Buying your first investment property (part three)

For those of you that missed the first installments   – start here and read up on the importance of picking your real estate team and some key rules to follow.  In part two we look into picking the right location and doing all of your due diligence ahead of time. Today we’re going to look at some concrete examples to wrap everything up.

I’ve covered a lot of ground fairly quickly in this series on buying your first investment property, but today we’re going to dig into some actual examples and apply some of the things we’ve learned so far.

Let’s say you’re in the beginning of our home search – you’ve met with your local bank and they’ve told you that with your income and asset level we can afford to buy a home of $300,000.  You’ve done a little bit of research and found a realtor who seems to have a pretty good idea about the rental property market, and he’s offered to take us around town to view a number of different areas.

The first area we go to is in the center of the city, with stylish 1-bedroom loft style apartments selling for just over $300k.  The realtor explains that this is the “prime” area of the city and these apartments will typically rent for anywhere from $2000-2500.  However, he explains that the HOA fees can be anywhere from $500-800 per month, which could bring the net rent down to below $1500 depending on the building.

The second area we decide to check out is slightly outside of the central area of the city, with fewer apartments but more townhomes and even some standalone homes sprinkled in the mix.  Here we go see a duplex selling for $300k, but given the extra space and bedrooms compared to the apartments in the center of the city, the realtor believes that each unit would still rent for around $1600 per month.

The final area we go to looks very different from the first two areas.  It’s in a part of town you generally don’t go to, and is noticeably more run-down than the rest of the city.  The realtor says that the area is considered to be “up-and-coming,” but you’re definitely skeptical.  Here we go to see an older home listed for $300k which has been converted into a triplex with three, 2-bedroom units.  Each unit would likely rent for around $1300 per month, leaving you with about $3900 in total rent per month, but the realtor warns that you will be responsible for all utilities.

You head home and think about which area makes the most sense for you.  The first area was definitely the nicest, but the apartments are a little bit outside of your price range, and you’re a little worried about covering all of your expenses with the high HOA fees.  The second area wasn’t as nice as the first, but you still like the feel of the neighborhood, there’s a nice lake nearby with walking trails, and there’s a relatively new mall with a grocery store and a coffee shop.  The final area was definitely more run-down, but the property you saw would also rent for more than the first two.  You decide to run the numbers and figure out which property looks the best on paper.

Property 1:

-Potential Gross Rent: $2250/month, or $27,000/year (we’ll take the average of the realtor’s estimate)

    -Subtracting Potential Vacancies: ($1,350)/year assuming a 5% vacancy rate

-Operating Income: $25,650/year

From here we’ll have to take out any regular expenses – HOA fees, utilities, insurance, taxes etc.  In this case an apartment typically will have basic cable and water paid for, which will leave the renter with the electricity bill.

-Monthly Overhead: $650 (avg HOA fees) + $300 (taxes**) + $50 (insurance): $1000/month

-Yearly Overhead: $12,000/year

We subtract this value from our Operating Income to leave us with our Net Operating Income (whatever you’re left with after paying all your bills):

-Operating Income: $25,650/year

  –Minus Overhead: $12,000/year

-Net Operating Income: $13,650/year

Here’s where we calculate the “cap rate” we talked so much about in the previous posts.  For those that remember, the cap rate is calculated by dividing net operating income by the purchase price.  So for this example:

-Cap Rate = NOI/Purchase Price = $13,650/$300,000 (we’re assuming we get it slightly under asking) = 4.55%

**Quick note on taxes: For those looking at homes in the US, if the previous owner was living in the home, they were likely qualifying for a homestead tax exemption.  What that means for you as a buyer purchasing the home as an investment property is that your tax bill will be higher than the previous year’s value provided to you in the prospectus.  How much it will go up will vary by market, but it’s definitely worth speaking to your realtor about roughly how much to expect to factor it into your cap rate calculations. 

Now let’s move on to the duplex!

Property 2:

-Potential Gross Rent: $1600/month x 2 = $3,200/month, or $38,400/year

    -Subtracting Potential Vacancies: ($1,920)/year assuming a 5% vacancy rate

-Operating Income: $36,480/year

-Monthly Overhead: $400 (taxes**) + $300 (insurance) + $600 (utilities) + $200 (maintenance) = $1500

-Yearly Overhead: $18,000/year

We subtract this value from our Operating Income to leave us with our Net Operating Income:

-Operating Income: $36,480/year

  –Minus Overhead: $18,000/year

-Net Operating Income: $18,480/year

-Cap Rate = NOI/Purchase Price = $18,480/$300,000 = 6.2%

Property 3:

-Potential Gross Rent: $1300/month x 3 = $3,900/month, or $46.800/year

    -Subtracting Potential Vacancies: ($3,276)/year assuming a 7% vacancy rate (slightly higher given the higher risk neighborhood)

-Operating Income: $43,525/year

-Monthly Overhead: $400 (taxes**) + $400 (insurance) + $800 (utilities) + $400 (maintenance) = $2200

-Yearly Overhead: $26,400/year

We subtract this value from our Operating Income to leave us with our Net Operating Income:

-Operating Income: $43,525year

  –Minus Overhead: $26,400/year

-Net Operating Income: $17,125/year

-Cap Rate = NOI/Purchase Price = $17,125/$300,000 = 5.7%

When we look back at the three properties, doing a quick 1% rule check would suggest that the first property wasn’t an investment candidate even from the beginning.  Property 2 and 3 certainly fell well within the 1% rule, with Property 2 at $3200/$300,000 = 1.1% and Property 3 at $3900/$300,000 = 1.3%.  Typically every city will have properties spread out in this way based on neighborhood, with the “highest quality” neighborhoods generally too overpriced to fulfill the 1% rule, and the worst neighborhoods fulfilling the 1% rule and some.  This is why it’s so important to break down all of the expenses and calculate the cap rate for each property.  As you can see above, Property 1 had a cap rate of roughly 4.5%, Property 2 had a cap rate of 6.2%, and Property 3 had a cap rate of 5.7%.  Had we bought purely based on the 1% rule, we would’ve likely ended up with Property 3, and as some of the eagle-eyed readers may have figured out, if the estimated maintenance and vacancy rates of Property 3 had been equal to that of Property 2, Property 3 would have actually had a cap rate of 6.8%, beating out Property 2 by almost $2,000 per year from a NOI standpoint.

Why then was I so harsh on Property 3? Low-income neighborhoods will typically have higher vacancies, as well as higher maintenance costs, so it’s definitely worth factoring that in from the get-go.  Even if Property 3 had come in at a cap rate of 6.8%, it still comes down to where you are most comfortable buying a home.  Would you be willing to live there someday? If the answer is no, then the home is probably outside of your risk tolerance and you should stick to more established neighborhoods.

Property 2 has a decent cap rate, the neighborhood is comfortable, and given it is a duplex, you could even live on one side while renting out the other to qualify for the tax homestead exclusion.  As “nice” as it would be to buy a great loft apartment in the center of the city, it’s definitely worth going through the numbers and taking the emotion out of the process.

Now that you’ve got the math down – it’s time to get out there and find a home! As long as you follow the basic rules, do your due diligence, and take your time, you’ll be signing the papers for your new investment property before you know it.


If you missed the first two parts in this series on buying your first investment property check out part one and part two here!

June Passive Income Update: Rainy Season, Hiking, and Inspections

Welcome to my monthly passive income update! For those new to the blog – I own 3 properties, an apartment, a townhome, and an apartment building with five 3-bedroom units.  The apartment is now owned completely in cash, while the townhome and 5-plex have mortgages which I’m trying to knock down as quickly as possible!  Now let’s get to the good stuff!

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June was another busy month (is it just me or is this year really flying by??) although I definitely made sure to fit some fun activities into the mix.  June is typically rainy season here in Tokyo but we were actually lucky enough to have somewhat decent weather throughout the month. 

Despite the hot weather, I spent my weekends getting some great hikes in and even got to the beach for a quick day trip.  For the most part we had blue skies the entire time and definitely made the best of the “rainy season” this year.

Beautiful little entryway on a hike in Kamakura, about 1.5 hours southwest of Tokyo

The beach was absolutely deserted, and when we asked some of our Japanese friends about it, they claimed that most locals prefer to wait until after “Ocean Day” in mid July before going to the beach.  I guess being a foreigner does have its perks!

Private beach anyone?

My expenses were fairly low for the month, although I did spend $50 on a golf lesson to sharpen up my game before hitting the course with some friends in early July.  My car and rent are typically the brunt of my expenses, but I do a pretty good job at keeping my discretionary spending on the lower end (of course always leaving some room to treat myself!)

Spent a great afternoon out of the office soaking in the sunshine and reading

Now onto the passive income!

Net Income for June 2017: $-90

Including Principal: $2,248

The specifics: 

Apartment: $1,200

Townhome: $1,995

5-Plex: $5,760 (caretaker is getting a $100 rent reduction)

Total Revenue: $8,955

Expenses by Property:

Apartment: $488

$0 maintenance, $434 association fees, $54 management fees

Townhome: $414

$0 maintenance, $335 association fees, $79 management fees

5-Plex: $3,538

$1,474 inspection repairs, $160 electric, $170 gas, $1339 water/gas, $395 management

Mortgages (including tax):

Townhome: $1,750

5-Plex: $2,833

Total Expenses: $6,793

Another fairly frustrating month from a cash flow perspective, but luckily I am diversified enough that my townhome and apartment were able to cover some of the issues in the 5-plex.  I was hit with a tough building inspector who left us with about $1.5k of repairs, but the real issue was a tenant who had failed to inform us of a leaky toilet valve and had broken off a piece in the shower, both of which left me with a water/trash bill of nearly $1400 which is easily $800-1000 too high for the building.  The electric and gas bills were adequately budgeted for prior to purchase of the building, but it’s really been the water bills which have been killing me lately.  We think we’ve solved the problem so hopefully next month will be a different story and we’ll be back in the $600 range.

Given my other two property utility bills are paid for by the renters, I’m realizing how much easier it is to let them deal with these sort of usage issues on their own.  I’m fairly certain that this particular renter would have brought this issue up much quicker had they been paying their own water bill…

Despite it being a rough month – I’m still chugging along as expected, and will likely end the year at around $36-40k including principal paydown.  My personal goal is closer to $100k per year, but even at $50k a year I am fairly comfortable covering my current expenses.  I will be raising the current rent on the 5-plex by about $65 in July which will help as well, but I’m definitely looking forward to having a smoother July (fingers crossed)!

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To read more about my story and more about the properties, check out my original passive income post or read more about me here!

 

 

Buying your first investment property (part two)

For those of you that missed the first one – start here and read up on the importance of picking your real estate team and some key rules to follow.  Today we’re going to dig into some of the details and get you one step closer towards owning your first investment property!

Location, location, location

Start close to home

This will likely be the biggest chunk of money you’ve ever seen leave your bank account up until now, so it definitely helps to make things as easy as possible.  This won’t necessarily work for everyone, but for many of us it’s easiest to start in an area we know better than anywhere else.  Even before starting your search you should have a pretty good sense of which neighborhoods are “better” than others, and as you apply some of the rules we discussed last week, you’ll start to have a pretty good idea of where you’d like to be.

Know your market

You talk to just about any home owner and they’ll give you a generic “it’s all about location.”  Sure, if you’re looking at buying a place in Manhattan, anywhere on Central Park would be a great area to be in.  Does that mean that you should buy there? No – there are tons of great areas to invest in, but with each area the parameters will change.  I’d separate these into mature, stable, and up-and-coming regions of the city.  We can call these A, B, and C level properties, and with each category you’ll need to have different expectations for how the property will perform.  A-level properties will naturally be the most expensive, and typically will actually have lower rental yields than the other categories.  B-level properties are somewhere in between, with a combination of appreciation potential and better rental yields.  C-level properties tend to have a lot of risk, but they also can have relatively high rental yields which can mean higher cash flow for you.

As you build up your portfolio, you’ll likely own a variety of properties which will provide some diversification across the different classes of properties.  When you’re starting off, however, I tend to think somewhere in the middle is generally a good place to be.  These will be areas with low crime (look through Trulia for crime maps of your city), relatively good schools (Zillow is good for school ratings), but usually they still won’t be considered “prime” real estate (yet).   

Find a catalyst (if possible)

You can also look for regions that may have some sort of catalyst to make the area more attractive going forward.  This can be anything from a new shopping center nearby, improved transit options (new train line), or some sort of investment from the city to beautify the region.  A catalyst isn’t always necessary as primarily we are looking at properties for cash-flow potential as opposed to appreciation potential, but it’s a nice bonus if you can factor it in as well.   Once you have an idea of where this neighborhood might be, it’s time to start narrowing down your options. 

Due diligence time

Last week we talked briefly about the “1% rule,” which as some of you may remember, states that monthly rent is greater than 1% of the purchase price of the home.  It’s an easy way to filter through the huge number of properties available in any neighborhood, and it will generally protect you from making a poor investment.  To even get started on using the 1% rule, you’ll need to have a pretty good idea of what average rents are for the city.  This is where it can really help to have a property manager that knows the area extremely well, as listed rents are not always accurate (although it is still a good idea to do some research on your own.)  As you begin researching average rents, you’ll find that there is often a big jump from 1 to 2 bedroom apartments and a slightly smaller jump from 2 to 3 bedroom apartments.  The takeaway? For similar houses, having more bedrooms is usually better, all else being equal.

Once you’ve found a couple of properties that fulfill the 1% rule, this is the time to really figure out your expenses.  The property sellers will often have a cash flow statement if the property has been used as an investment property in the past, otherwise you may have to default to the expertise of your property manager to figuring out what a ballpark range for utility bills, maintenance, etc will be for the properties that you’ve found.  This is where the “cap rate” comes into play, which is essentially a measure of the cash flow of the property divided by the purchase price.

What that means in practice is – you can compare properties on a more “apples to apples” basis.  One property renting for $1200 a month and costing $100k isn’t necessarily better than a property renting for $1000 a month and costing $100k, especially if the expenses for the first property come in at  $250 more than the second one.  The cap rate enables you to figure out what the actual return will be,  which will make deciding which property to purchase that much easier.   Ultimately the more you find out, the better off you’ll be to make an educated offer later on.

To sum up:

  • Pick a location that’s familiar to you, and find a stable neighborhood with homes that fulfill the 1% rule
  • Try and find a neighborhood with a potential catalyst to improve the value of the home over time
  • More bedrooms come at a premium for rent – but not always at a premium purchase price (homes often sell based on square footage, renters are more concerned about bedrooms)
  • Use a property manager to figure out average rents and expense levels throughout the city
  • The 1% rule is just the starting point – comparing properties by cap rate will give you a more realistic idea of how each property will perform

Join us next week for the third installment of buying your first investment property – if you haven’t read the first one yet give it a read here!

 

 

Buying your first investment property (part one)

So you want to get into the real estate game.  Chances are you’ve heard a bit of the good and the bad.  A friend of a friend may have made a fortune flipping houses, or your uncle may have lost thousands of dollars on tenants trashing the property.  Most likely your experience will end up somewhere in between.  That’s not to say you won’t get rich, but like all good things it probably won’t happen overnight.  Now let’s say you’ve taken the first steps – you’ve saved up enough for a down payment, you’re prequalified on a loan from the bank, and you’re about to sit down with a realtor to try and find your dream (investment) home.  Here is where the real fun begins.

Picking your real estate team

You’re about to part with a huge chunk of your savings, so you really want to make sure you’ve got the best team of people backing you up.  Just like Jordan would have had no chance at winning any championships without a great Bulls lineup behind him, you too will have very little chance of succeeding without the right team supporting you through every step of the way.  While most people will find a realtor through family and friends, investment properties are in a completely different ballgame from your standard homes.  Take some time to speak to a couple different realtors and ask them questions regarding their experience in the investment arena, and as you go into more detail on things like average rental yield, cap rate, vacancies, etc (don’t worry we’ll go into more detail on these terms in a future post), you’ll get a sense of how qualified they really are to help you.

Once you’ve found someone qualified who you get along with (that’s important too!), you’ll want to find a property manager to help price up all of the extra expenses you’ll be faced with upon buying the property.  Depending on the terms of the rental, you (the landlord) will likely end up paying for electricity, gas, water, insurance, maintenance, and taxes, all of which can add up.  The property manager will also give you a general idea of rental rates in the area, and I often find they have a better sense of the market than the realtors.  My one rule: make sure they are available to you 24/7 – it’s not worth having a property manager who responds to emails in 2-3 days and isn’t on their cell.

Get a good property manager so you can hang here instead of worrying about issues yourself!

Rules to follow

Now that you’ve got your dream team lined up, you’ll want to make sure you follow some rules of the trade.  This is obviously not an exhaustive list, but following just a few of these rules will likely keep you from getting in too deep on a bad investment.  Not every market in the US will have deals which fit all of these criteria, but if you’re looking for steady cash flow over the long term, this is a good place to start.

  • The “1% Rule” – monthly rent should be greater than or equal to 1% of the purchase price
    • This is the quickest way to “eyeball” properties in terms of “investability” – especially for single family homes.  It’s worth keeping in mind that apartments and townhomes will often have association fees, which can make that 1% rule disintegrate quite quickly.  Regardless – have an idea of the average rent for 1, 2, 3 bedroom properties, and you’ll be able to much more quickly screen through homes.
  • Shoot for a cap rate (net operating income divided by purchase price) of 5-6% or greater
    • Assuming home prices keep up with average inflation of 3%, that would imply an 8-9% increase in your home value per year, right on par with the stock market (before leverage).  Focusing on long term cash flow will likely keep you out of the hype of certain areas, and ultimately should limit any potential downside.
  • Stick with higher quality areas first, especially areas with some sort of catalyst
    • Your realtor/property management team can help with this, but anything else you can find out on your own in terms of potential catalysts will help you get ahead of the pack
  • Do your due diligence ahead of time
    • The absolute worst thing that can happen to a new homeowner is getting hit with an issue that they didn’t anticipate.  This can come in the form of lower than expected rent, higher utility bills, taxes, etc.  While you’ll never be able to know completely ahead of time, making a reasonable estimate of every possible expense will significantly protect you for the long haul.
  • Take your time – there will be other deals
    • Once you’ve committed a good amount of time and effort to the process it’s hard to walk away from THE deal once you’ve found it.  Make sure you give yourself an upper limit on price and stick to it.  If you get outbid then having the ability to walk away is a show of strength, and it will keep you in the game for other deals to come.

Now that we’ve covered some of the basics – look out for part two of buying your first investment property next week!