One of the first questions that can arise when deciding how to buy investment property is also one of the most important to answer.
Should I go into debt when investing in real estate?
Here’s a rule of thumb to address this question: pay down the debt until and unless the return on it is more than its cost. This holds true for good investments in general.
We are always looking for investments that yield a greater return than they cost. I want to provide you with a helpful outline guide to how to buy your investment property using our methods and strategies. Money is generated by an investment property, either by appreciation or by the cash flow it generates. But first, let’s do a little math.
How to Buy Investment Property: Determine Your Return
I am glad that I didn’t lose you after saying the word math! The goal is to figure out how much money we will make on the investment once all the costs associated with it are paid each month.
Let’s analyze two formulas, one to calculate gross annual cash flow and another to calculate ROI.
Estimated rental income – Monthly Expenses = X*12 = Gross Annual Cash Flow
Your gross annual cash flow is a number that you will want to calculate for each possible property purchase. And that brings up the next subject. How much are you willing to invest in this property to make it ready for renters to use as a primary residence?
- Consider your upfront costs:
- Home appraisal
- Down payment
- Closing costs
- Home inspections
- Repairs
- Upgrades.
All of these factors affect how profitable your investment will be out the gate.
Obviously, minimizing upfront expenses will be most desirable, so keep that in mind when shopping for investment properties. Does this mean that we are steering you away from fix and flipping? No, not at all, but we do only suggest this property investment strategy to those who have experience or are working with people who do.
You can easily get in deeper than is ideal (and maybe even over your head) with expenses once you are exposed to the cost of delays, materials and labor. Nobody wants their simple buy-fix-flip process to end up mired in headaches and unforeseen complications.
Naturally, greener and not-so-green fix and flippers can easily make the mistake of buying an investment property without really knowing what potential issues to look for, with the reality being that unforeseen problems can wipe out any investment property budget.
Have someone on your team with construction expertise who can assist you when inspecting the bones of a home. This will save you from many nasty surprises or unwanted long-term commitments! Your return on investment will be the income you generate in a year divided by the total amount invested.
ROI = (Income/Cost of Investment )*100 = ?%
Calculating and comparing accurate estimates of both of these numbers when shopping for investment properties will be your key to establishing value ranges. Now that we have the math squared away, let’s look at shopping strategies.
How to Buy Investment Property: Find the Right Location
Location determines how much you can charge for rent.
Location, location, location. You must have a finger on the pulse of the rental market in the area you are looking to purchase in. You should have answers to all of the following questions:
- What is its location relative to where everything is at? Is it located near a major city?
- What is the neighborhood like? What does it offer in terms of schools, parks, community involvement, walkability score, and public transportation?
- What does the future of area development look like? What is going on legally?
- Where is it? What’s next to it? Is it a high-traffic area?
- The lot itself, how big is it? What changes can be made to increase its value?
- What is the average rent price per square foot for rentals near the location? (rental price/sq. ft.)
All of these factors will help gauge how to properly set or adjust your rent once you multiply the square feet of your location by the average rental price for the area to establish a baseline.
Supply and demand are influenced by all the factors listed above, as well as outside forces in the economy. Doing exhaustive real estate market research is absolutely necessary if you are to be a successful property investor.
It’s also always good to call on help. We really like to meet with local property managers, as they have the inside scoop. You can also bounce your calculated rental rate off them to see if your rate will hold in the local market. Biggerpockets points out that these professionals work directly with tenants and have a firm understanding of deals on the leasing side of things.
Property managers are great allies and colleagues to connect with; and in the future, you may choose to have them manage your investment property for you to remove the direct responsibility or added job.
How to Buy a Property: Factor in Unexpected Costs
Drowning in unexpected costs can really eat into your profits.
It is important that your cash flow analysis be thorough, so your gross annual cash flow calculations will be accurate. This will also be essential to calculating the holding or carrying costs, which are the cost to own and maintain the property sans rent or a tenant. In general, you want to estimate a vacancy rate somewhere between 5-10%.
The known costs like the mortgage, HOA, landlord insurance, property management company, landscaping, typical maintenance, property taxes and depreciation (you can learn more in that helpful link to IRS guidance on depreciation) are often accounted for. It’s the budgeting for the unexpected costs and what-if situations that will really serve to paint an accurate picture.
The list below shares just a few unexpected costs that came to mind, but each property will have its own unique features and set of costs.
- Engineering
- Delays
- Permitting
- Pest control, i.e. termites, mice, rats, etc.
- HVAC unit
- New roof
- Deck repair
- Pipe breaks, water damage
To illustrate one risk factor, let’s take a look at termites and determine that a property is infested and in need of fumigation. This means that your tenants will need to move to temporary lodging until the treatment, which is toxic to humans and pets, has been completed.
If you are in California, compensation from the landlord for this inconvenience is necessary. SFGate explains: “Your landlord is obligated to compensate you for the time that the rental property is uninhabitable. There is no law that directly dictates how much you will be compensated. The California Health and Safety Code Section 17980.7(d) only requires landlords to provide reasonable relocation benefits.”
The cost of food often comes up as well because the tenant is unable to cook in the temporary lodging, putting a strain on their budget. So, not only are you paying the cost of the pest control, but collateral damage costs in the form of inconvenience fees. Your obligation to them is to provide habitable housing, and these added costs are necessary to not be in breach of contract.
Does your location struggle with termites? If so, you will want to budget for such an unexpected cost and set aside additional liquid reserves. All of these costs can be split up over 12 months and accounted for in monthly chunks. This means you are going to have to make some calls, and to get estimates for prospective investment.
Log all your entries in a spreadsheet and sum up the expenses column for the year. Divide this by 12, and you will have the estimate of your monthly expenses. These categories can be individually divided by 12, and this number can then be entered into your monthly budgeted expense
Initially, you can be less exact with this estimate; once it has been used to filter your options, more research and accuracy can be factored in.
How to Buy an Investment Property: Decide If You’re Cut Out to Be a Landlord
Do you or your team have what it takes in place to handle being a landlord?
You will be responsible for maintaining the home and taking care of any repairs that come up while tenants rent from you. This could mean a plumbing call to start your day, or a fire emergency caused by a candle.
Whatever may be called for, it is your duty to provide for property maintenance. That is why you need to determine if you are personally willing and able to handle the property management component, or if you ought to hire a professional property manager.
There are obviously pros and cons to each.
You must determine if property management interests you, what the time impact would be for you, and what your time is worth if this is detracting from other potentially lucrative or enjoyable efforts? This puts the idea of investing to pay for a sharp property manager into perspective, especially for landlords weary of random, untimely chores.
That said, property management is a luxury that may not make sense for everyone. The type of property and its relative location to your everyday life should also be considered. Every property manager has their own setup for how they charge for their services.
Typically, this is done through either a flat fee or a percentage of rent fee. The percentage of the rent collected can range from 8% to 12%, but for larger properties with a sizable number of units, this rate will typically be negotiated down.
It is important to note that you check to ensure that they are paid rent collected. Why? Because if they are paid rent due, that means that they will be paid regardless of whether or not tenants pay rent. You do not want to commit to paying for a property manager when units are unoccupied, generating you no income.
There are many other additional fees that could come up, depending on the responsibilities that you might choose to assign to them. The scalable option is to have independent property managers in place for each of these investment properties, with strategic locations.
Building passive income via real estate does not have to become a second job, and if you really want to grow your profits you will remove yourself from the day-to-day eventually, out of necessity.
How to Get an Investment Property: Pay Down Personal Debt
Many interested investors may want to consider working on bringing down their debt to income ratio, or DTI. How do you know where you stand? Add up all your outstanding debts and divide them by your income; take this number and multiply it by 100 to get your percentage.
Making this ratio more favorable is simple: work on paying off debt. There are many creative ways to do this. Some of the easiest include:
- Getting serious about a budget: That means download your chosen budget application, break out a spreadsheet, call your accountant, power up QuickBooks or whatever tool you plan on using to keep you accountable for spending within your means for each of your cost categories. Reconciling your budget on what could be daily, weekly, and monthly bases will be pivotal to your success. Consistency wins the game here.
- Cutting costs: This is where your new budget will come in handy. All your costs will be categorized, and it will be straightforward to determine where you need to categorically adjust your budget.
- Debt consolidation: Combining all your debts on one bill will typically allow you to lower the interest rate at which you are paying them off. This will free up more money to pay off your balance quicker, and some options include balance transfer programs with optimized entry rates. Plus, it’s more simple this way.
Optimizing the way you look on paper is easy; simply work the numbers, stick to your budget, and adhere to your plan faithfully.
How to Buy an Investment Property: Find the Right Funding
Funding your investment can be approached in many ways.
Working with a private lender can come in with options to assist in developing your investment strategy plan; we have the ability to structure a deal in many creative ways that are not possible for banks. The Forbes Business council notes: “Private lenders can be very useful allies when you want to buy a property but do not have the cash or credit score. Additionally, their processing periods are often much faster than that of banks.”
When applying for a business purpose loan, it is typical to need the following:
- Background Check: All signing parties will be required to submit to a background check.
- Experience: The minimum requirement for us is 2 projects in the last two years.
- Liquidity Requirements: Sufficient liquidity to meet or exceed the needs of the transaction are always a concern. You must have enough for closing, at least 3 months of estimated interest payments on the loan, and reserves that show you can cover costs that run over the estimate.
- Title Insurance: All loans submitted must include title insurance, and the coverage for the lender policy must be in the amount of the loan amount.
- Operating Agreement: For people borrowing as an entity, you will need to submit your operating agreement.
We allow borrowers to cross-collateralize property to finance their next project. This means they can tap into the equity in an existing property to purchase their next piece of real estate by placing a lien on the owned property. Multiple properties can be used to finance a transaction when necessary.
“Private money usually has shorter terms and a clearly defined repayment schedule. Terms for these types of loans will vary from lender to lender and will depend upon the experience level of an investor, as well as the length of an investor’s relationship with a particular lender. Therefore, there are really no hard and fast rules to Private Money.” – Mark Hanf, CEO at Pacific Private Money Inc.
Whether new to this game or an old hat, you should be working with someone who is experienced and knowledgeable.
All of your projects and transactions will be checked and verified. You should include all dates, addresses, sales price, costs, settlement statements, etc. How much money you made completing each project should be very clear.
To outline a common scenario, let’s take a peek at investing in a multi-family unit. You will be looking at either doing a rehab, value-add project or a ground up construction project as a sponsor.
At Pacific Private Money, it will be underwritten on a stabilized basis. This means the value assigned by underwriting will reflect an expected occupancy for the property once it goes through a stabilization period of time on the market.
The property value can be determined by dividing the forward annual NOI/Cap rate. The cap rate is determined by recently sold comparable properties in the area. Basically, you need to know how much money the property is going to make and divide it by the most suitable cap rate, which is based on comparable properties sold in the area.
Two other things you will need to be aware of are maximum leverage and minimum monthly debt service. Our maximum leverage is 75%, and our minimum monthly debt service is 1.25.
Leverage is the ratio of the loan to the cost of the project. This is calculated by taking a loan amount and dividing it by the construction cost. The lower the ratio, the lower the risk, and the more attractive your deal becomes.
“My advice to real estate investors is two things: 1) Really understand what it is going to take to rehab the property. The sum of what it takes to get it from point a to point b. Know all your costs, including your soft costs. 2) Understand the timeline and timing of the way things work. For example, permits can add months to a year to your timeline. Your scope of work must be complete.” – Tyler Simpson, Pacific Private Money Inc.
See how Pacific Private Money can help you with your real estate investment today!