Second homes and investment properties fascinate investors, who turn to Inman’s weekly Property Portfolio email newsletter as well as agents who work with this special class of client. This month, we’ll go deeper on everything from the latest at Airbnb and Vrbo to the changes investors are making to their portfolios in a shifting real estate market.
Prices are plummeting, sales volume is down, and interest rates are up. For smart investors who understand the power of buying when others are selling, we’re heading into one of the best opportunities since the Great Recession to acquire investment properties that will yield a maximum return.
Savvy investors know having a profitable real estate investment begins by identifying which properties have the greatest upside potential. Here are the steps to take to choose an investment property that can yield the greatest return possible.
Use the ‘Rule of 72’
In order to identify the right property at the right price, many investors suggest that you follow the “Rule of 72.” Applying this rule allows you to estimate how long it will take various types of investments to double in value. To apply the rule, simply take the rate of return and divide it by 72.
For example, if you have a stock investment that yields a 6 percent rate of return, divide 72 by six. Your stock investment will double in value every 12 years. If your real estate investment has a 10 percent rate of return, your rate of return will double every 7.2 years. This is a simple way to evaluate returns without using complex mathematical formulas.
Cash flow is king!
Your cash flow is the amount you keep each month after you pay all expenses, including the mortgage, taxes, any utilities, vacancy, etc. Here are common ways that investors increase their cash flow and increase the value of their investment.
Buy the property at least 10 percent below market value
This is the primary reason that savvy investors are contrarians who sell when prices are increasing and buy when prices are declining. During a seller’s market with limited inventory and a surplus of buyers, prices on properties priced below market value are quickly bid up to market value or more.
On the other hand, when there is a buyer’s market with a surplus of listings and few buyers, homeowners who must sell often end up accepting offers substantially below current market value. The deeper the downturn is, the more opportunities for investors to make a smart purchase with a substantial upside potential.
Choose the right neighborhoods
Begin by identifying neighborhoods generating the best returns. Be sure to include which rental price ranges are the easiest and the hardest to rent, which neighborhoods have the greatest rental demand, and what features renters in that area most want. Also, pay special attention to the condition of the property. Properties in poor condition can eat through cash flow quickly.
The authors of HOLD, How to Find, Buy, and Rent Houses for Wealth, recommend purchasing 2 to 4-unit properties on the edge of good neighborhoods or in transitional neighborhoods where there are essential public services nearby. While single-family residences may have greater rental demand, multifamily units have more tenants and generate better cash flow. Moreover, if you purchase a 2 to 4-unit property, the financing is identical to that of purchasing a single-family residence.
Search for properties with below-market rents
If you locate a property with below market rents, you can increase your cash flow by raising the rents to market level, provided you don’t run afoul of any rent control laws. Nevertheless, even in many areas where there are strict rent controls, most will allow you to raise rents to market level when the current tenant moves out.
Price appreciation: A pivotal piece to building equity
While cash flow may be king, purchasing during a downturn increases the probability that you can profit from a major upswing in value when the market transitions from a buyer’s market back to the next seller’s market.
Also, pay special attention to places where there may be a considerable amount of redevelopment, are located near where new rail is coming in, or new subdivisions are being built. Another option is to search for older properties that haven’t been renovated but are in an area where people are doing extensive remodeling or tearing down to build new construction.
In addition, look for the “direction” a city is moving. For example, when I first moved to Austin in 1998, there was a lot of new development about 15 minutes south of downtown. I paid $262,000 for my home, which today is valued at more than $1 million.
Today Austin is “moving” west towards areas like Dripping Springs as well as east of the airport, where Elon Musk is building a new SpaceX facility. The surrounding areas are already seeing rapid growth, which should benefit existing nearby rental properties.
Pay special attention to holding costs
Nothing can eat through your cash flow faster than runaway holding costs. Here are some key tips to consider when purchasing:
The most important features of the property to consider are the condition of the big-ticket repair items, including the roof, plumbing, exterior and interior condition, age of appliances, as well as heating and air conditioning. Carefully evaluate the age and the expected life of each of these improvements, so you can develop a budget to handle ongoing maintenance and replacement.
Compare property tax rates
In California, Prop 13 charges 1.2 percent of the value of the property at the time of purchase for property taxes. Taxes cannot increase faster than two percent per year.
On the other hand, Texas assesses property taxes at full appraised value (less homestead or other exemptions.) For example, tax rates vary significantly by location. Property taxes where I live currently are at .1545 per $100 of assessed valuation. In my previous house, they were .2301. That difference translates into property taxes of $7,725 where I live now vs. $11,505 where I used to live.
What is the vacancy rate?
The most recent numbers show that the national vacancy rate is at 5.6 percent. Properties with lower vacancy rates have less tenant turnover and hence, lower operating costs. If the vacancy rate is high, however, the question is, what is causing the issue? If it’s something you can fix (such as upgrading the appliances, landscaping, painting), etc.), that property might have good upside potential. If it’s noise, crime, or some other major issue you can’t control, look elsewhere.
Manage your tenants and properties like a pro
An important aspect of investing is to carefully screen your tenants. When you rent to a tenant, you are establishing a long-term relationship. How you interact with the tenant initially sets the tone for your future relationship. If you’re handling this yourself, there are a number of excellent screening services.
If you don’t want to handle this process personally, you can list the property with a real estate agent or with a property management company that handles rentals. These companies will screen the tenants for you as well as collect the deposits and finalize the rental agreement.
If you don’t hire someone to manage your rental property, you also must be prepared to deal with tenant issues such as repairs, failure to pay rent, damage to the unit, etc. To this end, you will need the following:
- A trusted vendor list to handle the maintenance and repairs on the property. If you don’t have a specific list, HomeAdvisor and Angi are great places to look for vendors who have been vetted.
- An attorney to handle any legal matters such as evictions, broken leases, illegal activities by the tenants, etc.
- A system for collecting rents and tracking property expenses accurately.
- A CPA or other tax professional to prepare your tax returns and who is also familiar with the 1031 Tax Deferred Exchange provisions and how they would apply if you were to sell your property.
- If you’re not going to handle the sale or purchase of your investment properties, a competent realtor to handle your transactions.
The recent seller’s market is history. The good news is that the emerging buyer’s market with increasing inventory and falling prices is a golden opportunity for you to invest in real estate to create income now and in the future.
Bernice Ross, president and CEO of BrokerageUP and RealEstateCoach.com, is a national speaker, author and trainer with more than 1,000 published articles. Learn about her broker/manager training programs designed for women, by women, at BrokerageUp.com and her new agent sales training at RealEstateCoach.com/newagent.