last thing I want to talk about is market conditions for rental properties.  In some areas of the country, it’s easy to buy houses and rent them out.  The housing prices are low and the rents are high enough to make a profit, even on retail properties.  Where I live at the beach, a modest house costs  $500K and would rent for about $2,500 per month.  It makes no sense to put down $100K and take out a $400K mortgage to lose $1,000 per month.  My uncle lives out in the desert and he just bought a nice 3 bedroom foreclosure for $60K cash and rented it out for $950 per month.  You could do really well finding three or four deals like this.  But, that’s not typical of the market in Southern California.  It’s important to understand the market conditions where you live, so you don’t get stuck with an alligator property.

The Bottom Line

The bottom line is that short-term thinking doesn’t work for a long-term investment, like real estate.  The payoff from rental property comes after many years, as the rents rise and the mortgage gets paid down.  If you are looking to get rich quickly, I wouldn’t recommend becoming a landlord.  If you are looking for cash flow from investments, real estate makes a lot of sense.

“Landlords grow rich in their sleep.”

John Stuart Mill – British Philosopher

Recommended Reading

Consumerism Commentary – A Housing Recovery in the Distant Future?
Online Investing AI Blog – Is this the end?  Housing Prices Drop (Again)
Financially Fit – Real Estate Red Flags

This post was featured on the Carnival of Personal Finance over at A Gai Shan Life.  This is the Greatest Blog Carnival on the Net.  Check it out.

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6 comments to Real Estate 101 – Investment Property

  • I’m currently the landlord of a triplex, and looking to buy another rental property, as well. I really like this story — it’s a great primer on how to get involved in real estate rentals.

    I think the most important advice to a first-timer is to estimate what ALL the costs will be: the monthly mortgage, the property tax, the homeowner’s insurance, the water and trash collection (if you live in an area where landlords have to pay that). Then assume a 10 percent vacancy rate, and see if you can still achieve a positive cash-flow with the rent. If you can, it’s a property that’s worth looking into …

    Just don’t forget to start saving an “emergency fund” to pay for repairs and maintenance!
    Paula @ recently posted..Can You Afford a MistressMy Profile

    • Thanks for stopping by Paula.

      I would love to get a triplex here at the beach, but they are close to a million bucks right now. For some reason the property values drop here last. I may have to buy one in the Inland Empire (Riverside), but I don’t want to drive there to work on it.

      You are right about the emergency fund for a property. It seems like there are always a lot of expenses whenever someone moves out.

  • Marilyn Furse

    I read this one with interest, since I have a rental property. It’s definitely been good for me. Since I bought the property in 1996, I’ve only had two tenants, and it has only been vacant for a total of two months.
    My advice is to treat your tenant like a friend. Don’t try to get the highest rent you can – be reasonable. Fix anything it needs IMMEDIATELY, and thank your tenant for letting you know about the problem. If you can, involve them in the decision about what replacement appliance to get, what repairman to call, etc.
    Sometimes things like slab leaks, mold remediation, etc. are really expensive and come at a bad time, so be sure to allow $ for that!

    • This is great advice. Vacancy is one thing that will sink your budget every month. Back when I rented, my landlord rarely raised out rent and I stayed there for 13 years. I paid off almost half of the term on a 30-year mortgage.

  • This is a great advice especially for people who are trying to invest in a property. This helps me a lot in making decisions wisely and think about a long term goal rather than short term goals.

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