How to Pick the Perfect Investment Property in 9 Steps

investment property

I’ve wanted to buy an investment property for a while. It seems like anyone who has money in retirement also had the foresight to buy real estate to rent out.

But in my price range, no property will be perfect. I’m not going to find a house that’s in a fabulous location, requires no repairs, and costs less than $150,000.

I want someone to tell me how to invest in a rental property — to hold my hand and help me choose which place to buy. But since that’s not going to happen, I figured the next best thing was asking expert David Meyer for some helpful tips.

9 steps for choosing an investment property

Not only does Meyer own three investment properties, but he’s also the vice president of growth and marketing at BiggerPockets, the world’s largest resource for real estate investors.

I hopped on the phone with Meyer to discuss what makes a good rental property. Here are nine steps he believes every budding property investor should take.

1. Talk to people

The first thing you should do, Meyer said, is get to know your market by talking to local real estate investors. You can look for meetups, such as the ones on this BiggerPockets list, or search for real estate associations in your area.

“One of the things people underestimate is the power of a network,” said Meyer. These contacts could provide insight and advice tailored to your area as well as leads on properties.

2. Figure out how much you’ll need to borrow

Then it’s time to contact a lender to find out the loan and interest rate you’ll qualify for. Meyer called this step “understanding your borrowing position,” and he said you should do it before selecting a property.

That way, before you get excited about a listing, you’ll know what your loan payment will be — rather than discovering later that the monthly payments are higher than you expected.

3. Envision your ideal renter

Now it’s time to think about who you’ll rent to — and the type of neighborhood that will interest renters.

“You don’t want a dingy studio in the middle of an upscale suburban neighborhood,” Meyer explained. “Find a property that fits the character of the neighborhood.”

Meyer, for example, invests in neighborhoods filled with young working professionals. By purchasing properties that are “appropriate for the area,” he said, it’s easier to find quality tenants.

4. Avoid fixer-uppers

We all love Joanna Gaines from the TV show Fixer Upper. But for a newbie investor, that type of property probably isn’t the smartest way to go.

“If it’s cosmetic — paint, tile, hardwood floors — that’s just your effort and is a great way to make money when you’re starting out,” said Meyer.

“But [avoid anything] that has to do with the core of the house, like piping or electrical,” he explained. “You’re not going to do that yourself, and that can be an absolute money pit.”

If the houses you’re looking at have higher monthly payments than you can afford, Meyer suggested “house hacking.”

That’s the practice of living in the property for at least a year — either by purchasing a duplex and living in one half or buying a single-family home and finding roommates — which allows you to qualify for non-investor interest rates and FHA mortgages.

“[By] living in a property and maintaining it, you learn a lot,” said Meyer. “And obviously, the financing terms are much more favorable.”

5. Estimate your rental earnings

Once you’ve found an investment property you like, it’s time to learn everything you can about it.

First and foremost, you should figure out how much income you can expect to generate from the rental property. If the property is already rented out, ask the owner for its rental history — and then compare those rates to others in the area to make sure the owner is being honest with you.

If it was previously an owner-occupied property, you can check Craigslist for rentals that are similar in size, amenities, and location. Learning how much they’re renting for will give you a better idea of what you could charge.

While you’re on the site, be on the lookout for listings that tout “first month free” or “no credit check required.” Meyer said that would concern him because it suggests nearby landlords are struggling to find renters.

6. Tally your expenses

Meyer said you can estimate that 50 percent of the income generated by the rental property will go to expenses — not including the loan.

So if you’re charging $2,000 per month in rent, you can assume $1,000 will go toward the expenses listed below. If your monthly loan payment is, say, $800 per month, you’ll have a cash flow of $200 per month (or $2,400 per year).

For more specific calculations, you’ll need to include the following:

  • Utilities such as garbage and water
  • Maintenance costs (these costs vary by location; ask in BiggerPockets’ forums if you need help estimating them)
  • Big expenses such as the foundation, HVAC system, and roof (Meyer said you should ask about their condition before purchasing)
  • Homeowner association fees
  • Vacancy (estimate one month per year or search “vacancy rates in [your city]”)
  • Taxes and insurance
  • Property management (typically 10 percent of monthly rent)

You also can use BiggerPockets’ rental property calculator to estimate your expenses and cash flow.

7. Consider the appreciation of your rental property

There are two kinds of value appreciation when it comes to housing: forced and market.

If you buy a house and do a bunch of repairs to increase its value, that’s forced appreciation. If the neighborhood improves and the value goes up over time, that’s market appreciation.

Meyer said you shouldn’t focus on forced appreciation as a new investor. “Cost-benefit analysis of repairs is difficult to estimate,” he said. “That’s why I don’t recommend flipping [houses] for new investors.”

Historical market appreciation, on the other hand, is easy to research. However, Meyer said you shouldn’t buy a property solely for its potential to appreciate.

As for what makes a good rental property when you’re getting started, Meyer said, “You should always look for something that is going to [generate] cash flow, regardless of appreciation.”

8. Determine your cash-on-cash return rate

We’re not done with the calculations yet. Meyer’s favorite is cash-on-cash return.

Let’s assume you invested $100,000 in a rental property (between down payment and closing costs). If that investment earns you $12,000 per year, that’s a 12 percent cash-on-cash return.

Meyer said anything above 10 percent is “awesome” in most places, but he also said it depends on the market. To determine a “good” cash-on-cash return, you’ll need to crunch the numbers for lots of properties.

“If you’re new, I recommend analyzing 30 to 50 deals before pulling the trigger,” said Meyer. “You’ll start to see the upper and lower bounds … and then when you’re more serious about a property, you’ll know where it falls.”

Don’t get so wrapped up in cash-on-cash return that you overlook the condition of the house, though.

“I wouldn’t encourage people to find the absolute max cash-on-cash return,” said Meyer. “Find something in the top 25 percent of deals that’s also in great shape.”

9. Calculate your capitalization rate

The last step: Figure out the capitalization rate (aka cap rate), which is the amount of time it’ll take to recoup your investment.

If you invest $100,000 in a property and earn $5,000 per year after expenses, that’s a 5 percent cap rate. It’ll take you 20 years to recoup your investment.

If you earn $10,000 per year, that’s a 10 percent cap rate, and you’ll earn your money back in 10 years. Obviously, Meyer said, you want to look for the highest cap rate possible.

Is that investment property worth it?

Although investing in real estate is tempting, it’s not a golden ticket. It takes a lot of work, and a payoff isn’t guaranteed.

“If I have to put $100,000 in cash on a property that’s going to make me $1,000 in a year, I can do better on [the] stock market,” said Meyer.

So think carefully before buying an investment property — and if you decide to take the plunge, don’t skimp on the research!

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Published in Buying a House, Income, Investing, Making Money