In part one we discussed how to determine whether a person had the right characteristics to be a residential real estate investor and how to find the right neighborhood. We now move to finding and managing the right property.
There are two really important axioms to keep in mind when investing in residential real estate. First, successful investors make money when they buy real estate, not when they sell it. That means buying from what is known as a distressed seller. This is an owner that is willing to sell for less than market value because of various reasons. When you buy at less than market value you have already increased your equity in the property. Read any real estate invest book by Robert Allen for more on this concept.
Secondly, the most important influence on the value of a property is the property next door. Property values in a neighborhood tend to seek the middle range of values as they appreciate or depreciate. What that means is that the house that is overbuilt for the neighborhood will rise slower in value from a percentage standpoint that the under-built house. One of the more common ways that real estate investors increase the value of their properties is to make repairs that cost less than the value that they bring. For example, painting a house can increase its value at relatively little cost.
Properly marketing the property is critical to finding that perfect tenant. Should you put up a sign in the yard, list it on Craigslist, run an ad in the local newspaper or put up signs on bulletin boards in local colleges and office buildings? It all depends on the where prospective tenants get their information. Put yourself in their shoes.
One piece of advice I always give is that you should announce that you are “taking applications” during the marketing period. That way you do not get caught in the trap of someone undesirable coming in and renting the house. Once upon a time my wife and I had a house for rent. We ran an ad in the local newspaper and placed a sign in the yard. During the marketing period I would work at my day job while she showed the property. Being the savvy real estate investor that I thought I was (sarcasm intended), I gave my wife certain instructions. “Do not rent to the first person that comes along. Tell them that you’re taking applications.”
I arrived home after work the first day the property was on the market and asked if there were any applications.
“I rented it out to the first prospect that came along,” she said. I prepared to chastise her for doing exactly the opposite of what she was supposed to do. Then she said, “Our new tenants are two medical students, and they are really nice. Plus, they gave me the damage deposit and the first six months rent.”
Needless to say, I was floored. But it does illustrate that sometimes flexibility and common sense override hard and fast rules.
It is also recommended that you prepare a three-year pro forma, which is really nothing more than a profit and loss statement. This statement will contain expected income minus expenses. Certain expenses are occur regardless of whether there is a tenant in the property or not. A mortgage loan on the property is a good example. When estimating income do not forget to assume that the property will be vacant sometimes. Estimating expenses can be tricky if you do not have a good past history of the property. In general, the owner/investor pays the property taxes and hazard insurance while the tenant pays the utilities and renters insurance on the personal contents. Nevertheless, it should be remembered that everything is negotiable.
One big mistake that residential real estate investors make is failing to set aside some of the revenue for repairs and maintenance and replacement of such things as roofs and central air conditioning units. This is known as replacement reserves on the income statement.
Finally, a bit of a sermon. Cities all across this country are suffering from neighborhoods that have declined and are littered with abandoned properties that are still owned by residential real estate investors. From the community’s point of view these owners are looked at as slum lords. From the owners’ point of view city officials do not appreciate the fact that when neighborhoods decline there will be tenants who tear up property and city services that are not provided. The owner/investor simply gets to the point where the cash outflows are greater than the cash inflows and the time and trouble to manage the property is untenable or even unsafe. As a residential real estate investor it is a good idea to remember that it is not just the house that was invested in, but also the neighborhood. What that means is getting involved in the neighborhood to extend its life as long as possible and even be a part of its revitalization.
To sum up the subject of residential real estate investing, these points are offered:
» buy the neighborhood first;
» never pay market value;
» take applications and screen prospective tenants;
» visit the property often;
» watch the financials, making certain to have a reserve account; and
» become involved in the neighborhood.
» Phil Hardwick is coordinator of capacity development at the John C. Stennis Institute of Government. Pease contact Hardwick at email@example.com.