Investor Guide to Buying Real Estate
KNOW WHAT YOU WANT
The first thing savvy real estate investors will know before purchasing property is how they expect their investment to perform. Are they looking for cash flow only to gain a steady annual income stream? If so, they will want to pay no more for the property than they can realistically expect to sell it for in the not-too-distant future.
Or are they looking for cash flow and equity? If this is the objective, then they will want to acquire a property for a price that is currently under market value that will still produce an annual income stream.
Next, they will determine how they are going to measure the success of their investment. How does an investment in real estate compare to other income earning vehicles, like money market funds, mutual funds, stocks, bonds? What kind of rate of return can they expect in these vehicles, and at what risk? What rate will make the investment in real estate more desirable than investment into any of these other vehicles?
As you can see, the best way to measure the success of your investment is by deciding what rate of return you expect to receive on it.
CAPITALIZATION RATE
Before considering the rate of return further, let’s consider this: How are you going to pay for your investment? Will you use cash? Will you borrow money? Let’s take a look at both options:
Paying Cash: Buying a property with cash allows you to weather the ups and downs of monthly cash flow a little more comfortably. For example, if a repair has to be made, rent can be used to pay for the repair. If you need rent to make a repair and also pay a monthly mortgage payment, your net monthly income will be impacted. It’s not unusual to have negative cash flow in a given month. And it’s not necessarily a bad thing when this happens either. It’s important to look at the overall performance of your property at the end of the year and over several years. Just like the stock market, your property can experience its peaks and valleys. But as you can see, a cash purchase leaves you less susceptible to monthly negative cash flow. When you pay cash, the capitalization rate is the measure of the return on your investment.
The capitalization rate, or cap rate for short, is a measure of the performance of your property when net operating income and purchase price are compared. Let’s take an example:
We are purchasing a property for $25,000. Our closing costs will run about $1500 and repairs needed to get the property up to snuff will cost another $35o0. This makes our total acquisition cost for this property $30,000.
This particular property happens to be a 4 bedroom, 1 1/2 bath single family home. You’re able to charge $825/month rent for it. The tenant pays for gas & electric usage and is responsible for lawn maintenance and snow removal. We, as the owners, are responsible for paying certain fixed fees: City/School and County property taxes, City water usage, landlord insurance and management fees. We also need to make allowances for certain variable fees as well. Sooner or later we’re going to have a vacancy – we should always plan for that. And we will have maintenance expenses that will vary from year to year. So let’s take a look at what income we’ll net out with on this $30,000 property:
$9,900 Gross annual rents: $825/mo x 12 mos
LESS:
$ 990 10% annual allowance for vacancy (an industry standard amount)
$1,188 12% of gross annual rents (again, based on industry standards)
$ 990 10% management fee
$2,400 City/School/County taxes per year for our pretend property
$ 350 Estimated landlord insurance policy for single family home
$ 240 Estimated water bill for single family
$3,742 NET OPERATING INCOME (NOI)
Our net operating income on this property is $3,742. The cap rate is determined by dividing the Net Operating Income (NOI) by the acquisition cost of the property: $3,742 / $30,000 = 12.47%. Not a bad return!
Once you decide what rate you’re looking for, the cap rate can be used in a different way, one that helps you determine what price to offer on a property; that is, what price will get you the rate of return you desire for any given property.
Let’s assume we haven’t bought this property yet. We know we want to have a cap rate of at least 12%. Using our analysis above to determine NOI, we have estimated that this property will net us $3,742/year. How much should we pay for this house? If we want a cap rate of 12%, we can divide the NOI by the cap rate to determine what we’d have to pay to get this kind of performance. $3,742 / 12% = $31,183.33. REMEMBER: this shows us our total acquisition cost. In our example above, our acquisition cost was actually $30,000. If we acquire the property at $30,000 instead of $31,183.33, we simply increase our cap rate by .47% to 12.47%. Good!
There’s an easy form that helps you calculate potential income and expenses on a property. It’s called an Annual Property Operating Data spreadsheet, or APOD. Click on the link below to see an example, complete with descriptions of what each line should be used for.
RETURN ON INVESTMENT
We’ve talked so far about buying a property with cash. Now let’s talk about mortgages:
Financing your purchase with a mortgage: Using only what cash is required by a lender to acquire a property and financing the rest allows you to create leverage. Leverage is the ability to make your money go further. Suppose you have $30,000 cash to invest. You could buy one property and pay for it in full. You could also put $10,000 down on 3 different properties instead of just one. That’s leverage.
With leverage, you also can assess your property based on the capitalization rate (cap rate) and something even more exciting: the Return on Investment (ROI).
Return on Investment, or ROI, takes our propety analysis one step farther than the cap rate. Assume you buy a property and put down $10,000, borrowing the balance of $20,000. Let’s further assume that your interest rate is 6% with a repayment term of 20 years. Using an amortization calculator (you can search for one online), you see that your first year of interest paid on this loan is approximately $1,185. This is your annual debt service.
Obviously, this debt service decreases your NOI and thus reduces your cap rate. BUT . . . there’s another way to look at this. If you take our scenario one step farther and subtract out the annual debt service, you’ll see that your investment will earn $2,557 per year ($3,742 – $1,185). Now remember, your out-of-pocket investment was only $10,000; you’ve borrowed the rest. So your $10,000 cash investment has earned you $2,557 after one year. This is a whopping 25.57% return on your investment, and part of the beauty of using leverage to increase your earning power.
HAVE AN EXIT STRATEGY
It’s great to have a producing property, but some day you may want to divest yourself of it. Always make sure that you know what you’ll have to do to a property to get it in shape to sell.
If you’re selling the unit as an investment unit, what are you going to need to do to make sure it’s desirable to another investor? Is the Certificate of Occupancy (CofO) current? CofO’s are good for 6 years and with single family units, transfer with the property. However, in multi-unit dwellings the CofO transfers only if it is 2 years new or less. How old is the furnace and water heater? The roof? Will it be more marketable if these issues were addressed prior to sale?
Or are you going to market to owner occupants? If so, you might want to wait to list your property until the current tenant mvoes out at the expiration of their lease. You’ll want to make sure proper written notice of lease non-renewal is given at least 30 days in advance. And you’ll want to make the unit ready for an owner occupant as well, which might mean spending a few extra dollars to spruce the place up. Selling to an owner occupant will often get you a higher sale price than selling to an investor who’s looking for a certain rate of return, but you might need to spend a little extra to bring the property up to the owner occupant’s level.
Planning in advance will allow you to maximize the sale of your property.
IT’S TIME TO BEGIN YOUR SEARCH
Properties are typically searched by type (single, 2 – 4 unt, complexes, etc) and price. If you want to spend approximately $30,000, then have your realtor conduct your search by the type of property you want to acquire and add another $10 – $15,000 to your maximum search level. You don’t want to miss anything available in the marketplace, including unique cercumstances that lie beneath the publicly visible property offering. And you don’t want to miss a great deal because you precluded yourself from seeing it by the limitations on your dollar amount. What if spending another $5,000 would get you a fantastic deal on an income-producing proeprty? You never know what values might be available, so the increase in range provides you with greater flexibility.
And remember: list price is only important to help guide your search. after that, you are going to name your price, based on your predetermined criteria.
Once you’ve located properties, sort through them and find the most attractive ones. Then verify data. Below are websites available to the public as well as phone numbers of various agencies who can help you gather the information you need:
City & School property taxes: Call 585-428-6940 or visit http://geo.cityofrochester.gov
County property taxes: CAll 585-428-5290 or visit www.monroecounty.gov/apps/propertyapp.php
Landlord insurance: Contact your insurance agent for a quote.
Water bills: Call 585-428-5990 and ask for the last 4 billing cycles.
Use the expense data you’ve gathered to fill in your Annual Property Operating Data sheet, or your APOD. See what your net operating income (NOI) is; apply your capitalization rate or cap rate to it and see what you could offer for the property. If using borrowed money to purchase the property, calculate your annual debt service and compare it to the cash out of pocket you will need to close the purchase; this will be your return on investment or ROI.
Looking good? Keep researching! You’ll also want to know about the condition of the property and the status of the tenants, if there are any. For condition of the property, check:
City water: see the phone number listed above. If the property is vacant, you’ll want to check if the meter has been removed or if the water was turned off at the street. Does a new meter need to be installed?
Certificate of Occupancy (CofO) status and/or outstanding violations on the property: Call the City at 585-428-6520 or 585-428-6521 or visit this link
Status of lead wipe test: same as for checking CofO status
Status of gas and electric service: Call Rochester Gas & Electric at 800-743-2110. If the properyt is vacant, you’ll want to know if hte service is on or off. If it’s off, has it been off for more than 6 months? If so, you’ll need to obtain an electrical permit and have an inspection performed; it is likely there will be electrical repairs to be made. Also ask if the meter is still in the meter box or if it’s been removed.
Status of deed: Visit this link for Monroe County landata. After registering, search by property address and pay the most attention to the most recent dates. See if there is a “notice of pendency” filed – this shows the bank has started the foreclosure process.
Ask your realtor to find out about the tenants:
- How long have they been there?
- When does their lease expire?
- What is the monthly rent being charged? Could it be more?
- How do the tenants pay their rent (cash, DSS, Section 8)?
- Are the tenants current?
- How much security deposit was collected by the owner/landlord?
Also, call the local N.E.T. office that oversees the area in which your property is located. Ask what the crime rate is like in that area. Ask about the composition of the neighborhood: Are most properties rental units? Are there many owner occupants in the neighborhood? You can also check out demographics for the zip code you’re looking in by visiting this Monroe county link.
The properties listed for sale on this website will give you all this information. Your Lighthouse Licensed Real Estate Salesperson will provide you with all the information you need, as outlined above, so that you can make a wise investment decision.
We’re here to help you make money. Our goal is to help you have a positive investment experience so that you don’t buy just one investment property with our help, you buy more. we’re looking to develop a long-term, profitable relationship with you. We can do that best by providing you with all the tools and knowledge you need to make a strong investment decision.
Please call us to discuss your goals. We’re here to help.
