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!

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