5 Rules to Follow when Buying Investment Property
If Your Not Making Money in Real Estate, This is Why
It really important to have some guidelines to follow when you are starting your career in real estate investing. If you follow the rules, you can never really lose. On the other hand, with experience you may be able to bend the rules and still make good deals.
Investing Rule #1 - Not All Deals Are On MLS
Most small unit residential property gets listed on your local multiple listing service (MLS) website, but not all. This is extremely important in the more competitive markets because the more people who see a deal means the more competition for you. As a new investor, you may not have the ability to compete against the big players, so you may want to focus on alternative methods of finding deals:
- Auctions - just like MLS, auctions have good real estate deals and bad deals. The number of potential buyers at an auction is much lower but everyone there is an investor. Additionally you will need to have enough cash available to pay.
- FSBO - Some owners list their properties without the help of a real estate salesperson and these go on a 'for sale by owner' website. Often these websites are full of overpriced real estate listings, but occasionally you can find a gem truly worth adding to your investment portfolio.
- Word of Mouth - "I heard John over there on Rose St. is looking to sell his property soon." Any time you can get make an offer before a property hits the market is a win. If they accept, you can possibly pay far less than market value.
- Driving for Dollars - You know that property at the end of the street that is always overgrown and needs some maintenance? It may be worth your time to go knock on their door and find out what's going on. When you have free time you can drive through neighborhoods you're interested in and possibly find deals.
Investing Rule #2 - Asking Price is Not Related to Market Value
Browse through listings for just a few minutes and you will find a property that's twenty thousand dollars more than others. You can also find properties asking for far less than what they could get.
The reality is, people often list their properties based upon what they hope they can get and usually people think their things are worth more than they are. The owner's perception has no real bearing on what the potential investment is worth.
Unlike typical homeowners, investors are generally a very rational group of people who really understand real estate. They may be asking for top dollar but they probably know the lowest number they will accept. Do not be afraid to offer what you think it's worth. It's rare, but investment properties can and do sell for half of their asking price.
Investing Rule #3 - Due Diligence and Inspections are Mandatory
You don't want to close on a house just to find foundation problems or termites so do the inspections up front. If you do find something, you can usually negotiate a more favorable agreement.
Also, don't forget about a proper title search. Ensure the title company is going back 50+ years or to the last instance of government ownership. Why? Well, imagine you get a phone call one day finding out a great grandparent died with no will leaving the equity to their 7 children and now some of those children have since passed away. You find out there are 15 potential claims against the property! This is a true example, so it can happen!
Investing Rule #4 - Run The Numbers
"Well, that kitchen may only cost $10,000 instead of the $12,000 I originally thought. Now the numbers work."
If it's not a good deal then walk away. People get attached to their own ideas so they may lie to themselves to make it work. It's really important that the property cash-flows and provides you income every month.
Don't forget to try to the new Rental Property Calculator which has everything you need to start analyzing your potential investment property deals.
When you run the numbers, don't forget to include everything. Besides common monthly expenses don't forget to include hidden expenses:
- Vacancy - 5-10% of rents for vacancy depending on your area. Your property will have vacancies so don't forget to include them.
- Capital Improvements - Major things will require replacement such as heating systems, the roof, etc... Add 3-5% of rents for these future expenses
- Property Management - You don't want to personally manage the investment forever. Don't forget to include 8-12% of rent for your property management
- Reserves - It is extremely important to have a cash reserve just in-case. Add another 3% or more for cash savings
- General Maintenance - Add 3-6% for day-to-day repairs such as the leaky faucet, new door knobs, lights, etc...
Related: The Importance of Due Diligence.
Investing Rule #4a - 2% Rule
It's really good to look at deals rationally, so there are a couple rules to help quickly analyze a property. The first is the 2% rule. Simply put, if the monthly rent is 2% of the sale price, or higher, it's a good investment. If you are paying $200,000 for the property then you should aim to receive $4,000 or more per month.
This is probably one of the hardest rules to follow. It can be very hard to find a deal that meats the criteria.
Investing Rule #4b - the 50% Rule
Assume that 50% of your rent will go to expenses before you even count the mortgage. This rule really feeds into the 2% rule. If half of the rent is immediately gone, you are left with only 1%. Then take the mortgage out of that and you are left with very little.
This number is to help you quickly analyze properties without having to sit down and do a spreadsheet on every property. Also, it's a good way to check for accuracy. If you find your expenses are only 15%, perhaps you forgot something.
Investing Rule #5 - All Rules Can be Bent
"Everything is Negotiable" goes the saying in real estate, and this is true for rules as well. For every 'rule' out there related to investing there is someone breaking that rule and making a fortune.
You may find that the 50% rule doesn't apply in your area which means the 2% rule can be lowered. Other people may find their best deals on MLS and others may live in such a competitive market that all properties sell above their asking.
Why Have Rules for Investing in Real Estate?
People tend to overlook things or get emotionally attached to a potential project. By having a checklist and set of rules to follow, it is much easier to stay focused and disciplined. These rules are a set of guidelines that will help you earn money. You can bend them and make money, but if you always follow the guidelines, you are far more likely to win than to lose.
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