I've had an interest in Real Estate investing for a while now. I'm not talking about "flipping" properties, what interests me is buying and holding cash-producing rental properties. This is an age-old, tried-and-true strategy. This technique has been making people money for centuries and it's just as good today as it ever was, even in this unsure economy. There are a few things that attracted me to this method of investing:
- The investment is in "real" property that is tangible and can be improved with physical labor
- As long as a person isn't a slumlord, this can be a type of responsible investing
- The tools for evaluating and acquiring a good deal are well-established
Each one of the items that I've listed has a counter-point, of course. At the end of the day, what a person invests in is a personal preference and, like anything, it will appeal to some people and not to others. For example, the prospect of replacing an old hot water heater or hanging storm doors is fun and interesting to me. I grew up around carpenters and something like this is a nice break from my daily hours spent in an office under fluorescent lighting. To others, nothing could be closer to torture.
The second bullet-point that I listed is also something that's very important to me. That is, ethical investing. I know that there are some funds out there that specifically focus on Socially Responsible companies and I think that's great. However, by owning and responsibly managing incoming producing real estate a person can have a direct, positive impact on a neighborhood while also earning a profit. In some ways this ties back to my first bullet-point, there are tangible aspects of real estate that stocks and funds don't have.
Hands down, the most appealing thing to me about investing in income-producing real estate is the fact that simple formulas can be applied to weed out the good deals from the bad. I've created a spreadsheet for evaluating properties and I've attached it to this post. I'll explain it in detail below. None of the formulas used in my spreadsheet are my own invention, they've all been around for a long time. As long as a person can separate themselves from the emotional attachment that often comes with selecting and purchasing property, the numbers are easy to live by.
One thing that the spreadsheet doesn't take into account is the appearance of a home and the desirability of the neighborhood. These are two items that you need to evaluate for yourself. Appearance is important, but it's usually easy to figure out what to do here; make the home look like the other homes on the block. In terms of desirability, be honest with yourself, see what people are getting for rents on Craigslist and make sure you feel safe in that neighborhood.
When evaluating properties to invest in it is likely that you will go through dozens, if not hundreds, before finding something that meets your specific criteria. There's nothing wrong with that, it takes work to find the right property. By putting this effort in up-front, you'll avoid a lot of pain (and financial loss) later.
On to the spreadsheet:
- This is designed to work with one to four unit dwellings, not designed for larger buildings (i.e. commercial lending).
- Make a copy for each property you look at, name it by the address.
- Fill in the appropriate fields:
- Property address
- Type
- Details (note things that are important to you like off-street parking and things that need work)
- List price (asking price)
- Purchase price (what you're willing to offer, play with this number... be sure to add in repair work here if you're financing repairs - more on 203K loans in a later post)
- Change the percentage in the "Down Payment" formula to reflect what you'll be putting down
- Under Operating expenses, find estimates that make sense. Fill in "taxes" for each property (this is in the MLS listing)
- Complete the "potential revenue" section, indicating the number of units and anticipated rents for each. Use Craigslist to figure out rents, don't trust what's in the MLS listing unless you've seen actual leases from the owner's tenants, if occupied.
- Fill out your interest rate
The rest is calculated for you. The spreadsheet includes notes in the "Important Calculations" section about what you should be looking for. You can tweak the "Acceptable Cap Rate" value to see what the calculated "Value of the Property" will come out to. Look at the calculated "Cap Rate" to see where that pans out. One of the most important items to the average investor is going to be the cash flow. This is listed as "Approximate Monthly Cash Flow" in the "Cash Flow Calculations" section. This MUST BE a positive number when all is said and done. If it's not, the property is losing money each month and it's not a good investment.
Real Estate investing isn't for everyone but if it's something that you're interested in, these are good rules to live by. If you play it by the numbers you can make a good income in this type of investing and you can make a positive impact on the world around you. You can provide a quality home for people to live in at a reasonable price and you can physically see and improve your investment. You can even live in your investment and share it with tenants.
I will be publishing a few more posts on this topic as I go through this process myself. In my next post I will write about investing in income-producing properties by using an FHA 203K loan and my experiences with that.
