Wavering on the sidelines, trying to decide whether to move forward with buying a rental property?
Ask yourself these five questions to help you decide whether to purchase or not.
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Deni: Hi everyone and welcome, I’m a little flustered because, you know, technology does that sometimes, anyway. Last week we talked about realtors versus for sale by owner. FSBO as it is also called. Today we’re going to speak about the five questions you should ask before you buy rental property? But before we jump right in, please let us know where you’re joining us from. And as we go through this, please ask your questions. It doesn’t even have to pertain to this subject. Just throw questions out. That’s what we’re here for. So, with that being said, let’s jump right in. Brian, let’s go right into the probably most difficult question of all: How does cash on cash return compare? How do you do that? How do you compare the cash-on-cash return to other investments you might be looking at?
Brian: Sure. So, I mean, that’s really the question before making any investment is what do you hope to earn on it? And one of the huge advantages to rental properties over things like stock investments is that you can actually calculate quite accurately what the return on investment will be for any given property that you go to buy. So, we have a free rental property, ROIC calculator on our site. It’s not even gated.
Deni: You know, fun to play with.
Brian:Yeah, it’s free. It’s fun to play with. So, you know, you go in and you put in the purchase price and your expected closing costs and so forth and your mortgage information, along with the expected expenses for the property. And it will tell you both, it’ll tell you cap rates, it’ll tell you about your cash on cash, return for you, for your own cash down payment and closing costs, and potentially any upfront repairs that are needed. So, in this way, if you get this right, you never have to make a bad investment again because you will know before you invest exactly what kind of return you’re going to earn on a property. I mean, one of my favorite things about rental properties is the predictability of returns.
Deni: Sorry. Are you OK?
Brian: So, it looks like you put a link to the free rental property calculator and the comments. Yeah, I look for cash on cash returns there at least seven to eight percent. You know anything less than that, and I figure I might as well just put my money in the stock market where, you know, historically you can earn 10 percent a year on average. Of course, some years it’s, you know, minus 20 percent. Other years it’s plus 30 percent, whatever. But yeah, anything less than seven or eight percent cash on cash return does not particularly excite me.
Deni: It’s funny because a lot of people have differences in that like they’re very either exact and they think it should be eight to 10 or. I mean, what if somebody finds a property that’s six and a half percent? Is that still something they should run from?
Brian: Oh, I mean, it’s up to you as an investor, what you’re willing to accept on your money. I really look for eight to 10 percent on my money. When you’re first starting out, you’re not going to be hitting home runs. I mean, as a real estate investor, that’s just what it is. Your first couple deals, you are really just trying not to lose money and learn the ropes. I, a six-and-a-half percent return is not necessarily a deal-breaker. I look for slightly better returns, but it just comes down to your goals and you might decide that you feel really strongly about a certain area that you think it’s going to appreciate really well over the next 10 years. Willing to accept, you know, an income yield of, say, six percent, seven percent, whatever, because you also believe that you will be earning some strong appreciation on that property as well, you in addition to that cash flow.
Deni: Tara says, Hey, guys, Tara, I just want to check with you and make sure we are live on the page. We were having some technical difficulties, so let us know. I’m pretty sure I saw us on the page, right? Sorry, everyone.
Brian: Well, you know, if she can see us and put comments there, we’re probably live.
Deni: Ok, well, there you go.
Brian: The important thing with calculating your returns on a rental property is to include all of your expenses accurately, and that includes a lot of these expenses that are not hitting you every single month, but that will hit you periodically. Things like repairs and maintenance, things like, you know, vacancy rates, turnovers, you know, you’re not going to have to replace the roof every single month, right? But when you do replace the roof, it’s going to cost you $10000 or, you know, whatever it is for your property. You do need to incorporate these. I usually estimate between 10 and 15 percent of the rent each month for, you know, set that aside for repairs and maintenance on a rental property.
Deni: Would that have anything to do with the age of the property? If it’s an older property, would you figure in more?
Brian: Absolutely. Yeah. If it’s a brand-new property, then by all means, figure in, less or on the lower side of that range. If it’s an old property that is in desperate need of repairs and maintenance, then you’re going to have to bump that up a little bit. So right.
Deni: And a lot of people don’t figure in repairs, which blows me away because of the lack of money. Yeah, I mean, that can really cause problems. What are some other costs that you see people missing?
Brian: You’re going to have incidental costs that any given one of those is not very big, you know, things like travel expenses, accounting, and bookkeeping, legal costs, marketing costs. Those are all small, but they add up to usually two to four percent of the rent, when averaged over the long term. Those miscellaneous expenses, set aside a little extra buffer for those. Also, bear in mind that property taxes will go up. That is inevitable. A lot of people, when they are calculating their cash flow on a rental property, they’ll use today’s property tax bill. But as soon as you buy that property for a higher cost than the current assessment, the assessment is going to reset to the purchase price that you paid for it. It may not happen this year. Usually, reassessments are done in three-year cycles, or at least they are in Maryland, but you know it will. It will reset. Your property tax bill will go up based on the purchase price that you pay for the property and then probably, you know, keep increasing from there because local governments want to sap as much money out of you as they possibly can. So, they’re going to assess your property for as high as they think they can get away with.
Deni: Not to mention, if you’re in an HOA or condominium and you are renting it out, they can go up to. You want to keep that in mind.
Brian: No question.
Deni: What about location, Brian, what are some of the things that you take into consideration when looking at the location?
Brian: Yeah. I mean, that’s really the second question that you want to dive into here before buying a property. You want to look at the neighborhood appeal. You want to look at what direction the neighborhood is trending in. There are more businesses closing or more businesses opening. Right? I mean, is the neighborhood going in the right direction or is it going in the wrong direction? And one that I particularly like as a litmus test is would you feel safe walking down the street at 10 p.m. in this neighborhood by yourself? Unarmed.
Deni: You know, it’s funny you say that because when I take people out, to show them houses and whatnot. One of the things I always tell them is to please drive through this neighborhood at all different times. Come by at dinnertime to see how the parking is, come by on the weekend evenings to see if there are issues or problems. And that’s important to do because, yeah, as you said, you want to make sure it’s safe.
Brian: Yeah. And you know, for urban neighborhoods, in particular, parking can be a big deal. You know, I lived in downtown Baltimore for a long time in Fells Point, and parking was a problem, at least in some parts of the area. But in the middle of the day, parking was easy. If you were only looking at properties there in the middle of the day, you would have a skewed view of what the parking situation is there, right?
Deni: And for renting, which is an issue. People don’t want to have a problem. It’s harder to rent out a property without decent parking.
Brian: In Fells Point Baltimore, just to give you an example, houses that have a parking pad in the back, can add $100000 to the value of the property where it can anyway in.
Deni: Oh wow.
Brian: More desirable parts. Yeah. So, I mean it, parking makes a big difference.
Deni: Wow, that’s amazing. So, let’s talk. And we’ve I’ve seen this question come up in the landlord hub about property class. You know, the A, the B, the C. Can you tell us a little bit about what they are first and how they affect it? You know, an outcome.
Brian: Sure, A-Class properties are where your upscale upper-middle-class professionals are working and living. Doctors, lawyers, upper managers. People who are earning six figures and up. Those are really your A-Class. Neighborhoods B-class neighborhoods are very solid, middle-class neighborhoods. This is your teachers and firefighters and police officers and skilled workers, accountants, B class neighborhoods, solid middle-class. C-class neighborhoods, you’re starting to get into a little grittier working-class neighborhood. D-class neighborhoods are really gritty and borderline slums. That’s like the thirty-second overview and of course, the cap rates and the returns are going to be higher in the higher risk neighborhoods because the risk is priced in. You know, if you’re buying rental property in a neighborhood where a bunch of upper-middle-class professionals is living, there’s very little risk there. At least much of the risk is lower. You know, there’s a much lower risk of rent defaults. There’s a much lower risk of them abusing your property. First of all, credit matters quite a bit to these people, and they’re also easy to find and collect from. So, you know, if they were too stiff you, somehow you could go after them and get a judgment against them and actually be able to collect on that judgment. In de class neighborhoods where I first started investing, you know, years ago when I first got started. You’ll never collect from any of those people. I mean, most of the time, I never bothered to get a judgment against tenants, even if they left owing me, you know, thousands and thousands of dollars. I knew it wasn’t worth it to go after them because I’d never be able to find them, much less collect them from them.
Deni: What is the appeal? Then there has to be an appeal. People do invest in those areas
Brian: In class neighborhoods, higher cap rates, higher potential returns. But there is a lot higher risk. And I mean, I’ve run into crime problems, you know, break ins. I’ve had many times I’ve had people rip apart the air conditioning condenser to steal out the copper piping. I mean, you just run into all these extra risks, you know, higher turnover rates in the neighborhoods, you know, higher crime rates, of course. And the crime rates, you know, that affects you, not just in direct crime against your property, but crime against your tenants, you know, encourages even your good tenants to move out. And if you know, if people don’t feel if good tenants don’t feel safe living there, then you’re not going to have good tenants, right? I mean, I’ve had good tenants move out of my properties in bad neighborhoods before because they didn’t feel safe there.
Deni: So, it makes perfect sense. So definitely, beginners should not be looking towards those.
Brian: No, and they’re appealing to beginners because the prices are lower right and because the cap rates look really good on paper. So I mean, that’s what drew me to those areas when I was 23 and in first getting started, you know, and I thought, Oh, you know, I can buy these affordable properties, and that will let me diversify because I’ll be able to buy a whole bunch more of them, you know, rather than having to put all of my money into one expensive property, I can buy, you know, 10 cheaper properties or whatever, but that’s it didn’t work out. The short version of that. There’s a reason why the cap rates are so much higher in order to try to attract people there. I mean, that is the market speaking because the risk is so much higher and there are so many more headaches in trying to collect rents in tenant damage to your property and tenants not treating your property well and crime, all that stuff.
Deni: Yeah, a lot more aggravating, a lot more time-consuming.
Brian: It is. And the higher turnover rates in those neighborhoods make a huge difference in your returns because turnovers are not only where all of your headaches come in as a landlord, but they’re also where most of your expenses come in as a landlord as well. You know, you have to go in and at the bare minimum, you have to repaint the unit. You have to usually put in new carpets or new vinyl floors or whatever. It’s just a nightmare. Turnovers are your worst enemy as a landlord and the worst neighborhood. The higher the turnover rate.
Deni: Thanks. So now let’s talk about the physical end of the building, let’s talk about the condition. What are some of the things that you should pay particular attention to?
Brian: Well, first of all, look for any needed structural repairs because if the building needs structural repairs, consider that a huge red flag. Those can be extremely expensive to repair. They can also be very difficult to repair and sometimes unpredictable, you know. If so, for example, a property with foundation problems, you might think you can get away with spending $5000 or something to repair these foundation problems, only to get the specialists in there and get halfway through the job. And they say, no, it’s actually going to be more like $15000 or worse. I mean. So, you really got to be careful of major structural repairs. Beginner investors should avoid properties with structural repair problems. You know, the next thing is major mechanical systems. You know, the HVAC, you know, the furnace air conditioning, condenser hot water heater, the plumbing in the house. How old is it, the wiring in the house? How old is that? If the property needs major mechanical overhauls, these are much more predictable than structural problems. But they’re still going to require you to get permits, which you may or may not feel comfortable with, and they’re still going to require licensed contractors. So just be aware that there’s you can make good money renovating properties, flipping properties, doing the BR method with these properties that need major mechanical overhauls. But just keep in mind that it’s going to be a lot more work on your part and cost a lot more money in renovations and repairs. So, if you are inexperienced, if you have not done many deals, I would stay away from major mechanical repairs for your first few deals. I would stick with cosmetic improvements if you wanted to buy a fixer-upper or a property that needs some updating.
Deni: Now, people who are not mechanically inclined or are just knowledgeable on these things, would you advocate a home inspection or at least bringing along a contractor to check out the home before you buy?
Brian: You should always get a home inspection done. I mean, even if you’re making an offer without a home inspection contingency, you still need to know what the property’s condition is and what the needed repairs are. So, yeah, even if you don’t include that as a contingency clause in your offer, still bring in a home inspector so that you are aware and that you know what the needed repairs are, because sometimes these are behind the walls or not obvious to you. So, you know, even if you’ve done some home remodeling in your own house, for example, you can still miss some of these needed repairs that a home inspector who’s going to go in and spend like three hours poking and prodding the house that they will hopefully find.
Deni: Right, right. And what are some other things? Let’s talk about the outside of the house.
Brian: Well, you know, curb appeal matters now. If you’re buying an ugly house, as they say, or, you know, a fixer upper. Just make sure that you can improve the curb appeal, right? Because it’s inexpensive? Yeah. I mean, so you just want to make sure that your price in any of those esthetic updates that the property needs as well so that you can give it that good curb appeal. And let’s face it, some houses are just forever ugly. Right? I mean, no matter how much money you sink into them, they’re still going to be ugly on the outside. And you should really probably stick to staying clear of those because, yeah, you do want to have that curb appeal. You do want people. You want to make a good impression, a good first impression on prospective tenants, and later to prospective buyers when you want to sell. So, yeah, the exterior of the house does matter.
Deni: And I know we talked a lot about, you know, how things are working and the furnace air conditioning and the roof and all that. But what about cosmetics? Because that is important. I mean, it’s the first, you know, people walk in your renters, potential renters and you know, that has a lot to do with. People are very, you know, that’s what they say the first five seconds they look, and it can make it.
Brian: They make their judgment, right? Yeah. So, you just have to price in any needed cosmetic repairs or updates that the property needs. You know whether that is as simple as a coat of paint or as complicated as putting in a new kitchen, new bathrooms know whatever. Again, these are pretty predictable repairs, which is good. They don’t require permits, which is really good, especially for new real estate investors. So, yeah, I mean, again, you just want to make sure that you have accurate estimates for what it will cost to make these kinds of updates.
Deni: Gotcha. Well, let’s move on. We talked a little bit about this already, but let’s get into a little bit more about the property taxes because that is a lot of people don’t realize that they’re not a flat line. This is it. You’re going to pay that for the rest of the time.
Brian: Right, so just be aware that the assessment will go up, so what you need to do when you invest in rental properties, you need to know what the local county rate is, the property tax rate and then multiply that by the purchase price that you’re paying for the property as an estimate of what you will be paying in the future for your property tax bill. Now, the fifth and final question here for buying a rental property and making this decision easier is exit strategies and what kind of exit strategies you will have available to you in case your first plan goes awry. You know, so for a lot of people with rental properties, their first plan is keeping it as a long-term rental signing, one year lease to your lease, whatever. It’s nice to have contingency plans in place. So, could you use it as, for example, a short-term vacation rental property? You know, could you rent it out on Airbnb and still make the same kind of return on it? You know, even including expenses like property management and cleaning and so forth? Could you keep it as a corporate rental and rent it out for a few months at a time? You know, maybe furnished Al Williams, and we’ve brought him on a couple of times to teach corporate rentals as an investing strategy. And he gets into all kinds of fun stuff like rental arbitrage, and you know, how to use other people’s properties to build your own corporate rental business.
Deni: One of the things, though, I have to say that sticks out to me, and it’s and it’s amazing when you know, it’s like when you buy a car and then you see everywhere you drive, you see that same car. So, he brought out the whole facts. If you see a lot of the executive hotels and their parking lots are full, then you’re probably in a decent area to do this. So now I drive around, I find myself doing that like looking. And are they full?
Brian: Absolutely. And you know, if you do buy a fixer-upper, like we’ve been talking about with some of these potential repairs needed and so forth. If you are aiming to force equity through extensive renovations or even just cosmetic renovations, you know, and your primary plan is to keep it as like a BRRRR property, you know, buy, renovate, rent, refinance, repeat
Deni: Brian’s favorite word.
Brian: It’s a good strategy Could you flip the property instead, a contingency plan as an alternate exit strategy The more exit strategies you have at your disposal, the better off you are in case Plan A. doesn’t work out. I’ve had that happen to me before where, you know, I was planning on flipping a property and the market dropped out in that particular neighborhood. So, I ended up keeping it, and the homeowner market anyway dropped out in the neighborhood. So, I ended up keeping it as a rental property. But having multiple exit strategies, having multiple contingency plans can save you a lot of panic. And, of course, money down the road if your first plan does not come together.
Deni: Absolutely. So, Brian, do you have any other? Tips, tricks of the trade.
Brian: No, I think we covered it, so, you know, to recap. The first question you should ask before buying a rental property is, you know, what is the cash-on-cash return and how does it compare to other potential investments? The second question is how does the location know? What’s the appeal? Third question is what is the property class? I mean, what’s the neighborhood class? Third question, how is the physical condition of the property, and what repairs does it need? And of course, how much will those repairs cost? And the fifth question finally, is what alternative exit strategies could I use if Plan A goes awry?
Deni: All right.
Brian: Deni, is there anything else that you want to throw out there before we call this episode complete?
Deni: I don’t think so. I added a link to an article that goes into this subject a little bit deeper. And as usual, if you have any questions, send them our way. And if you get a chance and you happen to be listening to our podcast or watching us on Facebook, feel free to leave a review and please send us the subject matter. We would love more ideas.
Brian: Yeah, we want to talk about what you want to hear about. So, you know, let us know what you want to hear about. And like Deni said, please leave us a review on Facebook on-site Jabber. If you are listening to this podcast on iTunes or Stitcher, leave us a review there. We really appreciate it and please don’t be a stranger. Shoot us a message over a Spark Rental. Com Sub or email support at Spark Rental, and we will see you next Tuesday.
Deni: Absolutely. Have a great day, guys. Bye now.