Investing gives us the ability to grow the money that we have saved. One way we create passive income is through investment properties. Moving every 3-4 years has forced us to approach home buying differently than most. Instead of becoming life-long renters, we decided to use our situation as an opportunity to acquire investment properties. Here’s our 8 tips.
1.) Research the Real Estate Market
Once we are notified that we will be moving to a certain area, I immediately begin looking at the real estate market. Is it a buyer’s market? Is it a seller’s market? How much has it grown over the past 5 years? Are homes typically selling for less or more than the original purchase price? Be careful buying in a hot market. It may seem appealing because home prices are increasing, but as we learned, when the market cools off, you may realize that you over-paid for your house. The best deals can be found when the market cools off.
2.) Analyze the Rental Market
Even if you plan to sell your house, remember that the real estate market is unpredictable. Be prepared to rent your house out in the event that it doesn’t sell. Discover what price ranges have the largest pool of potential tenants. You don’t want to buy a home that’s too expensive, where you have few tenants that could afford to rent your home. There’s usually a price range for rentals that will attract the most potential tenants. When you are looking at a home to buy, try to think about how much you would need to rent the home for to cover your mortgage, property management fees, vacancies, HOA fees, and repairs. Once you have figured out this amount, make sure it fits within that price range that most renters are looking at.
3.) Explore the Local Area
Pay attention to school districts. I’ve found that prospective buyers that do not have children often skip this step, and it could be a huge mistake. Buying a home in the best school district will always be appealing to buyers and renters alike. I can’t tell you how many times I have passed on a perfect house, because it wasn’t in the desired school district. Research neighborhoods. Look at popular neighborhoods within your price range. Make sure it’s a home that you wouldn’t mind living in. If you wouldn’t want to live there, chances are, others won’t either.
4.) Avoid Homes That Require Expensive Maintenance
We tend to avoid homes that have pools, hot tubs, or landscaping that requires constant up-keep. They’re wonderful to enjoy as a homeowner, but as a landlord, they can pose a real headache. We also tend to stick to newer homes. There’s usually less maintenance, and the homes are modern. Costly maintenance can quickly eat away at your cash flow, so think low-maintenance.
5.) Buy What You Can Afford, Not What You Are Approved For
I’ve seen this so many times. The mortgage company approves you for x amount, so you start looking at homes that cost x dollars. Buy what you need, not what you are approved for. If we would have purchased what we were approved for, we would have been house poor, and our investment properties would not have produced a positive cash flow.
6.) Keep Your Capitalization Rate Over 6%
To calculate this, first determine the annual gross income (AGI). This is the amount that the property will rent for. Next, determine your annual operating expenses. This will include your property management fees, HOA fees, vacancies, and maintenance. Subtract your operating expenses from your AGI. This will give you your net operating income (NOI). Divide your NOI by the purchase price of the home to calculate your capitalization rate. We have about a 10% cap rate on our first two properties, and an 8% on our 3rd.
7.) Maintain a Positive Cash Flow
Positive cash flow is very important. There’s nothing worse than having a negative cash flow eat into your income. Positive cash flow also allows money for repairs and vacancies. We put all of our cash flow money into a separate account. If we have a repair or a vacancy, we just pull the money out of that account. This way, the money comes out of our business instead of our personal expenses.
8.) Always Plan For the Worst
No matter how much time you spend researching real estate and rental markets, the truth is, they are unpredictable. They tend to fluctuate, and you need to be prepared for the worst-case scenario. We do this by only buying homes where the mortgage is less than our monthly savings contributions. Since we have managed to keep our expenses much lower than our income, if the house sat empty for months, we could afford to pay the mortgage with our monthly income by stopping our retirement contributions until the home rented. In 4 years, we have yet to have a rental property sit vacant for even a month, but if it did, we are financially prepared to cover the monthly mortgage.
Investment properties aren’t for everyone, but they can be a great way to build wealth. Be sure to approach the process from a logical standpoint instead of an emotional one. If the numbers don’t work, be prepared to walk away. Understand that there will be times that you will have to deal with repairs, maintenance, and maybe even bad tenants, but if you go in prepared to deal with the bad and the good, it can be a great way to build passive income.