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A Tried and True Formula for Buying Rental Property

A little over a month ago, guest writer Arthur Garcia contributed a well-received post about how he and his fiancée used a $40,000 inheritance to purchase an investment property.

I know you may not be an active (or even aspiring) real estate investor, but I think the principals of real estate investing can benefit ANYONE. Real estate investing is about identifying opportunities through careful research, leveraging your own assets and the financial system to make the investment, and managing your investment to produce cash flow (recurring monthly income).

Today, Arthur’s shares a little bit more about why he invests in real estate (despite the risks) and the formula he uses to ensure every investment property is profitable.

Here’s Arthur:

The following is a true story but names have been changed in case the parties involved read this!

It’s ten o’clock in the morning and John has just gotten another phone call from the property manager who’s currently trying to fill a vacancy in his duplex. He’s told that the existing tenant is breaking the lease because someone has broken in and stolen the tenant’s tools—for the second time in 12 months.

This property has been nothing but problems since John bought it a year ago. Here are just a few of the things that have gone on over the past year:

  • John’s been unable to secure a tenant for longer than six months.
  • John had to replace two broken windows from vandalism while units were vacant.
  • John received three midnight phone calls reporting gunshots.
  • There is a busted crack house across the street.
  • The next-door neighbor (an elderly woman) was kidnapped from her front porch and is still MIA.

You would think that after dealing with these headaches, John would abandon real estate investing all together.

But that’s not the case.

In fact, he’s more passionate than ever about acquiring rental properties.

Why?

Well, for one, John’s learned some very painful and important lessons from the above nightmare. In fact, over the course of the past year, he’s come up with a strict set of criteria that will ensure that many of these problems aren’t repeated. I’ve taken John’s formula, added a few notes, and even threw a couple of my own criteria into the mix.

The result? A near-perfect strategy for buying cash flowing rental properties.

Before I continue, I just want to emphasize that this strategy is the result of HOURS of reading, multiple conversations with other investors, property managers and real estate agents alike, and an in-depth analysis of our own investments —this strategy is a bi-product of our own personal experience and could vary depending on yours.

Here we go…

The first step to ensuring that you don’t end up with a real estate nightmare is:

EDUCATION

Before getting into specific techniques, I’d like to re-emphasize that just like any other investment out there, if you don’t know what you’re doing, you will get burned and lose A LOT of money. I always recommend doing your homework and investing FIRST in your education.

Here are a couple of things I do to get educated:

Talk to other investors – make sure you are getting solid advice from people who have accomplished what you are trying to do, not from broke family members! You will be surprised by how many well-meaning people are eager to give you free advice on something they know NOTHING about.

Read, Read, Read

I am a HUGE fan of reading. It’s advisable to read a variety of authors who have different approaches. Your job will be to read enough material to begin seeing patterns and to form your own opinions and strategies.

Consider Buying Courses

There is a TON of quality content out there; however, just like any other industry, there’s also plenty of snake oil salesmen peddling get-rich-quick schemes, so be careful. Usually, a thorough Google search will help sort out the bad apples.

KNOW YOUR MARKET

I recommend buying in an area that you are familiar with, at least for your first few properties as you get your feet wet. If you are not familiar with an area, try spending a few weekends in your target market over a period of months. Drive around in 2-3 zip codes you are interested in and talk to neighbors, local shop owners, property managers, etc. so you can get a feel for the area and the potential clientele you’ll be dealing with.

What type of neighborhood should you be looking in?

Well, each person’s strategy is different, but here is how I analyze properties and scout out neighborhoods:

I evaluate them as one of three categories…

A Class

These are in “pride of ownership” neighborhoods occupied predominantly by homeowners. The houses are typically well maintained with green lawns, tree lined streets, etc. These tend to make great homes to impress your friends, but don’t usually pencil out as great investments. I stay clear of these areas.

B Class

This typically has the largest range of product between the three classes. These houses usually serve the greatest number of people within the community and have the largest amount of inventory. I usually try to target a neighborhood where there is a large portion of blue-collar workers and where there is a 35/65 percent ratio of renter to homeowner. You can usually tell if you’re in one of these neighborhoods by the number of utility vehicles parked in driveways – cable repair vans, constructions trucks, etc.

C Class

These are in “run-down” neighborhoods occupied predominantly by renters. These rental properties typically have a high renter turnover rate. People tend to RUN in these areas at night, NOT jog. There’s high crime, gang and drug activity, substantial cop presence, etc. I am not saying these are poor investments; typically the cash flow on these deals can be high. But the successful investors taking these on are probably running a tight operation and have a specialized property management team in place. For someone looking to acquire one or two investment properties as a way to supplement income, I would recommend against this. I haven’t purchased one and I don’t think John is eager to buy another one either.

THE FOOLPROOF FORMULA FOR BUYING INCOME-PRODUCING RENTALS

a. Buy below market 10-20%.

Think of this not only as a way to grow your net worth, but also as a way to ensure your financial security. If you ever have to sell due to an emergency, that 10-20% is going to allow you to lower your offering price to move it quicker. On a positive note, if you don’t have to sell in an emergency, you’ve just made an instant return on your investment.

b. Property must generate at least a 15% ROI, cash on cash.

That means the rent minus the debt (if mortgaged) and expenses must equal 15% or more. For example, a $20K down payment would have to yield at LEAST a yearly cash flow of $3,000. This is actually fairly low – most of my and John’s deals have been well above the 20% threshold.

c. Buy in a B-class neighborhood, 35/65 percent ratio of renter to homeowner.

d. The rent should be at LEAST 1% of the purchase price.

For example, a $100K home should rent for at LEAST $1000 per month.

e. Due your due diligence regarding repairs before buying.

If the repairs plus your down payment exceeds 15% ROI, move on to the next property.

f. Maintain six months of cash reserves per property to pay the debt service.

This should suffice for any unforeseen repairs or vacancies.

TAKE ACTION

These next few years will probably go down as the best time to purchase income-producing rentals in our lifetime. In many markets, you can acquire property far below the cost to build. Interest rates are at historic lows. Generation Y is three times the size of Generation X and is expected to continue to rent for the foreseeable future—while property values have dropped significantly, costs to rent have not.

So what’s John up to now?

Since the acquisition of his nightmare duplex, he’s gone on to purchase three additional B-class properties and is in the process of buying a forth this month. Each house brings in roughly $400 a month in cash flow. And even though he still has to deal with the occasional headache resulting from his duplex, he’s still on track to generate a second income so that his wife can stop working during the first three years of childrearing.

If you’ve ever thought about investing in real estate, what’s holding you back? If you’re already investing, is there anything you might add?

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Arthur Garcia is a real estate investor who blogs at The Business of U, focusing on personal finance, business, and self development.

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Comments

  1. Thanks a lot for sharing insights on your way to financial independence.

    What really strikes me odd is renting $ 100 K house for $ 1000 a month. I have never seen it in my life. Typically you would have $ 1200 or so for $ 200 K + property.

    If it is $ 300 K property you tend to have $ 2000 a month rental of it.

    How do you do otherwise puzzles me..

    • I agree here. This might be location dependent. In the midwest a $100k house might rent for $750/mo.

    • Hey Guys – David and Financial Independence,

      I think your questions are great! It really does come down to location. As they say, all real estate is local. All markets vary and so do the prices within them. That being said, you will typically find deals like this in markets with very low land value or in markets that have over-corrected due to the reccent RE bust.

      So for examples markets in Central CA, like Fresno, Bakersfield or in the Inland Emprire/Riverside area in Southern California you can pick up houses between 90-130K. Some other markets that have similar ratios are Texas, AZ, FL, KS, Atlanta, TN, the rust belt, just to name a few. I am not an expert, as I only invest in CA, but I know quite a few investors that buy out of state.

      I’d also advise to look in your own market to see what is currently available in that price range. If you can’t find a single family for those prices, I would consider buying a multi family (2-4 units) and applying the same formula. I have good friend who owns a few triplexs in the New England area and he does quite well for himself. Multi-families are a great option even for a primary residence. Like I mentioned, my friend lives for free renting the other two units out his building and his financing is great since he lives in the property.

      Like I wrote in the above post, the first step is education. Talk to other investors in your area and property managers are also a great source of info. And you can also consider investing out of your local area, possibly out of state (all my properties are 2 hours from where I live).

      Anyway just food for thought. Feel free to send me an email if you have any other questions – artieag81(a)gmail.com.

      thanks again!!

      ALl t

  2. I’m curious: Do you buy houses that require little to no initial repairs? Or do you prefer to look for houses that require some fixing up and get them for a lower price because of it? Or a combination of both?

    • Hey Brian,

      I currently look for houses with little or no repairs. I am not interested in “flipping” the property so I can afford to pay a little more for a “nicer” house. In my market, there are a TON of REOs and short sales and not a whole lot of buyers, so I can usually get the pick of the littler.

      Most of the investors in my market are targeting really cheap houses that need work since they can’t get traditional financing. Since I CAN qualify for traditional loans, I get go after a more expensives houses (90-120K) that most cash buyers in my market wouldn’t touch, as it would only yeild 10% return, but since I am leveraged I can get 25-35% return cash on cash.

      The only thing I have done reccently that was similar to a “rehab” was buying a 52K property (2bed/1bath). I noticed the kitchen had a den-like area that was being used kind of like an office with no door. Once I bough the house, I drywalled the space and threw a closet in there and presto a 3bedroom house. The rent for a 2b is around 800, but you can get 1000 for a 3bed. It worked out pretty well, so I am going to try and replicate that again.

      I am almost to the 10 mortgage limit and then after that, I’ll probably have to find properties that require a little TLC. I come from a family of contractors so I am pretty familar with the basics of home repairs. I am also talking to a few possible partners who don’t have cash, but are willing to use their credit to acquire financing. We’ll see where it goes. let me know if you have any other questions.

      • Thanks!

        I asked because in my area there aren’t many renter ready house available at a price that makes sense with the amount of rent I could receive (our area didn’t have a huge decline in the market).

        There are, however, a lot of houses that need some TLC but can be bought extremely cheap, and once fixed up, could generate a enough rent to make provide a good return. A contractor friend and I are currently scouting them out and running the numbers to determine if and which properties we should purchase as fix up rentals.

        • Brian,

          That is a great strategy. One thing you could also do is buy a fixer upper in cash fix it up and refinance it so you get your money back out of the deal and keep the property as a rental and keep doing the same thing. I know a few investors that only do this strategy and have grown their portfolio quite fast.

          Please feel free to contact me if you think I can help. Here is my email – artieag8(a)gmail.com you can also check out my blog. I write about RE investing 90% of the time – thebusinessofu.com thanks!

          • Thanks again.

            I was planning on buying in cash, but I hadn’t thought about refinancing once it is fixed up, rinse and repeat. That is an incredibly good idea, and I’m embarrassed I hadn’t thought of it already.

  3. Brain,

    With interest rates at 5%, you are litterally getting free money. Depreciation, interest deductions and inflations you are gonna be sitting pretty!

    AG

  4. Hi, I found your information very helpful, however I’m in a peculiar part of the country right now. Investors from all over the world have and are buying up properties in AZ for cash. These are properties under $120K, and in the 35/65 neighborhoods. The result is that I can’t find/bid on a home because the investors move in and offer full price – cash.

    What is your advice on dealing with this situation?

  5. Hi Holly,

    This is a common problem, however you are in good company. The 130K and below markets are really HOT right now. Properties are moving FAST here in CA as well. If you are trying to buy an REO, you need to manage your expectations and realize that it may take you 15-20 + offers before you win a bid. In addition, speed is the name of the game, you have to submit an offer as soon as it posts on the MLS. Here are a few suggestions:

    1. Write offers on property where the agent can double end the deal (buyer/seller).
    2. Write 10-15 offers a week until you get a property under contract. Remember you can always back out during the inspection period.
    3. Only bid until the numbers make sense, don’t buy if your ROI drops below your threshold.
    4. Find a listing agent who is listing a property as a short sale. Since this process takes longer many of the cash investors don’t make offers. The only downside is this process takes 3-6 months sometimes.
    5. rinse and repeat – remember this is a numbers game, don’t fall in the love with the house. Think of it as a wheelbarrel a way to transport your money from cash to a high-yeilding investment backed by physical proeprty. If the numbers don’t work, don’t buy!
    6. lastly – education is the key. You really need to know what you are doing. try to find local investors or a REIA group and pick their brain. Read, read and read some more.

    If you have any more questions just shoot me a note – artieag81(a)gmail.com

  6. Utterly ridiculous information.

  7. This guy is telling the truth.

  8. My wife and I purchased a duplex 3 years ago and haven’t looked back since. We live in one side and rent the other for $900/month. We have worked to increase amneties on the property and have improved the over all quality of life for future tenants. I plan on paying the duplex’s mortgage off completely with the use of inheritance, and when it comes time to build a home, we will have a steady $1600 a month income after taxes and insurance with both sides rented. Either we build or move onto another multifamily. Still don’t know.