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3 Things You Need To Know Before Investing in Residential Real Estate

Updated: Jan 30, 2019

Over the years I have seen many working-class folks accumulate substantial wealth through their real estate investments. Unfortunately, I have witness others that were not so fortunate. This post is not intended to provide you with detailed knowledge, as there are many great books on the topic. This information is to give you a head start towards making your decision and (hopefully) keeping you out of the “I lost my shorts” group.

You’re going to need some cash: You can obtain a loan but unlike your primary residence, investment loans for 1 – 4 units typically require 25 to 40% down. Keep in mind that lenders tend to be very conservative when loaning to investors with less than two years of experience.If you are taking out a mortgage, you will need to verify that the property can generate a positive cash flow after expenses: monthly payments, insurance, taxes, dues and utilities. You will also need to maintain financial reserves for major breakdowns, think furnace & water heater, and vacancies which is around 5% in our area. While this may sound like a complicated formula, it is quite simple: Income minus expenses & vacancies equal net operating income or NOI. If you come up with a positive number, you can say “it pencils”.

See, you are sounding like an investor already but keep in mind that while Northern Nevada rental rates have been on a steady climb for almost a decade, this hasn’t always been the case. You’ll also need to maintain financial reserves as insurance for major breakdowns (think furnace & water heater) and vacancies (around 5% in our area).

Valuing the property: There are many formulas for establishing the right price, some are quite sophisticated. I’m going to keep things simple, so I’ll focus on three fundamental approaches to evaluating income property:

Sales Comparison approach: Simply locate similar active and recently sold properties in the subject property’s neighborhood then compare. This approach works well with single family homes, but I have found it to be less accurate when valuing multi-family properties.

Gross Rent Multiplier or GRM: This is a pretty simple formula, but it will allow you to compare multiple properties and property types based on their Gross Annual Income. To find the GRM divide the list or sale price by the gross annual income. Example: A duplex is on the market for $300,000. Both units rent for $900 per month generating a gross annual rent of $21,600. 300,000 divided by 21,600 = 13.8. This number represents a good “back-of-the-envelope” formula for comparison.

Capitalization Rate or Cap Rate: This approach requires a little more data and works best in cash transactions. On the other hand, the cap rate calculation is absolutely critical when forecasting the rate of return on your investment. The formula itself is quite similar to the GRM but requires that you use the annual NOI rather than the gross annual rent. Let’s go back to the example above: The Gross Annual Rent is $21,600 minus annual expenses of $5,600 leaving a NOI of $16,000 as the remainder. We then reverse the formula a bit and divide the NOI by the sale or list price: 16,000 divided by 300,000 = %5 cap rate. Some investors will then factor in an appreciation rate (about 8% annually in our area over the past decade) to come up with a total cap rate of 13% in this example.

Begin with the end in mind: As we have seen in the past, rental rates and property values do not inexorably rise. Unless they’re planning to fix and flip, I recommend to my investors that they evaluate their decision with less favorable economic factors in mind. In other words, the investment should pencil in the best and worst of times rather than purely speculative and reliant upon sustained appreciation.

Again, I’m offering very simple guidelines for a complicated topic. Other considerations include; the local economy, property condition, neighborhood appeal and the buyer’s financial condition and experience of course. The list goes on, but this is where a good adviser comes into play. An experienced tax expert and real estate broker can help you fine tune your decisions. Also, consider that there is a multi-family loan program that can actually fund “fix-up” money to the investor/borrower at the time of purchase. This can create a great opportunity for some investors looking for fixer-uppers that are otherwise unfinanceable. please feel free to contact me for details. Seasoned investors should check out:

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