Buying Residential Properties As An Investment

I will begin by stating that these are my thoughts and suggestions when evaluating property for purchase based on my experience and common sense. These are guidelines that you may choose to follow at your own discretion. I cannot guarantee results or success for any investment. It is up to you to properly evaluate investment opportunities and make decisions in line with your goals and risk tolerance.
Picking the location

Here are important elements in selecting the area to purchase an investment property

(1)Safe area
(2)Close to highway access
(3)Within 30 minutes drive time of major employment centers
(4)Proximity to shopping and other amenities
(5)Proximity to schools
(6)Strong rental market – I mean with a track record of other properties being rented for rates which you can use to evaluate the viability of the property as an investment

Picking the type of property

These criteria are designed to reduce your liability and investment risk and maximize your upside potential. Size criteria is meant to keep the property is the range of properties that are easiest to lease, rent for the highest value per square foot and are also easiest to sell down the road since they conform to the largest market segment of potential buyers.

For Single Family Homes

(1)3-4 bedrooms, 2+ baths
(2)1,200 – 2,000 square feet with 2 car garage
(3)Newer homes are better. Try and stay with 1995 or newer
(4)NO pool/spa in backyard (too much liability and maintenance)
(5)Low or No maintenance landscaping is preferable

For Condos

(1)Minimum 2 bedrooms 1.5 baths
(2)Decent amenities in complex (pool, spa, clubhouse)
(3) Stick with larger communities with 100+ units. If you’re looking at a smaller complex, make sure to verify the viability of the HOA and fees

The benefit to condos is less overall maintenance required – particularly on the exterior and to the community grounds. The downside is that they may appreciate at a slower pace than single family residential.
Evaluating the numbers

Even in the best worst market that we have to accumulate wealth through real estate, you need to be careful. There are as many, if not more bad deals out there as good deals. Properly evaluating a property will make all the difference between a success investment and an underperforming one.

Before getting to number analysis, let's not forget evaluating the CONDITON of the property. We always recommend that you obtain a HOME INSPECTION on every home you plan to purchase to help insure that you are buying what you think you are buying.

Initial Analysis

Before placing an offer on a property, you want to perform an initial analysis to see if the property will generate a positive cash flow. In order to do this, you should have already been pre-qualified by a lender so that you know what down payment requirements you will have and what your finance costs will be. Once you know what those cost are, you are ready to evaluate the income and expenses.

Evaluating the INCOME is fairly straightforward. You will want to compare the going rental rates in the area for similar sized homes in fair to good condition and use a figure in the bottom ½ of the going rental rates to be conservative.

Analyzing EXPENSES is a bit trickier. There are a few items that you will need in order to verify costs and come up with a total expense amount. These may be broken down into the following:

Recurring Expenses

Property management - Figure 8-10% of the gross rent will be paid as management fees on single family homes. The more properties you have under management, the better the fee you may be able to negotiate with a management company.
Insurance - You will need to have enough insurance to cover the home and liability to cover accidents, having tenants in the premises. Make sure you have adequate

Taxes

HOA Fees - Many single Family Homes in Phoenix belong to a homeowner association where fees are collected periodically for community maintenance. Please make sure to

Utilities - usually paid for by the tenant on single family residences, so you don't have to worry about this. Check with you property manager for what is typical in their area

Legal/Accounting - many investors forget this one. Remember that you own and investment and need to make appropriate plans to minimize your liability and tax exposure. Please talk to legal and tax specialists for more information. The more property you own, the less this items costs per property since you can spread the cost over all your investments.

Maintenance Costs - you may have to pay someone to maintain the exterior of the home One of the main reasons to buy a home with no pool/spa and low-maintenance desert-style landscaping. Once a tenant is in, they are typically responsible for maintaining these areas.

VACANCY FACTOR - You will not always have a tenant in the property. You need to make allowance for time between tenants. If you price your rent aggressively for the market, 1 month per year as vacancy should be more than adequate.

One-Time Costs

These are costs you will incur in purchasing the property. You may bundle this into the total investment cost along with the down payment you intend to use. They will include:

Escrow fees and other closings costs
Home Inspection
Termite Inspection
Other Inspection Fees (if applicable)
Finance Charges (for the loan)

You will be able to prepare an estimate for all these costs prior to putting in an offer on a property. Typically, you will have 10+ days after offer acceptance to run all inspections and tighten up all your figures to make sure your estimates were accurate. If you find something wrong with the home during this time, you will usually have the ability to cancel the contract and get back your earnest money. Speak with your Real Estate Professional for more information about the procedure of placing an offer on a property

Emergency Fund

It's important to always have some extra money put on the side to cover emergency expenses, a tenant that skips out or is delinquent on payments, repairs costs, etc. Always be prepared for the unexpected.

Sample Analysis

Let's work through an example so you may see how a typical investment might look on a single family home:

Our sample property is a single family home with 3 bedrooms, 2 baths and 1,400 square feet for $100,000. We will assume that you will need to put 30% down to purchase this home. A home like this is fairly typical in today's market and might have sold for $180,000 - $200,000+ 3 years ago.

Total Purchase Price$100,000
Down payment (@30%)$30,000
Loan Amount$70,000

Closing Costs
Down payment$30,000
Escrow Fees$1,000
Finance Charges$1,500
Home Inspection$400
Termite Inspection$100
Total Closing Costs$33,000

Income
Monthly Rent$950
Less Vacancy Factor (1 month)$950
Annual Income$10,450

Annual Expenses (est.)
Taxes$800
Insurance$400
Property Management (@9%)$940
HOA fees ($50/month)$600
Maintenance/Repairs/Cleaning$450
Legal/Accounting$250
Total Annual Expenses$3,440

NET OPERATING INCOME$7,010

Annual Mortgage Payments (@ 7.5%)$5,874
Positive Cash Flow$1,136
Return On Initial Investment (ROI)3.4%
return excludes appreciation

Condition Of Property

There are 3 different types of properties you can look at purchasing as an investment as it relates to condition.

Option A - Property In Good Condition & Ready To Rent

Option B - Property in fair condition but requiring cosmetic repair to make rentable. This is a property that might be bank-owned or otherwise vacant for a while. May have been heavily used or poorly maintained by the previous owner. Work required is more cosmetic in nature and easy to estimate. Things like carpet cleaning or replacement, new appliances, repainting, cleaning, landscape repair, drywall touch-up

Option C - Property in poor condition, requiring major repair and/or replacement. I only recommend this option for seasoned, experienced investors that have a background in home construction, repair and cost analysis. While you may be able to purchase property well below current market values and create instant equity by fixing them up, you can also lose your shirt if you don't know what you are doing.
If you are a beginner real estate investor, I suggest you stick with option A until you get your feet wet and a little more experience with repair and replacement costs.

Be Pragmatic

Remember, it’s an investment. Be a Vulcan. Don’t exhibit emotions when dealing with buying a property or renting it to a tenant. The numbers have to make sense and the upside must be there. NEVER FALL IN LOVE WITH A HOME YOU’RE BUYING AS AN INVESTMENT. You will not be living in it. Think of it strictly as an income producing asset like a stock or bond. Make sure tenants are properly screened and qualified.

Property Management

It is important to have quality local management to oversee your investment. Yes, it cost more money to pay them, but they help maintain the value of your asset and save you from those calls at 3 am about a plumbing leak. Factor them into the numbers when evaluating an investment and don’t buy anything that doesn’t positive cash flow without management.

Why Not Commercial?

Commercial real estate like apartments, office, retail and industrial make excellent investments – if purchased at the right time. The consensus among leading real estate investment professionals is that this segment of the market has not bottomed out and likely will not for a while. The time to pick up distressed real estate investments in these asset categories may yet be 3-4 quarters away (from 4th quarter 2008).

Why? Because as the economy fails and the recession heads into full swing, many business eventually fail. This drives up vacancy rates and reduces asset performance while at the same time, reducing rental values as more space competes for limited tenants. Investors start demanding higher rates of return and factor in higher vacancy rates into their calculations of asset value driving the prices of property down. It usually takes some time for property owners to catch on to this market trend and reduce their asking prices to falling market values which further puts strain on values. This is the same scenario that has happened in the residential property arena in mid-to-late 2006 and into 2007. I suspect that there will be many commercial properties that enter default and revert back to the lenders creating opportunities for seasoned investors to purchase commercial real estate assets for very attractive values – but the time has not yet arrived. Patience is warranted in this area.