• Investing & Markets

What You Need To Know Before Buying Rental Property

October 6, 2014 | Financial Samurai

After two years of living in my first condo, I decided to rent it out and buy a house. I always wanted to live in my own house and finally found one by chance while helping a friend find a condo one Sunday afternoon. The house needed some new windows and only had one and a half bathrooms, but I didn’t care. Over the next two years I fixed it up and added a couple full bathrooms to make it more livable.

In hindsight, I think I overpaid for the house because it had been sitting there for a couple months. But to me, it was brand new because it was the first time I ever saw it. This type of thinking is like a child who believes nobody can see her if she closes her eyes. Instead of only bidding 2% under asking, I should have bid 4-5% under asking because I probably would have won. I was blinded by my desire to own a single family home and wasted a lot of money as a result.

I’ve been a landlord for 11 years now, and I’d like to share some thoughts on owning rental property. It’s not for everyone, but if you can get rental property right, you’ll be able to develop a terrific passive income stream that will bolster your financial well-being. If you haven’t been through the property buying process yet, you’re in for a very emotional ride. I’d like to help you anchor your emotions so you don’t end up overpaying and regretting your decision later on.

Related: Why Real Estate Should Be A Part Of Your Retirement Strategy

RENTAL PROPERTY: THE BIG PICTURE

When owning real estate, it’s important to focus on the big picture. I personally don’t buy property to rent out immediately. Instead, I buy property to enjoy for at least a couple years and then rent out after I’ve accumulated enough funds or want to live somewhere new. The idea is that if I’m willing to live in the future rental property I’m buying, so will others.

* It’s all about income. As a real estate investor you must ascertain what is the realistic income the target property can generate on a sustainable basis every year. Once you have an income range then you can calculate a property’s gross rental yield and price to earnings to compare it with other properties on your acquisitions list.

* Price appreciation is secondary. One of the big reasons why there was a housing collapse was because investors moved away from the income component of property and just focused on potential appreciation. Investors didn’t care they were hugely cashflow negative if they could ride the wave and flip within a year or two. Once the party stopped, speculators got crushed, which caused a domino affect that hurt neighbors who planned to buy and hold. If you are primarily focused on property appreciation and not income, you are a speculator.

* Property prices historically rise closely with inflation. Property price appreciation generally tracks inflation by +/- 2%. In other words, if the latest inflation figure is 3%, you can expect a 1-5% increase in national property prices. Over the years property price changes can fluctuate wildly. But if you look at property prices over a 10 year period you’ll see a relatively smooth correlation. 10%+ annual increases are unsustainable because eventually property prices will become unaffordable as wage growth fails to keep up.

* Property is always local. Be careful not to extrapolate property statistics. Just because one report says national prices are up 10% doesn’t mean you can sell your San Francisco home for 10% higher than a year ago. Property price statistics tell you the general direction of prices and the relative areas of strength. The most realistic value for your property is if your neighbor sells and has a very similar layout.

SPECIFIC STEPS TO VALUE YOUR PROPERTY CORRECTLY

Here are some specific steps I like to go through before purchasing any property.

1) Calculate your annual gross rental yield. Take the realistic monthly market rent based on comparables you find online and multiply by 12 to get your annual rent. Now take the gross annual rent and divide by the market price of the property. For example: $2,000/month = $24,000/year. $24,000/$500,000 = 4.8% gross rental yield. The annual gross rental yield is used to get a quick apples to apples snapshot of what the blue sky potential is for a property if one were to pay 100% cash and have no ongoing expenses.

2) Compare your gross rental yield to the risk free rate. The risk free rate is the 10-year bond yield. Investors say “risk free” because there is practically no chance the US government will default on their debt obligations. All investments need a risk premium over the risk free rate, otherwise, why bother risking your money investing. If the annual gross rental yield of the property is less than the risk free rate, either bargain harder or move on.

3) Calculate your annual net rental yield (cap rate). The net rental yield is basically your net operating income divided by the market value of the property. The way I like to calculate net operating income is by taking your annual gross rent minus mortgage interest, insurance, property taxes, HOA dues, marketing, and maintenance costs. In other words, we are calculating the actual bottom line annual profit. We can add back depreciation, which is a non cash expense, but I’m focused on cash flow. For example: $24,000/year in rent – $3,000/year HOA dues – $4,800/year property taxes – $500/year insurance – $1,000/year maintenance – $10,000 in mortgage interest after tax adjustments = $4,700 NOP. $4,700/$500,000 = 1% net rental yield. Not so good, but at least cash flow positive from the get go. Net rental yield can differ by each investor given some put more money down, while others are better at streamlining operating costs and charging top dollar for rent.

4) Compare the net rental yield to the risk free rate. Ideally, the net rental yield should be equivalent or higher than the risk free rate. You will pay the principal down over time thereby increasing the net rental yield and spread over the risk free rate. If all goes well, rents will also go up and your property will appreciate. There are plenty of properties in Nevada, Florida, California, and Arizona with net rental yields several percentage points higher than the current risk free rate after the collapse. The reason why more people weren’t snatching them up in 2010-2012 was because buyers often had to pay cash because banks weren’t lending.

5) Calculate the price to earnings ratio of your property. The P/E ratio is simply the market value of your property divided by the current net operating profit. In the example above $500,000 / $4,700 = 106. Woah! It will take an owner 106 years of net operating profits to make back his or her investment. This obviously assumes the owner never pays down his mortgage and does not see an increase in rents which is highly unlikely. A nicer way to calculate things is to take the market value of the property divided by the gross rental income = $500,000 / $24,000 = 20.8 for a blue sky scenario. Obviously, the lower the P/E for the buyer the better, and vice versa for the seller.

6) Forecast property price and rental expectations. The P/E ratio and the rental yields are only snapshots in time. Great opportunity comes in properly forecasting expectations. As a real estate investor you want to take advantage of fear and unfortunate situations such as a divorce, company relocation, layoff, bankrupt city, or natural disaster that creates motivated sellers. As a real estate seller you want to sell the dream of forever rising prices. The best way to forecast the future is to compare what has happened in the past via online charts provided by DataQuick, Trulia, and Zillow, and have realistic expectations about local employment growth. Are employers moving into the city or leaving? Is the city permitting tons more land to develop or do they have restrictions such as building heights? Is the city in financial trouble and looking to raise property taxes?

7) Run various scenarios. If rents decrease for five years at a pace of 5% a year, will you be OK? If mortgage rates for 30-year fixed loans increase from 3.5% to 5% in five years, what will that do to demand? If the principal value declines another 20%, are you going to jump off a bridge? Hopefully not if you live in one of the non-recourse states where you can hand back the keys and protect your other assets. Always run a bearish case, realistic case, and bullish case scenario as your bare minimum.

8) Be mindful of taxes and depreciation. Almost all expenses related to owning a rental property are tax deductible including mortgage interest and property taxes. The confusion lies in the phaseouts of deductions based on your income. What is also interesting to understand is depreciation, a non cash item that reduces your Net Operating Income. $250,000 of profits for individuals and $500,000 of profits for married couples is tax free if you live in the property for two out of the last five years. There is also the 1031 exchange which allows investors to rollover proceeds to another property without realizing any gains and therefore taxes.The tax code is confusing but at the margin favors property owners.

9) Always check comparable sales. The easiest way to check comparable sales over the past six to twelve months is to punch in the property address in Zillow.com. There you will see the tax records, sales history, and comparables on the lower bottom right side. You need to compare your target property’s asking price with previous sales and measure it against what has changed since to make sure you are getting a good deal.

10) Check the financial health of your HOA. If you are going to buy a condo, it’s imperative to ask for the HOA’s financial statements. Take particular note of its reserves and read the meeting notes taken by the HOA secretary. You don’t want to be stuck buying a condo with HOA litigation either. Things can get messy, quickly.

Rent vs. Mortgage Over Time

After three mortgage refinances

BEING A LANDLORD ISN’T THAT BAD

Besides following the above steps in figuring out the right value for your potential property, you must screen your perspective tenants like the CIA. Do the aggressive due diligence early so you save yourself the headache later on. An attractive face and a nice resume is not good enough. You must ask for references, the past two pay stubs, a recent credit report, a credit score and a bank account that shows enough savings to cover rent for the duration of the lease if there’s a sudden job loss. They don’t have to give you everything you ask, just like you don’t have to rent them your property.

Over time your rent should grow and the interest portion of your mortgage payment should decrease. If you can hold onto your property for the long term, chances are high that you’ll have another fantastic asset as part of your overall net worth.

You Can Now Track Your Property via Zillow on Personal Capital

Photo Credit: Bass06, Flickr Creative Commons, HK

Regards,

Sam

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