Considerations before buying residential investment property
by Phil Hardwick
Published: December 11,2011
The residential real estate market is in a state of flux. Residential values are declining in some areas while moving slightly up in others. Foreclosed properties are at record levels in some cities. Investors have cash looking for a place to invest. They are told that investing in hard assets is a good idea and that now is the time to buy while prices are low. What’s an investor to do?
The important thing is to not to forget the fundamentals. Buying residential real estate, or rental property, has many advantages and should be considered if the investor is aware of the management responsibility that buying rental property entails. Below are several important considerations when buying residential real in any market as well as something relatively new that affects today’s market. While there is no guarantee of success these basic steps will reduce the chance of failure.
1. Buy near an institution. Universities, hospitals, military bases and similar large employers are institutions. These are establishments that are characterized by large numbers of people moving in and out of an area. Institutions are the source of renters and heavily impact the demand for rental property in the area. Institutions provide stability to nearby neighborhoods.
2. Determine the market rate by surveying similar properties. The prospective residential real estate investor should put himself or herself in the shoes of a prospective tenant to determine what the going rate is today for a specific type of property. Relying on the advice of the others can be risky because the information provided may be stale information. For example, if a real estate agent tells you that a certain property rented for $800 per month last year it may very well be that the market this year is for $700 per month. On the other hand, such information may provide clues to the trend in market rents.
3. Determine stage of the neighborhood cycle. The stages in the life cycle of a neighborhood are growth, stability, decline and renewal. The trend in property values and the percentage of owner-occupied properties are indicators of the particular stage. Generally, an increase in the number of renter-occupied properties indicates that the neighborhood has moved from stable to declining. But in today’s topsy-turvy market it may indicate that a declining neighborhood is entering the renewal stage. For example, a subdivision that has over 50 percent of the properties vacant due to foreclosure may be coming back if an investor purchased the properties at a low price and then is renting the properties to prospective homeowners.
4. Carefully consider needed repairs and improvements. Determining the market rate for the rent may be for naught if the property has serious defects that have not been discovered. These can range from termite infestation to shifting foundations. A licensed home inspector should be part of the analysis of the property.
5. Do a pro forma analysis. This is a financial statement that reflects the projected income and expenses of the property. It is a way for the investor to measure projected return on investment. In the real world, real estate investors often account for repairs and maintenance on pro forma statements, but fail to actually set aside the funds necessary. That leaves them vulnerable to expenses that come due for replacement of such things as roofs, heating and air-conditioning equipment, etc.
6. Sit on the curb across the street and observe the property. This sounds rather silly, but it can be one of the most important things that a real estate investor can do. Although the investor does not need to literally sit on the curb, he or should understand the rhythm and flow of the neighborhood. For example, what if in a subdivision similar to the one mentioned above that there is an undue length of time getting out of the subdivision during rush hour because there is no traffic signal or that the traffic signal does not stay green long enough. That could be such a problem that current owners are discouraging buyers and renters from moving into the subdivision. An investor may have never learned of that situation without actually being there at the right time of day.
Those are the fundamentals. After they have been accomplished the best advice in buying residential real estate if an investor wants the highest return on the investment is to buy from a distressed seller. An axiom in real estate investment is that the investor makes money when real estate is purchased, not when it is sold. In other words, ?never pay market value for the property.
Finally, as today’s real estate markets decline and change be aware of increased regulation on rental property owners. Local governments are increasingly becoming more involved in the regulation of rental property in order to prevent decline in neighborhoods. Investors should meet with local officials to understand the issues involved in buying rental property in a particular jurisdiction. For example, some jurisdictions now require a property inspection by the local government permitting office before allowing new tenants or new ownership. The smart real estate investor will work with the jurisdiction and understand its needs and requirements. The residential real estate investor does not want to be tagged with “slumlord” label.
In summary, some of the old rules about investing in residential real estate are changing in today’s dynamic market, but most of the fundamentals stay the same.
Phil Hardwick is coordinator of capacity development at the John C. Stennis Institute of Government. Contact Hardwick at firstname.lastname@example.org.
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