Wednesday, March 30, 2011

investment property search

i was talking to a friend of mine the other day about investment properties. he asked for some advice and the best thing that i could tell him was that if he was really serious, he'd have to stop looking for reasons not to take the plunge. he had concerns about finding a place that would rent, or about maintenance, or bad tenants, or any number of other things.

the fact of the matter is that he's right. there are a number of things that can make purchasing a property for investment purposes go terribly wrong. it's a risk that you have to weigh against the possible returns. of course, this is the case with any investment, but with real estate, it seems like so much more could go badly. but, there are a lot of things in your control, too. you can drop your rent if your property isn't moving. you can sell your property if it's too big a hassle. you can actually live in it, if you have to.

i'm about to begin a new search for some properties to invest in, and i thought i'd chronicle my search through this site to give a view into what i look for. the most important thing, as i said, was to just make the decision that you are going to become a landlord. the next thing to do is to develop a model that outlines the costs associated with a property against the revenue that you can expect. this is pretty easy to do:

your expenses include:

your revenues include:

there will be some ancillary costs associated with leasing like utilities and rehab, or with purchasing like closing costs, appraisals, and inspections, so you want to have a sense for those, as well.

i look to put between 20% and 25% down, depending on what kind of terms i can get on a loan.

after you have a model in place, you can fairly easily troll the listings for properties that fit with your investment strategy. i look for places that cash flow. so, generally speaking, i look for properties that i can rent out monthly at or near 1% of the purchase price. so, if i find something at $150k, i'd like to see it rent at $1500. this is just a rule of thumb -- i always go back to my model to validate cash flow. in general, with this formula, i can return between 6-10% in cash on my initial investment.

i have a few geographical places that are my go to places as far as location goes. the only reason for this is that i'm knowledgeable on the market rents and sales prices. when i made my first purchase, i had to make some assumptions. but, you can get a good feel on this, again just based on trolling the listings.

the next thing (or the first thing) that i'm going to do is contact my realtor. she's able to keep an eye out for properties for me so i don't have to spend all my time looking. i'll report back on that next time.

change of plans

well, after much deliberation, i decided against paying off rental property #1. the reason for this seems kind of at odds to my approach on finding good cash flow and yield on my investment. you see, the property has about 7 years left on the note, and the rent that we collect is just enough to offset all the expenses related with owning the property. if we were to pay off the property, we would easily see a positive cash flow out of the property. i took that cash flow and projected it over 7 years. it came to be roughly equivalent to the lump sum amount that we'd have to pay in order to payoff the property.

this means that by doing nothing, and leaving our money essentially just in cash or some vehicle that at least keeps up with inflation, we'd be in the exact same position in 7 years whether we pay off the property now or not (assuming no appreciation). in one situation, we'd be out that cash, but it would slowly be building back up, and in the other, we'd have that cash on hand and the property would pay itself off.

instead, if we found some other vehicle for that capital that i was going to use to pay off the property, we'd actually come out ahead (assuming that the capital retains its original value). for example, if we purchased another property, that cash would be converted to equity, and any return on that cash would actually improve our position.

this seems to be a 180 degree reversal from what i was advocating before, which was to seek out investments with good cash flow. though the cash flow would not be as good, it actually makes more sense in the longer term. after 7 years, our cash position would be less, but we'd actually be cash flowing 1.5 times what we would cash flow by paying off the property.