Investing in real estate sounds really complicated, especially because there are so many ways to do it. In this article I’m going to focus on the most straightforward way that most people are familiar with, single family homes. To a large extent, the rules still apply to most of the other strategies or property types, but there may be some interpretation required to translate from one strategy or property type to another. I hope you enjoy!
Over the years I’ve learned a lot about investing in rental properties. Most of what I’ve learned has been what NOT to do, thankfully some of that information was obtained through my property management business with client/owners who had made some major mistakes, most of which were coming to me to fix them. In most cases if they had done some research and asked around they could have avoided those mistakes entirely, but I’d be lying if I said I didn’t learn most of my lessons the hard way too. I’ve come to realize that there are some simple basics that apply to almost everyone, and I’ve used them as the first steps on the path of testing a potential new investment. This is the first time I’ve ever actually written them down, so hopefully it doesn’t come out a jumbled mess.
Rule #1: If you wouldn’t have lived in the home at some point in your life, you shouldn’t own the property. This is especially important if you plan on managing the property yourself, rather than turning it over to a professional property manager, but even if you are planning to use a manager, it still applies. The reason for this is simple, for anything to be a good investment, you have to have some idea of the cash outflows (purchase price and repairs, debt service, etc) AND the inflows. Each are very important, and often difficult to determine, especially by a rookie investor. If you’re purchasing a “war zone” property that you wouldn’t have even considered in your broke college student days, then I can tell you without a doubt that there’s no way you can guess accurately at what your income OR expenses will be. You don’t have any way to relate to the tenants that will live in that home, and they can’t relate to you. You won’t understand each others behaviors, and generally it will all end in disaster with every tenant, every…single…time. Sound like fun? It’s NOT!
Think about the worst home you’ve ever lived in, if you owned that house and were renting it today do you think you’d know what to expect out of a typical tenant in that home? Most of the people that I ask that question of actually underestimate the quality of a tenant for any given home that they perceive as being undesirable, and that’s actually a good thing. That means your income and expense, turnover, etc numbers will be conservative, and when the property is properly managed it will outperform your expectations. As long as you were doing the right math when you bought the home you should experience a great return on investment!
Rule #2: Doing the math makes EVERYTHING apples and apples. Learn to love math, and you’ll go very far in real estate investing. If you’re looking at two different properties the math can tell you everything you need to know about which one to purchase, or whether you should purchase either one. Stick to your numbers, and your required return on investment. If you don’t have a lot of financial resources (like cash) to work with, make sure you’re adjusting your required return up to ensure that you’re getting your best “bang for your buck” and not just investing in the first thing that comes across the table.
Unless you’ve got a background in construction and feel VERY confident in your ability to estimate construction costs, make sure your first few projects don’t require more work than you can do in 2 weekends by yourself. That way when the bids come in you’ll have something to weigh the costs against (cash expenditure vs 4 long hard days working). Most importantly generate a very conservative estimate of the amount of time it will take to get the project completed, AND account for the carrying costs (debt service, utilities, insurance, taxes, etc) during that time in your cash expenditure formula.
Once you’ve got a ceiling value figured based on the math and your best estimates you have to stick to it. Emotions can cloud your judgement, but if you’ve double checked the numbers and everything checks out and is accounted for it will keep you in the black.
Rule #3: Consider your best use of time, and be honest with yourself about your abilities. When you’re starting out you may have plenty of time available, and it may make a lot of sense to do the renovations and property management by yourself to save your cash and supercharge your cash return on investment, especially if you already know what you’re doing and won’t just be learning on the job. But consider the fact that laborers can be hired for $15-20 per hour, slightly higher if you’re paying by the task rather than the hour (but you have a fixed cost rather than open ended one) for the same work you’re doing. What else could you be doing rather than working on your rent house, and what kind of product will you come out with when you’re done? Can you make more money doing something else? Will it be a high quality job or will it have to be done every few years?
Tasks like property management can usually be contracted out for MUCH less when evaluated on an hourly basis, considering it is just a percentage of rent, and the most time consuming and expensive time is when the property is vacant and they’re not making ANY money. Depending on how much time you have available a good property manager will almost definitely make you more money than managing yourself, because they’ll have better processes and systems to get properties rented faster and keep them occupied longer. Good property managers also should have a broad knowledge of tenant landlord laws, the latest technology, and what strategies other landlords are using to maximize their return on investment. Great property managers are also actively investing in real estate (walking the walk) rather than just managing it for a buck. If you don’t have the time or inclination to go to several conferences a year to keep up with the latest trends and technology, and/or you aren’t investing on the scale that it can be your full time job, chances are you’re going to be better off with a good property manager on your team.
Rule #4: Time is literally money. Don’t get hung up on rent rates, just stick to the math. When you KNOW your house is worth $2000 a month and you just won’t entertain anything less, how long will you let it sit there vacant consuming your time, money, and energy before you accept that $1900 offer? It only takes 18 days to make up that difference over the course of a year, and at the end of the year you can adjust the rent to get to (or closer to) your target rent rate. If you haven’t rented it in the last 18 days at your current rent rate, why do you think it will rent in the next 18 days? If you don’t have any reasonable reason to believe it will rent at your asking price in that time period, then you should take the offer, but always give a counter offer if the offer is more than a $50 discount.
Rule #5: Attempt to determine what tenants want, and find or make that in your rentals. Especially for single family homes there are a alot of things that people don’t consider. Things like fenced yards, deadbolts, ceiling fans, etc. There’s a long list, and every prospective tenant is different. I do my best to ensure all of my houses have deadbolts on every exterior door, ceiling fans throughout the home, and fenced back yards. I also pay attention to things like parking, lighting, and kitchen arrangements. Small investments like that can pay huge dividends if it means your homes are renting faster and/or for more money. Generally tenant quality increases as well, which is reflected more in lower expenses generally than higher rents.
Rule #6: Value is the only thing that matters to a tenant, and it can come from a long list of items. Value is a tough thing to explain, but most often referred to as “bang for the buck” or something similar. It’s not always about cost, but cost is usually a big factor. There are a lot of homes in my hometown of Shreveport, LA that rent for less than $500 per month, but as a consumer I wouldn’t live there even if it were free, because they hold NO value to me. There is a subconscious value that every prospective tenant assigns to each property they look at, and your goal should be to maximize the value of your property as high as it possibly can be, that’s the only way you’ll guarantee it’s income in the long run. You can rent any home, but not at any price, eventually you can get down to a price that someone is willing to pay in rent to live in even the worst homes, there is definitely a threshold at which it’s impossible to generate any profit on a home, even if it’s paid off, which is why I don’t invest in low income housing, and I generally don’t recommend it for anyone other than experienced investors who have a well diversified portfolio of more than 50 properties.
Value can come from nice appointments, large square footage, great location, lot size, energy efficiency, or just a great price. If your home is sitting on the market for an extended period of time, the prospective tenants aren’t seeing the value, so you should either look to make major changes, or my recommendation is usually to just drop the price and monitor results. So long as you have significantly high exposure to the market, the market will tell you what the right price is.
Rule #7: Always stick to the top of the bell curve. I picture every market as a bell curve, with price on the x axis and quantity on the y axis. For those that are familiar with statistics, I like to buy within .50-.75 standard deviations of the average home price, or top of the curve. This means that I don’t invest in low income properties or high income properties. I consider this to be the meat of the market. It’s not a perfect strategy, but the way I look at it, homes in that price range have the most flexibility. If the market were to suddenly lose population, or a boom market occurred where lots of new homes were built, those that would have been in lower price homes would abandon those homes and rent my relatively nicer homes. In a bust market the occupants of the higher priced homes will abandon those homes in favor of my more affordable options. If there is a sudden population influx incoming residents or current residents experiencing unreasonable rent increases will pay a relative premium for my more modest affordable housing.
My rules are a mix of offensive and defensive strategies, some are meant to increase income, some are meant to avoid losses, but all revolve around maximizing overall long term performance of a property. When you really think about it they aren’t rocket science, but you’ve got to think about it! I hope you’ve gained something from this article, now get to investing!