Rental Property

[Slug]

My real estate agent is doing a 90 minute presentation to my wife and I tomorrow on rental property acquistion and management at my request. I have bought and sold with this agent 3 times with primary homes so her integrity is without question.

3 questions:

1) What questions should I be asking that as a neophyte I might overlook?

2) Are any rental property acquistion and management books worth reading. There are many highly rated on Amazon and at my public library.

3) Are there any income ratios on how much I should property I should buy in terms of $.

PS I know that rental property takes up time. I get that and I don't mind doing the management myself esp. in the beginning. I am reasonably handy myself and have access to a very affordable handyman in my area.

PPS I am not in a hurry to own anything. I expect to look for several months locally.

PPPS My target renter will likely be MBA and MD students next to the university where I reside.

[cjscully]

The most important questions involve the rental market you're interested in. What is going on there? Crime rates? Investment by the city/county or lack of it? Vacancy patterns? Employment? All of these things influence whether an area is a good one to invest in.

Any book that covers how to analyze an investment property in terms of affordability and profitability is worth reading. When you take out a commercial mortgage (which will be for any building with more than four units) lenders are concerned with a few basic things. Occupancy, Net Operating Income, Capitalization Rate and Debt Coverage Ratio. These figures determine how much a lender will loan on a property. You need to know what they are.

Occupancy = Is the building fully leased and for how long? What are the expected vacancy rates (partially affected by local economic factors and partially by the property itself)?

Net Operating Income = Gross Rents - Vacancy allowance - operating expenses (not debt service).

Capitalization Rate = Net Operating Income / Cost or value of the asset.

Debt Coverage Ratio = Net Operating Income / Debt Service Payments. The higher this figure is the more profitable the property is. Most lenders will want this figure to be above 1.25% if I recall. However that standard changes as the market changes.

Hope that helps.

[Slug]

Helpful yes however it's unlikely I would be looking to buy something more than 4 units at this time unless I find a well-heeled partner.

My market is a university town. Home prices are stable and have moved very little due to the recession, although there are a glut of homes in the $800k+ range.

[cjscully]

Got it. Here's the big difference between four units or less and over four units when it comes to financing - loans on four or less units are governed under residential lending policies and regulations. This means that while the income from the property will be taken into account for the loan, the underwriting of the loan will be based on your personal credit and your personal income. The bank will want to be sure that you'll be able to pay the loan whether the property is fully rented or not.

Commercial loans look to the property itself to pay the loan. It's a slightly different rationale. The bank wants to be sure that the property cash flows sufficiently for them to be paid solely out of the income from the property. If the bank has to foreclose due to mismanagement or something they would still be able to collect the rents, therefore their risk is mitigated to some degree. Also, commercial properties are usually held by business entities, whether they're LP's, LLC's or Corporations.

[Slug]

That makes sense. I'm not buying any sort of investment property until I create an LLC for sure.

[jIM_Ohio]

I would focus on 3-4 issues

1) (and this is a BIG one)- what are your risks? Think outside the box and ask lots of questions- if its a risk to you, its important... if there is an answer see if its BS or real- if its a risk to you, its important (don't let someone mitigate or make you feel less if they downplay risks)

2) will the property make money?

3) will you make money?

2 and 3 are two different things, make sure you know the difference

4) the tax implications of all decisions



For a rental, I would analyze it like this:

Rent is rent, the rent does NOT change based on your expenses. Rent does not change based on your costs. So first ask what you could rent a property for. $800/mo? $1200/mo? $2000/mo? focus on this issue when evaluating any property.

Costs need to be minimized. If a property rents for $800/mo, if you put $10,000 down or $100,000 down, you are still collecting $9600/year in rent. I would much rather collect $9600/year in rents on a 10k investment than on a 100k investment (with 10k investment, I might have recovered all my costs in 1 year, where as with 100k down it might take 10-11 years for same recovery). Some people analyze rentals with cash flow- the way to minimize costs against cash flow would be to make a high down payment and have higher profit from cash flow... the alternative way is look at total out of pocket costs vs yearly cash flow.

Which situation is better? Both are the same property which rents for about $1200/mo

1) put 45k down on a 180k property for a payment of about $1000/mo (140k financed at around 5%)
2) put 90k down on same 180 property for a payment of around $700/mo (90k financed at around 5%)

In situation 1 you "earn" $2400/year in profits, plus the tax benefits (might be worth another $3000??-$6000??). This means you recover 6k per year and break even in maybe 8 years.

In situation 2 you "earn" $6000/year in profits plus tax benefits (low end, maybe $1000-$3000). This means you recover 7k per year and recover costs faster.

If my numbers are right, situation 2 is better, but each situation is different... meaning most of the time you the lower outlay of cash returns the money to you faster (which lowers your risk).

I could also argue it would be better in above situation to put 45k down on two properties than to put 90k down on one (for example).

I would also argue that it is generally best not to tie money up into illquid investments- meaning it is better to tie 45k up into an investment you cannot get at, than it is to put 90k into same investment you cannot get back... but if 90k were to be used, it would be better to tie 45k up into 2 different properties than 90k into one single property. Lowers the risk IMO.

But others will have different opinions. My thing is for any outflow of cash into an illiquid investment, I want that cash outflow to be as low as possible, and I want to get that original cash back as soon as possible.

If you do not know tax implications, you want to find an experienced tax professional to help you before investing as well. Ask the person giving you presentation about the tax benefits, and you might want to look up a schedule E (rentals) prior to the meeting.

[rj.phila]

One thing i would spend a good amount of time doing is looking at the relationship between prop value and rental income across multi-unit properties.

my aunt owns a multi-unit; i own 2 single units. for both of us, if we get just 1 bad tenant, the effect from a managerial standpoint is a drag, however, she has a higher relative risk of that(its happened to her, not to me).

if a single unit prop that sells for 200k in your area can net 1500/mo in rent, and a triple unit that sells for 200k will bring 750-900 or so/unit, i would consider the single unit, even though it will net a smaller profit.

also, remember that a business plan is just a bunch of numbers if you cant get bodies in the room. expect carrying costs, and i would even prepare for the prop to be a net loss for a year or two, its not uncommon.

YMMV, though-good luck.

[Slug]

More good thoughts from RJ and Jim. My plan is to break-even or be slightly positive on a cashflow basis + tax breaks and keep the property for 7-15 years before selling and buying 2-3 more with the proceeds and additional capital. Even if cashflow is negative for the first couple of years, that would be fine. My own cashflow will be opening up in August when my little one begins public school vs. the current private preschool.

[rj.phila]

cool-good luck. another thing to consider, but is evident already if you've crunched the numbers. carrying a mortgage can make it that much harder to net $$$ off a rental. but once its gone, it becomes quite feasible, and SUSTAINABLE. i would encourage you to see it as a long term investment that will require attendance. IMO it would be very easy to get underwater at yr 15 of your plan if you've got 2 or more mortgages, and NEED to get bodies in the rooms. that's a disaster story, and i had a friend hit it recently. crunch lotsa numbers first!!!

[Slug]

The good thing here is that there is a constant flow of professional/graduate students to the university. The class sizes are only expanding. Thus, although I've assumed a 5% vacancy rate in my calculations, I think the likelihood is low that it will be a problem in the short or long-term.

Besides with Obama now giving me an extra $84 per paycheck through the SS tax cut what could go wrong?

[Sissta2009]

The good thing here is that there is a constant flow of professional/graduate students to the university. The class sizes are only expanding. Thus, although I've assumed a 5% vacancy rate in my calculations, I think the likelihood is low that it will be a problem in the short or long-term.

Besides with Obama now giving me an extra $84 per paycheck through the SS tax cut what could go wrong?

Haha that's gotta be nice little extra bit of extra money in your pocket, thanks Obama!