Common Questions Series: #5 How Do We Know Which Properties are Good Rental Investments?
Earlier this week we talked about how to know which properties to buy when flipping houses (check it out here), but how does it vary when looking for rental properties? There are some criteria that are universal when house shopping, but there are differences in how you look at the numbers for evaluating the investment quality of a house. Here is what we look for in rental properties:
Let's start with things that are the same as flips...
One of the biggest risks in real estate is that market conditions can always fluctuate, but we’ve found one way to mitigate that risk is to stay closer to where the businesses or schools are. Doing this will ensure there will almost always be renters. And to be honest, the market fluctations are not as big of a deal with rental properties because if you are not planning on selling the market price does not affect you. In fact, when the market goes down and more people are going into foreclosure, there are more renters!
But with that in mind, you still need to pick a location that has enough people to fill the rental property. We like to be in cities where there are at 2-3 Fortune 500 companies. These companies typically have hundreds or thousands of employees with many new hires with reliable income who will be relocating and looking for housing. Also, buying rental properties near colleges provides a lot of opportunity for finding renters because of the large number of students. Other factors we look for to help in this regard are to look for cities with population over 200,000 people, and a history of growing population trends over the last few years. No one can predict the future, but there are certainly ways to hedge your risk by understanding your market before jumping in. Again, smaller cities and rural areas aren’t bad, we actually have property in these smaller areas too, but just remember to compensate for that risk and be aware of how market fluctuations can impact your rental values and vacancy rates.
Now we are known amongst friends and family for being willing to live or work in areas that seem a little sketchy to most people (hey, the numbers made sense in these areas so why not??). With that said, we actually do have a standard and want to be able to walk safely down the street still. Hopefully you understand your neighborhood and market well enough to know where is safe and where to stay away from. Just like every other criteria, we need something measurable so we do have a way to ensure we’re not in a “war zone.” For us, we run all of our properties through Trulia’s crime map to get a general feel for what the crime is like in an area. We will buy properties in green or yellow areas, but are very leery about buying in the red zones as those definitely have more crime. Just type the address in Trulia and start playing with their interactive map. It tells you how many crimes occurred in the area, what block they happened on, and the nature of the crime (i.e. we avoid shootings!).
Trulia Crime Map
Now for the differences from flips...
A really quick way to filter through properties when looking for rentals is using the 1% rule. That means that monthly rent should be 1% or more of your purchase price. For example, if a house can rent for $1,000/month you should not pay more than $100,000 for it. Or if you find a fourplex where each unit brings in $600/month then your total monthly income is $2,400 and you should not pay more than $240,000 for the property.
Now this is not a hard and fast rule that you should purchase based solely on because you need to look at all the specific expenses and cashflow. But this is an absolute base minimum for us, and we don't spend time analyzing properties that don't meet this because we know it does not cashflow as much as we want.
So after we find a few houses that bring in rent that is at least 1% of purchase price, what we you look for? We have a spreadsheet that we plug in the income and expenses to see what monthly cashflow would be.
The first thing you need to do is figure out what the house would rent for. As you get to know a city or area you will know this figure pretty quick. But when you are starting your house hunt, you will need to do a little research. Essentially you just need to act like a renter looking for a place to live and see what your competition is. If you go onto Zillow, Trulia, Rentler, or other sites you can see what houses or apartments of the similar size and quality are renting for and average those to get a rental amount for your house. We also like rentometer.com where you plug in your address and bedrooms and it says what the average rent is in the area, but the free membership only allows you to do a few addresses a month. Also, if it is currently rented the seller should list what price they rent for (but even then, you should do research to make sure it's at market rent--often they are low if the person has been living there a long time).
Often people forget that there are other options for monthly income on many rental properties. For single family homes this may be more limited, but on multifamily or apartment complexes you can rent garages, parking spaces, storage units, charge a flat utility rate, or install coin laundry machines. If the property you are looking to buy has potential for any of this additional income be sure to include it in your calculations.
For each property you are considering to purchase you should do a thorough breakdown of expenses. Some of these things you can look up, some you can ask the current owners what they have paid historically, and some are pretty standard across all properties. Here are the items we include in our analysis spreadsheet:
Once you have all these monthly expenses you need to subtract them from your monthly income and see if it cashflows positively, and if it is enough to make the house worth investing in. Everyone has different cashflow they look for, for us we try to make enough cashflow to recoup all out-of-pocket expenses (downpayment, initial rehab if needed, closing costs, etc) within 5 years of purchasing. Those are more strict standards than the average investor, so you don't have to do the same number as us, you just need to decide what you are comfortable.
Overall, when it comes to rental properties we are less picky about the house--we invest in a variety of sizes or in lower end areas that would not be good for flips, it all comes down to the numbers. You can make updates to change the ugly parts of a house, and can calculate those costs into your expenses. All that matters is that you have done your due diligence and accounted for all the expenses that would occur and that you are still able to make the investment profitable. Often people are so excited to get into a rental property that they buy it with just taking rent minus their mortgage and are surprised when all the other expenses pop up and they aren't actually making any money. Don't be that guy! Put in the time now to research expenses so that you make a good investment.