A strategic guide to becoming a polymath, millionaire, and living a fulfilling life.

Money

Investing In Residential Real Estate

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Summary

Buying your first rental property is exciting!   You have entered the phase that you have enough savings that you are ready to risk some of your money on potential investments.  What I would like to do now is to walk you through how to invest in residential properties and make them rental units.  Real Estate is a local business in my view.  What I mean by this is that you can’t just research a property online and then buy a property.  You have to know the area and be familiar with it.  I have heard numerous horror stories about people doing this process and they get into problems down the road because they did not know the neighborhood well.  I only invest in areas I know well.  I know the area, the macro and micro economic factors, communities, etc.  By investing in areas you are familiar, you minimize the risks of losing your investments.

Here is the process I follow when I invest in real estate.

  • Figure out how much you can afford
  • Spot the area you are interested
  • Select banks with good terms and conditions
  • Crunch numbers if the investment makes sense
  • Understand the risks
  • Close the deal

Figure out how much you can afford.  So, let’s say you have saved $50,000.  For the vast majority of investment properties, lending institutions would require at least 20% down payment in the form of equity.  So, $50,000 will allow you to buy a $250,000 property (20% of $250,000 is $50,000).

Look for properties.  I suggest that you look for properties in areas you are familiar with.  For us, we have properties in Hawaii and the Mountain West.  We had lived in these areas previously so we know the market.  It is also important to consider these factors:

  • Demographics.  It is important to understand the demographics of the area.  For example, if you don’t know that the place you are considering is a retirement area, then most likely you will not be able to younger working couples.
  • Socioeconomic background.  This has a huge impact on your rental pricing.  Suppose it is in a poor neighborhood and the median income is $40,000.  It would be very hard for you to rent that property at a higher rate.  Whereas if you find an area where employment rate is high and with many middle income families, you can ask for a higher rental rate.
  • Access to good schools.  Good schools are magnets.  Many families want their kids in good schools.  Enough said right.  With good schools, property values rise faster as the demand is higher than areas with poor performing educational system.
  • Access to freeway.  Self- explanatory.
  • Access to grocery stores. Self – explanatory
  • Proximity to work.  Self – explanatory.

Spot the area you are interested.   You can utilize www.zillow.com or real estate agents who know the area well.  What I like about Zillow is that you can quickly search the areas you like to see.  You just type in the city or zip code and then it will show you the homes that are for sale, being auctioned, foreclosed, or short sale.  It will also show you the estimated values, the tax history, and some brokers who may be able to help and so many more.

The downside of Zillow is that there is sometimes a delay in showcasing the properties available for purchase.  Sometimes, the estimated values may also be off.  There are other weaknesses, but it is a very helpful platform to get a macro view/micro of the areas you are considering.

Real Estate Agents.  Look for agents that are really familiar with the area.  Agents who have closed so many deals can provide you with details you won’t find online.  You have to be careful when you use them as some of them don’t like you just using their time and not really purchasing anything.  It is a waste of their time.  So, I only use them when I am for sure going to buy a property.  You can also negotiate fees with them.  Usually, they ask 3% of the closing price.  If you have been working with them in the past, you can negotiate the fees.

Select Banks.  It is important to reach out to multiple banks or lending institutions for rate quotes.  I don’t have any preference for a particular bank but usually local banks have a better knowledge of the local economy than outsiders.  As you approach banks you should ask for, understand, and compare the following:

  • Rates and tenors (5, 10, 15, 30 years)
  • Conditions (recourse, non -recourse)
  • Down payment requirement
  • Escrow establishment
  • Others

Crunch the numbers.  As soon as you figured out the rates, value of the home, how much you could rent the house for, improvement and maintenance cost and taxes, crunch the numbers on an excel sheet and see if your property is profitable.  In my view, if the annual yield or rental rate is greater than 9% (annual rental revenue divided by the initial investment), that’s a good deal.

This does not also include the tax saving you get from depreciation and house price appreciation.  Overall, if I add the annual yield and capital appreciation and I get at least 20% Internal Rate of Return or IRR over a five year period, I would be happy.  In simple terms, IRR is the return you get over a period of time assuming that the cash generated each year is reinvested.
Resource:  Real Estate Model

Understand the risks.  It is very important that you understand the risk of your investment.  Granted that for real estate properties, the risk is lower relative to stocks given that a hard asset is backing the loan.  But, you as an investor need to be aware of the major risks:

  • Renters.   Will be discussed in Part 2.
  • Overall decline of property values in the area.  You may not be aware that there are labor market risks in your area and therefore jobs may not be as good as it should.  This could be mitigated if you do your diligence in the beginning.
  • Fire.  You can resolve this by buying insurance.
  • Natural Disaster.  You can resolve this by buying insurance.
  • Others.

Close the deal.  If you like the returns and you feel comfortable about the investment opportunity, you can close the deal.  As you close, you need to do the following:

  • Further due diligence on the property.  Make sure you get the house inspected by professionals (structural, electrical, termites, etc.).
  • Closing time. It is important to understand how fast the banks can close the deal.  The sooner you can close the deal, the sooner you can fix and rent out the property.
  • Other factors are depending on the nature of your investment.

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