Buying a rental property can be a very lucrative investment strategy. Unfortunately, the TV shows you've probably seen get it all wrong. Real estate is not a get rich quick scheme, it's actually a lot of work and pretty risky. Things don't always work out in the end.
To help you in your quest for realistic real estate success, I've compiled this checklist of "must ask" questions. Working from this checklist will ensure you're fully informed about the property and its investment potential.
If you don't know the answer to any of these questions, then you need to do more research. Search the Internet, call local appraisers, and consult with professional real estate brokers. The more you know, the better your chances of success.
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1. Location, location, location
A quality location will ensure less vacancy, better rental rates, and a higher caliber of tenant. You want your house occupied and cared for, and rents paid on time. Location can make all of the difference in the world to this end.
- Is this home in a good, desirable school district?
- Is the crime rate in this area low or high?
- Are amenities convenient? Parks, shopping, transit, walking/biking trails, schools, businesses, etc.
- What are other rental properties in the area renting for? Is the area predominantly rental or owner-occupied?
- Have property values increased, stayed the same, or decreased over the past year? Over the past five years?
2. The investment potential -- cash flow is king
Remember, this purchase is an investment. That means you have to consider the income potential, the likely expenses, and the value of the initial purchase. All of these factors combine to determine if a property will make a profit or turn into a money pit.
Don't lose sight of the real money maker -- rental income. You're not buying this rental property to flip or speculate on rising prices. You're buying it because a tenant is willing to pay cold, hard cash for the right to live in this house. Cash flow is truly king.
Make sure you think critically about costs as well. The current owner may have delayed certain expenses to artificially inflate the property's profits. An appraiser can help you sniff out these inconsistencies.
Your mortgage payment will almost certainly be different that of the current owners. Make sure you include your payment, not theirs, in your expense estimations.
Ask yourself:
- Does the property have a strong rental history? When was the last time it was vacant, and how long did it take to bring in a new tenant?
- How much does the current tenant pay in monthly rent? How much do other properties in the area demand in rent?
- What were the property's expenses over the past 12 months?
- Can you review profit and loss statements for the past three years?
- Does the monthly rental income cover both estimated expenses AND your mortgage payment?
- Do you have copies of the current lease agreement? Are there any unusual stipulations that could impact your income or expenses?
3. Unexpected expenses
Rental houses generally require more maintenance than your typical owner-occupied home. It's just the nature of the beast.
Just like the home you live in, from time to time there are larger expenses that must be dealt with. Roofs eventually need to be replaced. Air conditioners break. Styles and tenant preferences change over time. For your potential investment, make sure you understand the probabilities of these events occurring before you buy.
- How old is the HVAC unit? How old is the compressor?
- How old is the roof? Visually, does the roof appear to be in good condition?
- Does the floor sag or slant in any particular area?
- Is there evidence of water damage in the bathroom, around sinks, in the laundry, or in the kitchen?
- What is condition of the siding and exterior of the house?
Many of these questions will be answered in great detail by a professional home inspector. Always hire a professional to inspect the home before you buy (including for termites). It is the best $250 you'll ever spend; if they find a serious problem with the house, that home inspection is your get-out-of-jail-free card.
Plus, they'll crawl under the house and inspect the foundation so you don't have to!
4. Real estate valuation
Just like any other investment, you don't want to overpay for the asset you're buying. It's true for stocks, and it's definitely true for real estate. Conversations with local real estate agents and appraisers can help you with the heavy lifting, but at the end of the day it is your decision as to whether a property is worth the asking price.
US Rental Vacancy Rate data by YCharts - Rental property owners have done quite well over the past several years with low vacancy rates and increasing rental income.
Depending on who you ask, there are a handful of "rules of thumb" to assess a property's value.
There is the 1% rule -- if one month's rent is equal to or greater than 1% of the home's value, then it's a good deal. If it's less, the property is likely overpriced.
Others say a rental property is a good deal if the rental income is sufficient to pay for all expenses and pay off the mortgage in 10 to 15 years.
The commonality between the various approaches is the relationship between price and cash flow. Again, rental properties are not about speculation or home-price appreciation. These investments are all about rental income. Key word: INCOME!
- How much monthly cash flow -- that is, income after both expenses AND your mortgage payment -- can you expect?
- If the tenant moves out, how many months will it take to find a new tenant? (These months will have expenses and mortgage payments, but no income -- you must budget for this!)
- Is the cash flow sufficient to pay off the mortgage loan in 10 to 15 years?
- Does this property pass the 1% test?
After all this work, you should be prepared to make that real estate investment. Remember, real estate investing is not a get-rich scheme. Plan for the long term, be conservative, and focus on buying quality properties at reasonable valuations.
