How to find a good investment.
When you live by the tenet that leveraging your assets will change your life, lulls in the housing market can prove to be extremely fortuitous. Right now many people are backing away from the housing market, but our brave and bold clients are starting to approach us with big dreams of getting into their first investment properties. This is the time! There is less competition, listing prices have come down slightly, and sellers are more cooperative in their willingness to negotiate things like seller paid closing costs, rate buy-downs, and repairs.
It’s awesome, it’s exciting, and we know it can be a little overwhelming taking that first step. Luckily, regardless of whether buyers or sellers dominate the market the components of what makes an investment property solid remain the same.
Where to start? Maybe as a buyer you have an idea of what you want but don’t know how to break it down and articulate it to your agent. Or maybe as an agent you know how to identify a good investment opportunity for your client, but explaining those concepts in a way your buyer can understand is proving difficult. How do you articulate the years of experience you’ve gained in watching your market into a few concise categories that are digestible and easy for someone new to investing to calculate?
To make it simple we have broken the process down into answering the 5 following questions. We actually pose these questions to our clients for each property of interest. We call it “The Game”…
“Does it Pencil?”
Is the property in a location that has been appreciating steadily over the last 5 years?
Is the unit safe and in good working condition? The main item we’re looking for here is significant deferred maintenance. Have the current owners have kept up with maintenance, repairs and updates? Specifically, have the major systems (roof, plumbing, electrical, foundation, drainage) been maintained?
If one or more of the units are rented are the rents commiserate with current rental rates in the area? (If we move forward we also need to find out if the tenants in place have paid adequate deposits and that the trust account has been untouched by the seller).
Can you make at least 20% profit per month after accounting for fixed costs (mortgage, insurance, HOA, property management, etc)?
If the answer to all of these questions is YES odds are good it’s a good investment!
Is the property in a location that has been appreciating steadily over the last 5 years?
How do we look that up? And more importantly how does someone who doesn’t have access to RMLS reports look that up? Wellllll good old fashioned Zillow! Zillow has an API connection to RMLS (meaning its system talks to RMLS’s) and stores the prior years sales. Go into Zillow’s search feature, switch to sold, type in the Zip Code, filter by similar # of beds and baths and see what the prices are on average over the last couple of years. Alternatively if you’re working with an agent you can ask your agent to run a market report for you so you can get a picture of how prices have been trending. We look at this metric is because even in a time of depreciation or price reduction like we’re seeing right now (winter 2022) checking for long term appreciation in a given area is generally a good indicator of how a property’s equity will continue to grow. Remember equity growth is a huge part of your financial portfolio. Though cashflow is generally top of mind, equity growth is key when we invest in real estate.
Is the unit is safe and in good working condition? Has maintenance been deferred?
It is extremely common for investors to sell off property with significant deferred maintenance. In fact we would wager that more often than not rental properties will have significantly more deferred maintenance than owner occupied homes. There are a few reasons for this. When renting a home people are inherently less invested in the care and overall condition of the property than when they own it themselves. This doesn’t mean tenants don’t care about where they live, but they’re less likely to notice things like cracks in the wall that could indicate a settling foundation and might not necessarily care if the HVAC system makes a strange groaning noise when it fires up. Tenants are less likely to know what you, as the owner who wants to maintain their investment and is required to provide a safe and habitable environment, would find concerning. This is why inspections are paramount and you need to be prepared to walk away from a property if you cannot satisfactorily negotiate based on the condition of the unit(s). During the lifetime of ANY building you will incur costs for maintenance and repairs. Knowing your level of comfortability with ownership costs before you enter into a real estate contract will help you choose the right property.
A word on fixers. First, you should determine in advance if you’re in a position to take on a property that needs significant work keeping in mind that major repair costs can eat into the equity and cashflow of a rental. If you are prepared to take on a fixer there can be significant benefits, but there is always a level of risk. Some basic things to consider:
How much cash on hand will you have to make improvements?
What is the estimated cost of the work to be done? We suggest you add a minimum of 20% to your cost estimate, surprises are inevitable.
How long will it take to complete the work and what are your holding costs during that time? As with construction costs we suggest you add a minimum of 20% longer than your original timeline. There are always things that come up requiring more time, it’s rare a construction job finishes within their original timeline.
Are you planning to do some of the work yourself? It is important to learn what the local building requirements are and to make sure any work requiring a permit is permitted correctly and final inspection is approved by the municipality.
Will updates increase the amount of rent that can be charged?
Buying a fixer can mean a significant reduction in purchase price, but it is important to understand the downstream effect the upfront costs may have on your investment. Most importantly work with an experienced agent and inspectors who will give you a realistic view of what to expect.
If the units are rented are the rents commiserate with current rental rates in the area?
This is where A LOT of people make a mistake when buying an investment property. Market rents are crucial to successful investment. While not all houses cashflow immediately the ability to make a profit each month from your home is what makes buying an investment property worthwhile. Often times people sell rentals with tenants in place who are not paying market rent. Reducing rent to slightly under market is a great strategy to get and keep quality tenants, but it can affect property value when it’s time to sell. Many people don’t realize that many cities (or counties) have limits for how much rent can be increased at one time. For example, the state of Oregon passed Senate Bill 608 in 2019 in an effort to control rent increases and evictions. The bill sets the annual amount rent can be increased to 7% plus the rate of inflation calculated by the CPI (consumer price index) measured from September to August. There are few exceptions to this rule.
Let’s go over what this looks like when purchasing an investment property. Starting in 2023 the maximum annual rent increase in Oregon is 14.6%, the highest allowance since SB608 went into effect. You’re looking at purchasing a 2 bed 1 bath unit knowing the market rate for rent should be about $2000/mo. You find a suitable property and know with your purchase price and down payment the mortgage is going to be $1800/mo. You learn the tenant is currently paying $1100/mo. In this scenario you’re looking at a loss of over $600/mo and a minimum of 4 annual rental increases to get to $1800, this calculation assumes the annual rate stays as high as it does for 2023, which is unlikely. So why not just evict the tenant? While this seems like a logical option many municipalities have regulations around this too. It is important to consult with a real estate attorney to make sure you understand eviction laws for your local area. Here, in Portland Oregon, the simplified explanation is that you have to give the tenant 90 days notice as well as pay relocation costs that are pre-established by the city based on the number of bedrooms. The combination of attorney fees (worth every penny!) and tenant payouts this can cost thousands of dollars and may totally eat your first year or more of profits. Bottom line is if evicting is too expensive and you can’t raise rent enough in the first year to at least break even, or ideally turn a monthly profit, it doesn’t pencil. This is a clear example of why it is incredibly important to work with a realtor who knows the local market.
Can you make at least 20% profit per month after accounting for fixed costs (mortgage, insurance, HOA, property management, etc)?
This is the rule with the most flexibility. It is also the one that many experienced Realtors and investors will push back on. For the record, before someone comes for us, the 20% rule is the goal, it is not a typical starting place for most first time investors. For example, if you’re renting a unit for $2000 per month, and your fixed costs are $1500, that’s a 25% profit margin! That’s dang good! But if you’re renting for $2000 / month and you’re making $200/ month cashflow on top of that that’s also great! That’s 10%. Where else can you make 10% on an investment that’s liquid like that? (Like really, if you know of anything let us know). The 20% is the rule of thumb for checking all the boxes but if you’re cash flow positive you’re doing well. The main thing is to turn a profit because you need to build up adequate reserves. Reserves are the money that you should leave in an account for the purpose of addressing inevitable surprise costs that come up. You know, a broken dryer or a surprise water leak. It is important to build your reserves up in the first years of ownership. This is why I always advise making sure you’re cash flow positive. You want that house that pays for itself and makes additional money for you. Some people are more comfortable with less cashflow because they are investing for equity and tax purposes rather than passive income. This type of investment can be a solid financial strategy for people who have already built substantial wealth. Newer investors are often first time home buyers who don’t have a significant savings and for these clients we recommend making it a goal to hit that 20% mark as soon as possible. Keeping the mindset, “Shoot for the moon. Even if you miss, you’ll land amongst the stars.” But way less romantic and far more practical, because, “Shoot for significant cashflow so you don’t have to file Chapter 11 when your roof needs replacing.” doesn’t sound quite as charming.
If the answer to all of these questions is YES odds are good it’s a good investment!
If the answer to all of these are yes, snap that bad boy up! Get that offer in, tell your Realtor to make those moves and have your earnest money ready! But honestly, if the answer is yes to only 2 or 3 of these it could still be a good investment. The important part is being realistic and evaluating where you’re willing, and able, to make trade-offs to reach your goal. One size doesn’t fit all when choosing a property, much of it depends on the type of investor you are, or want to be, and what your current financial situation is. In the end this list is a blueprint to help guide you through what can otherwise be a daunting and non intuitive process.
Hopefully it goes without saying, but if you ever want to talk through your investment goals or have questions feel free to reach out!