Buying Rental Properties

How to Buy Rental Property at the Right Price

When buying rental properties you need a quick and easy way to evaluate whether or not the property will have a positive cash flow. In this article I will discuss two rules of thumb to use when buying rental properties. These are the 1% rule and the 40% rule.

The biggest mistakes that beginning rental property investors make is not understanding how to get a positive cash flow. Many beginners think that as long as rent covers the mortgage payment that they are OK. Or they think that they can stand to have a property that has a negative cash flow because it will appreciate and they can " flip real estate " for a profit. People often do that type of analysis when buying vacation property and kid themselves that it is a "good investment".

Any rental property that has a negative cash flow is not a good investment. Now if you have lots of extra cash and want to speculate that your beach front rental will double in price, that's OK. Maybe you get lots of pleasure from summer vacations there. However, it is not a good rental property investment, it's a speculative gamble.

The first step you must take before looking at buying rental properties is to have an idea of what the going rental rates are. Look in you local newspaper or on CraigsList and make some notes on what single family houses are renting for in your target investment area. Next, pose as a perspective tenant and call a couple of listings and actually go to look at the properties for rent. Are they in excellent condition or just marginal? Note the type of neighborhood and conditions of nearby properties. Is the landlord offering incentives to get you to rent? There may be a glut of housing if the property manager has to do this or the rent may be higher than normal. Or are is the rent under market value due to poor condition of the property?

The first mistake property investors make when buying rental properties is underestimating expenses. If you want a way to quickly evaluate estimate how much you should expect to spend on property expenses on a monthly basis use 50% of the expected rental income. Typical rental property expenses to plan on include insurance, taxes, repairs, vacancies, damages and legal fees. If you are going to have someone else management your property, you need to add another 10% for property management fees. Many beginning investors wonder why you would use such a high percentage. That is because they forget about the potential for major repairs, such as roofs, furnaces, etc. For beginners I recommend that you learn how to be a landlord.

Once you know the typical rent and the logic behind the 40% rule, simply take the average going rent and multiply it by 40%. For example, if average rents are $1000 per month then after the 40% rule, you have $600 per month left over for the principal and interest of any loan you may need.

The next step is where the 1% rule comes into play. Simply divide your gross monthly rental income by 0.01. In this example 1000/0.01 = $100,000 maximum purchase price. Real estate agents usually like to use a 1% rule as a basis for the purchase price of property.

So how might these two rules work? Typically for a $100,000 rental property you might be able to get a 7% interest rate loan with 20% down payment. Investor loans are often for 20 years as opposed to owner occupied properties which may have a 30 year amortization. Using a real estate financial calculator you can see that principal and interest payment on an $80,000 loan is about $620 per month. So what you see is that using our 40% rule for expenses this $100,000 property is a break even proposition and is worth considering as a rental property investment.

Once you find a property that is in the right range of prices and cash flow then you need to do more investigation about what capital improvements will need to be made to the property before purchasing. Also realize that if you are buying single family residential property that what price you pay as an investor and what a retail buying homeowner might pay can be very different prices. Your goal is to make money by having a property that can be rented out without draining your bank account. If the retail market for home buyers is above the 2% price that you pay, then that is instant equity that you realize when you purchase the property.

Before making the final offer when buying rental properties you should do a detailed cash flow analysis. This free rental property software can you help do that type of analysis.

Once you purchase the property you should look at two other strategies on this website that show you how to get higher rental income and decrease your monthly expenses. Making the best home improvements can get you the maximum rent in your area. The rent to own strategy typically can get 10-30% higher rents and reduce your maintenance expenses.

By taking the guess work out of buying rental properties with the 1% and 40% rules you can be sure that you are less likely to make a big mistake with investment rental property.

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