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!