Since checking in last, I’ve searched for and put a contract on our 5th rental. Because I’ve done this a few times now, I feel pretty good about telling other people how to buy a rental property, so I thought a step by step guide may be helpful to potential investors. It also gives me a good place to refer to with our next ones because there are some steps that I totally forget from property to property so this series is for you AND to refresh my sometimes terrible memory!
I’ll be using the house that we recently put a contract on as a case study and at this stage I’m on the scheduling the inspection stage. But let me back up to the beginning…
There are lots of reasons why you may want to invest in rental properties from earning a little extra income on the side to wanting to replace a full time income. Figuring our your “why” I think is super important, otherwise you don’t know if you’re investing for short term gains (cash flow) vs. long term gains (appreciation). Sometimes you can do both, but I’ve found that at the beginning you should focus on one.
Because my husband and I are in our 40s and 50s, I invest for long term appreciation. I don’t need the month-to-month cash flow, so I’m willing to sacrifice that a little to make sure that the property that I choose is in an area that I know is top notch, will be easy to rent out, and is in a neighborhood that historically appreciates. But, just because I don’t focus on cash flow doesn’t mean that I don’t get great cash flow; I do. It’s just that it’s my secondary focus after appreciation.
Someone who is a little younger than me or has a different financial picture may want to focus on cash flow. I’ve found that if you focus more on that, the areas in which you invest are not as “quality” meaning that the areas are maybe in “C” neighborhoods instead of “A” neighborhoods. In these areas, property purchase prices are lower so the financial bar to get into property investing is lower. At least in my area, the cash flow in these areas is much greater than in the “A” neighborhoods because the difference between the purchase price and rent per month is more favorable.
Okay, enough of the theoretical, let’s get to a real live example… My third property purchase was one where I focused on cash flow. I invested in a “C” neighborhood because I knew that the cost of the property vs. what I would get for rent was great. I paid about $145,000 for this property. The rent that I get though is $1,600. So there’s this thing in real estate called the 1% rule meaning if you can get at least 1% in rent vs. your purchase price then you’ve got a great rental investment. So, according to that rule, I’ve got a winner because my rate is 1.1%. ($1,600/$145,000 = 1.1%)
But there are downsides to investing for purely cash flow, especially in “C” neighborhoods… One is that I have more problems with tenants. Properties in “C” neighborhoods typically tend to attract “C” tenants. I’ve had to take one of my tenants to court due to non-payment and the tenant that I currently have is headed in the same direction. Sigh… Both tenants looked great on paper- well paying jobs, no criminal record, no problems with prior landlords, but I still have issues with payment in my “C” neighborhoods.
The other problem with investing purely for cash flow is that it can miss the value of appreciation. This property has not appreciated since I bought the place and I have no notions that it will appreciate anytime soon because the neighborhood is not top notch. Unless there’s a gentrification of the area, which I don’t see anytime soon, I’m stuck with a flat market with little to no appreciation. But when the tenants actually pay, it’s great to have a smattering of these properties in my portfolio because of the great cash flow per month.
The flip side of the coin is the story of my second property. Three years ago, I bought the property in an “A” neighborhood and paid $252,000 for the place, almost twice that of the “C” neighborhood. Since that time, it has appreciated $50,000 in three years! I have absolutely no issues with the current tenants and I’ve never had an issue with any of the tenants in that unit because they are “A” class tenants. The rent for the place is $2,200 making my magic rate only .87% so short of the 1% rule. HOWEVER, the unit is never empty because it goes to great schools and the tenant quality is superior. And, when I go to sell, which at this point will be never because the tenants are so great, I can count on appreciation to make this a good deal on the back end. This property never keeps me up at night and that alone is worth it for a lesser rental return per month.
Okay, so let’s get back to our goals for investing now that we have a little framework. If your goal is to supplement, but not replace your income, you may want to focus more on appreciation in “A” neighborhoods. But let’s say that you’re young and don’t have a lot of cash and think you can deal with potential problem tenants, in that case, I’d focus on cash flow. There are many reiterations of life situations where in my opinion I’d choose one over the other, but the top things I’d ask are:
- How much money do you have to buy a property? A little? Focus on cash flow. A lot? Focus on appreciation.
- How much time to you have to deal with problem tenants? A little? Focus on appreciation. A lot? Focus on cash flow.
- Do you want to focus on income replacement or income supplement? Replacement? Focus on cash flow. Supplement? Focus on appreciation.
- How much time do you have for repairs/renovations? A little? Focus on appreciation. A lot? Focus on cash flow. (I’ve found that the “A” properties don’t need as much work as the “C” class properties.)
This list of course is not exhaustive but they are the top questions in my mind to ask yourself to clarify your WHY? Once you do find your WHY, write it down, make it specific, and refer to it often when on the hunt for a property. Also flesh out your WHY with how you plan to achieve it, either with cash flow properties or with properties that appreciate, and make a timeline for yourself on the steps you need to complete to get to that first buy.
My WHY is to diversify our retirement portfolio with some properties that cash flow but mostly with properties that appreciate. All the properties that I buy from this point forward will be in class “A” neighborhoods just like the one I have under contract. We’ll chat about that specific property, how I found it, how I negotiated the price, and all the ins and outs of how I bought it in the next post.
If you’ve found this post helpful, let me know! Also chime in with any burning questions related to buying rentals and I’ll try to answer them.