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DIY television has made home buying, remodeling, and even flipping, seem too easy. In reality, buying a home for investment purposes takes a lot of work both on the part of an off-camera crew and experienced real estate investors. For those of you that are interested in owning a rental property, we asked real estate expert Louis DiGonzini what he sees of his experienced investors.
Q: What should investors have in order before taking the leap into rental property ownership?
A: Before making a big investment like buying a property, you first need to be sure you are financially capable of purchasing an illiquid asset like real estate. The lender will require that you have reserves when you are applying for a loan, so, in addition to your normal emergency reserve and down payment, you should plan to have at least 3-6 months of property expenses set aside.
Q: What should be considered about the property itself before buying?
A: First, although flipping houses is trending and appears easy on television, it is much riskier and requires much more skill and expertise in the real estate market. So, for those just starting out, we recommend a buy and hold approach.
Properties that are move-in ready that won’t require much rehabilitation work are easier and help ensure a renter can be placed quickly and cash flows will follow soon after escrow.
Like any investment, the most important factor of profitability is purchase price. The lower the price, the more return potential the property will have. I tell my clients to seek properties that will provide net cash flows of between 7-10% at a minimum, plus appreciation potential of another 3-5%, for a total return of 10-15% over time. Given higher demand and prices, return potential tends to be greater outside of urban areas like Los Angeles or Seattle. Speak with a realtor or other specialist to help determine a reasonable rent amount and the stability of rents in the given area.
Tally net cash flows by creating a summary of the rental income expected, less expenses like landscaping, water and/or sewer (and any other utilities you may cover), HOA, property taxes, homeowners insurance, property management and mortgage. Be sure to account for a vacancy rate when running projections.
A 5% vacancy rate is a good rule of thumb. Also, remember that time is money. You might find yourself collecting rents, coordinating maintenance or making check-in trips to your property as often as monthly. It is important to add the cost of your time to the property’s expenses.
Q: What are your top tips?
A: A few things to keep in mind: it’s necessary to keep a large “slush” fund for the property in case of maintenance issues and other upkeep or an extended period of vacancy. Keep excess cash flow in a dedicated checking account in case such expenses come up.
Related: 3 Financing Options to Understand Before You Buy a House
When screening for tenants, require a rental application and run a background and credit check to make sure the potential tenant is financially responsible and has ability to pay rent. Do not let anyone take possession before they complete your application, pass a background and credit check, sign the lease and all payments have cleared. There are free forms online that you can use for the actual lease agreements, but I recommend hiring a real estate professional to assist with the leasing process and all legal forms. If you hire a property manager, he or she might also assist you in finding a tenant.
When you meet with the tenant to sign the lease, collect from them the first month’s rent and a damage deposit equal to the same amount. It is NOT the last month’s rent. When the tenant moves out, you will have the place cleaned up (and repaired if needed) to its previous condition and the remaining amount of the damage deposit will be returned to them.
Case Study: (The following example is for illustrative purposes only). A client purchased a single-family home in La Quinta, CA at a purchase price of $205,000. They put 20%, or $41,000, down and financed the balance at 3.875%.
They were able to secure gross monthly rents of $1,500 and, after carrying costs (including mortgage, property taxes, insurance, covered water and landscaping), they were left with $350 per month or $4,200 per year. Divide $4,200 by a $41,000 down payment, the couple is making around 10% return on cash flows.