Rental Property Purchasing Guide - The Three Essential Components to Purchasing a Successful Rental Property
Are you ready to pull the trigger on a rental property but have some reservations? Are you worried you might miss something in your analysis that will cost you big time?
Using this simple three step guide, you’ll remove your fears from buying that rental property, because you will discover the goal of the property (Step 1), how to effectively analyze the property (Step 2) and who you need on your team to properly manage the property (Step 3).
I review these steps myself when I analyze potential rental properties for purchase. In just a few short years, using these simple steps, I have successfully purchased over two dozen rentals and now manage several dozen properties for select investors.
Buying rental properties can be intimidating. For most of us, it’s one of the largest investments of our lives. The following questions and information will help you put your mind to rest when buying a rental. Reviewing the questions will not guarantee you’ll buy a successful rental but it will definitely increase your odds of buying the right property for you, and your goals.
Goal of the Property
Appreciation or Cash Flow? – Determining why you want to buy rental property in the first place will help you cut through the noise of what the local wholesaler or real estate agent is selling, and find the property that gets you closer to what you’re trying to accomplish.
Do you want to quit your job and live off the cash flow? Or use the cash flow to fund your next deal? Or are you okay with little to no cash flow while waiting for a large cash-out refinance in the future?
In most cities (including Houston) the closer you get to the city the more expensive the properties become - great for appreciation, but not so great for cash flow. Conversely, outside the city (in the suburbs) the properties are less expensive - great for cash flow, but not so great for appreciation.
Knowing what you want out of your rental will save you countless hours reviewing deals downtown, when you want cash flow, and reviewing deals in the suburbs, when you want appreciation. Note: this is not always the case but a good rule of thumb to help you target your focus.
There’s no right answer on what type of property you should buy - it’s just a personal preference on what the property needs to deliver to help you reach your goals. And it’s not to say you can’t have both cash flow and appreciation, or buy a property in the suburbs that appreciates, but knowing your main goal of your investment will help you narrow your focus and land the right property for your goals.
Exit Strategy? – Like it or not, at some point you’ll have to sell the property you’re about to purchase (or pass it down to your heirs in a massive tax savings strategy). I hope you (like me) are looking to build long term wealth and hold these properties for many years, but what if the property is not performing to your standards? Then what do you plan to do with it?
Asking yourself the following questions can help provide some clarity:
Can you sell the property to a retail buyer or investor? If so, at what price?
Will you spend the money to upgrade and sell at retail?
How much will you need to spend to sell at retail?
Can you owner finance the property?
Can you lease to own?
Can you survive if rents drop for a few years?
How long will you hold onto the property if rents drop?
Do you have proper cash reserves for an emergency or extended vacancy?
Having plans if things go sideways is always a wise decision. I try to plan at least two exit strategies for a potential rental, that way if Plan A fails then I move on to Plan B. Some investors like to have three or more exit strategies. The truth is, if you can find multiple ways to profit from one property then you’ll be more dynamic and effective if the market shifts.
No project or property has ever gone exactly as I thought - there is always something that comes up. And if you have thought through the potential problems and how you will protect yourself, you can weather the storm with a more level head to mitigate and eliminate the risks.
It was Ben Franklin (a real estate investor himself) who said “If you fail to plan, you are planning to fail!”
Role in Your Portfolio – Since most of us can’t retire off one property, we’re looking to build a portfolio of several rentals. There are various reasons to buy multiple properties - main reason being diversification.
Here are some questions to help you determine the role the property plays in your portfolio:
Are you buying the property for diversification? (neighborhood, price range, cash flow vs equity, etc.)
Are you buying the property as the cash flow machine in your portfolio?
Are you buying the property as the major appreciation play in your portfolio?
Is it the random property that was a good deal in a strange part of town?
Is the property in a new area you are planning to get into?
What are your success metrics for the property?
What are your projected returns of your portfolio with the addition of the new property?
Keep in mind that each property is just one cog in the wheel of your portfolio, rolling you towards your goal. Understanding how your next property fits into your portfolio will help your wheel roll smoother and reach your goals sooner.
I have purchased properties that break-even on cash flow because they are great appreciation plays. But, I already owned numerous properties that cash-flowed well (and don’t appreciate substantially) so adding break-even properties that have huge upside appreciation made sense. Would I buy a negative cash flowing property to start? Absolutely not! But that’s why understanding how the property fits into your portfolio is important.
Review your portfolio returns as a whole annually or semi-annually - you may find you want to purchase a different type of property than you’re accustomed to.
2. How to Analyze the Property
ROE vs ROI – The majority of investors evaluate a rental property based on Return on Investment (ROI) and totally neglect Return on Equity (ROE). Some of you may be thinking “what is equity?”. Equity is simply the money you would receive if you sold your property and paid off all the loans/liens. For most of us, that is simply the market value minus the mortgage balance.
Most investors have a gut feeling about leaving too much money stuck in a property but never do the math. Equity is real money and should be treated as such. You wouldn't let a big pile of cash sit under the floorboards of your house, so why would you neglect the equity in your properties?
Example: You invest $20,000 into a property that has an annual net income of $5,000 for a ROI of 25%. That's great at first glance, until you look further. You notice you have $75,000 of equity in the property which equates to a 6.7% ROE ($5,000/$75,000).
These are two very different returns, and I don’t know about you, but a 6.7% return for my rental property is not acceptable, especially when the stock market historically returns ~9%, and that’s liquid!
I’m not saying don’t buy a property strictly because of a poor ROE, but it’s definitely something you want to review and understand how the property’s ROE fits into your portfolio (Step 1).
I aim for at least 15% ROE for each property.
Where did I come up with that number? As I mentioned above, the general stock market historical returns are ~9%, and that’s liquid (meaning you can buy and sell portions or your entire investment almost daily). Since real estate is illiquid (meaning you can’t sell quickly without selling at a discount or completing a cash-out refinance), I want a greater return that makes it worth the risk. I settled on a minimum return of 15% ROE to be satisfactory but your return may be higher or lower, depending on your risk tolerance, comfort level and competitive advantages.
Check out this short video where I go into more detail comparing ROI and ROE.
Leasing Costs – One of the most common mistakes I see new investors make when analyzing rental properties is forgetting to include the costs to find, screen and place a qualified tenant - the leasing costs. Even if you plan to lease the property yourself, it would still be advisable to include this cost for when you scale. I strongly suggest you find a reputable lease agent to handle leasing your properties as it’s an imperative part of your business.
A standard lease fee is the first month’s rent which equates to 1/12th of the annual rents or 8.3% - that’s 8.3% right off the top of your gross annual rents!
Everyone has different rules, but I include this fee every year in my analysis as a tenant can move after their lease (and we usually sign a 12-month lease). It is uncommon you will have every tenant move after a 12-month lease (the majority of our tenants renew for at least a few more months), but it can happen, and when analyzing a new purchase you definitely want to err on the side of caution.
You might be thinking that you can save that cost by simply finding, screening and placing the tenant yourself. I warn you, that will be one of the most time consuming tasks you do for your business, and potentially the most risky. If you place a bad tenant, you’ll be begging to pay the lease fee over the cost of fixing the property and the loss of rent while: (1) getting the tenant out (2-3 months), (2) repairing the property (1-3 months), and (3) placing a new tenant (1-2 months).
One thing managing dozens of rentals has taught me - don’t cut corners because it will become a larger, more expensive problem later. And handling your own leasing (unless you’re an agent specialize in leasing) is cutting corners.
CapEx – Capital expenditures are another cost that most investors fail to take into account. CapEx is the cost to maintain the integrity and safety of the property overtime. Some argue you don’t need to take CapEx into consideration if you’re only going to hold the property for a few years. I disagree - circumstances change and you might be stuck with a property for longer than your anticipated timeframe. Do you think the investors who wanted to sell their properties in 2009 decided to hold on for a better price? You don’t want to put yourself between a rock and a hard place if you have to sell - that’s why I always run my rental numbers with CapEx, regardless of the holding period.
Brandon Turner wrote an excellent article on BiggerPockets where he explained the math behind the monthly CapEx figure for long term holdings. To summarize the article - he listed the useful life of the major property expenses (roof, AC, floor, paint, appliances, cabinets, etc.) and the associated cost to replace each item at the end of it’s useful life. He then broke the figures down to a monthly cost and added them all together to get $182/mo. We round his number up to $200/mo for each single family property or $2,400/yr.
I have changed the figure slightly for our small multi-family properties (2-4 units). Since multi-family properties share a common roof, foundation driveway, etc. one would think the CapEx figure would be much less than the $200/mo figure of a SFR. However, there are now multiple appliances, water heaters, HVAC systems, etc. for each unit. Therefore, I use $150/mo or $1,800/yr per unit for our small multi-family properties.
Example: You’re analyzing a triplex (3 units). The monthly CapEx figure I would suggest in your analysis would be $450/mo ($150 x 3 units).
CapEx is also the reason so many cheaper properties trick so many newbies. A roof, HVAC system, foundation, etc. all cost the same whether they are for a $30,000 or $300,000 property. When your property only rents for $800/mo and $200/mo must be allocated to CapEx, that’s 25% of rents ($200/$800)! While a $2,000/mo rental only has to allocate 10% of rents to CapEx ($200/$2,000). This is also why you won’t see many pro-formas for cheaper properties including CapEx figures.
If you’re feeling a little intimidated, you’re not alone. I had to learn a lot of this from mentors and the school of hard knocks. I put all this information together in my own personal rental property analysis spreadsheet, which you can access for free by following this link.
3. Team
Realtor/Leasing Agent – All lease agents are realtors but not all realtors are lease agents. A lease agent is a licensed realtor who shows your property, takes the phone calls and appointments, and finds you a qualified tenant that meets or exceeds your standards. A quality leasing agent will reduce vacancy, problem tenants and evictions.
Leasing agents can be the most valuable player on your team. You won't know how valuable your leasing agent is until you have a bad one. Finding great tenants is one of the keys to successful management and a successful investment. The better the tenants, the easier the management. Unfortunately, finding good tenants is also one of the most time consuming parts of property management.
When you’re starting out or just have a couple properties, I highly recommend you find a good leasing agent to work with, preferably this person will specialize or focus only on leasing. They should have dozens, if not hundreds, of leases under their belt. You don’t want to work with someone that’s just starting out because you’re fairly new and don’t have the time to learn real estate yourself, and teach your leasing agent.
A good leasing agent should have developed robust criteria to screen applicants and share this information with you. If they don’t want to provide you the criteria, then move on until you find someone that wants to build a long term business relationship with you.
If you’re interested in the criteria we use to screen applicants you can see our website.
A typical leasing agent will charge one months rent for placing a tenant, paid with the tenant's first month's rent and security deposit.
Tip: NEVER pay the lease agent until the tenant has paid both first months rent and their security deposit. Trust me on this.
Contractor – A trusted contractor is an essential member of any team. The best contractors quickly handle repairs at reasonable times while maintaining a quality relationship with the tenants. Your reputation as a landlord depends on handling repairs and issues in a timely manner. There is no quicker way to damage your reputation with tenants than neglecting repairs.
Unfortunately finding a trusted contractor or handyman is much easier said than done. When you’re first starting and don’t know much, contractors seem to be hard to find and even harder to trust. I’ve seen contractor bids range from half to double what it actually costs. And continued maintenance and repairs are one of the most important parts of maintaining the value of your rental over time.
So, how do you find good contractors? I really wish this was an easy answer. Here are the best ways I know to find honest and reliable contractors:
Referrals from your network. Ask everyone you know who they use or would recommend, especially those folks that are doing a lot of deals. You’ll have a few that end up being bums but you’ll find someone.
Search Angie’s List, HomeAdvisor, etc. This is how we found our most recent maintenance guy and he’s awesome!
Contact a management company and ask for their contractor list. Some companies protect their maintenance people but some will let you contact them. It doesn’t hurt to ask!
Here’s a short video further discussing how to find an honest contractor.
Technology – One of the biggest areas you can leverage your time as a landlord is investing in technology. The proper technology and systems can save you countless hours of handling maintenance, scheduling, tenant communication, record keeping, etc.
Almost every person on the planet, whether they want to get into real estate or not, has heard the horror story of a landlord getting up at 2am to fix a leak or unclog a toilet. If you don’t have the proper technology and systems in place, then what do you do when you want to go out of town or on vacation?
One solution is to get a property management software that allows the residents to submit requests online and automatically contact your maintenance person or team. We currently use Buildium but it’s too expensive if you have just one or two properties. I have heard good things about Cozy but have never used it myself. Note: neither are affiliates.
Properly implemented and utilized technology will reduce stress, time involved, late payments, disagreements with tenants and overall disorganization. No matter if you have one or 100 properties, you should be utilizing technology to make your life easier.
I hope you found the information in this guide valuable to implement when purchasing a rental property. I believe if you complete these three simple steps then you’ll be better at spotting (and taking advantage of) profitable rental property opportunities.
You’ll never be able to know everything about how a rental purchase will turn out, but armed with the above information, I’m confident you’ll have enough insight to select winners.
Best of luck on your investing journey!
- Cameron
