Buying Investment Property: The Basics

Real estate has been long been regarded as one of the most stable long-term investments, and for good reason: it is the biggest industry in America, and historically has created more individual wealth than any other business. This is according to Donald Trump, who should know. One of only 371 billionaires in the United States in 2006, his fortune was derived entirely from real estate. It is therefore no surprise that, given the popularity of infomercials and Trump’s own televised testament to success, The Apprentice, many people have purchased rental property in an attempt to cash in on some of that wealth. If you are thinking of joining their ranks, here are a few basic rules that, if followed, will save you many a potential headache in your quest to become a real estate mogul.

Know your limits, and buy right.

One of the biggest mistakes new real estate investors make is taking on more financial responsibility than they can handle. If you are credit-challenged, work on improving your credit by paying down bills before you attempt to buy real estate. Despite what you may have heard, having a marginal credit score puts you at a distinct disadvantage in purchasing property. You will not be able to get the best interest rates available, which markedly decreases the chances that your purchase will generate sufficient income to cover your expenses. So if you haven’t yet, take advantage of your rights as a consumer and get a copy of your free credit report by visiting www.annualcreditreport.com.

Before you even begin to look at properties, know what you are able and willing to spend. If you will be getting financing, get prequalified and learn the maximum monthly payment you can comfortably assume based on your current income. You should be able to carry the property during times when it may be vacant and producing no income, without compromising your lifestyle. From your projected annual income on the investment, subtract estimated taxes, insurance, a 10% vacancy rate, and 2-3% maintenance. People new to real estate investing sometimes avoid figuring vacancies and repairs into their calculations, wanting to concentrate only on the potential riches they stand to earn, but in order to get the true picture of whether a property is worthy of your time and money, these realities must be factored in. Hopefully, if you “buy right” and stay on top of your investment you will not maintain a 10% vacancy rate. But when estimating, it is better to err on the side of caution and be pleasantly surprised than be caught up short with unanticipated problems.

Be wary of properties that sound too good to be true. They usually are.

You’ve got your financing arranged and are ready to go. You see an ad in the Sunday paper for a house that seems ideal for your first investment, and is dirt cheap to boot. You’re interested. The first thing you will want to do is drive by the property with pen and paper ready to take notes on your initial observation; things that stand out at you from a driver’s seat view. Gut reactions can be useful in making a decision later. Note: if the ad does not give the property address, or the seller or agent does not want to release it to you in a phone call, move on. You shouldn’t have to prequalify yourself to an agent or seller to get basic information. If you do, there is not sufficient motivation and probably little room for price negotiation.

If an area is heavily populated with renters, you will pass. This is an undesirable factor that subtracts from the value of a property. There are ways to tell if an area contains mostly rentals: the most obvious clue is that houses will be rundown and require extensive work just to be rent-ready – narrowing, and in some cases eliminating – your profit potential. You will not be able to rent for top dollar in a ramshackle area, no matter how nice your house may be fixed up.

Crime in such areas is also a consideration. Empty houses will be easy to detect because they are a magnet for criminal activity. I have seen houses for sale that were stripped of siding, plumbing, and fixtures by opportunistic criminals. Frequently, the owners will not even know what bad shape their property is in, because they have long since turned everything over to a real estate agent and don’t even go by the property anymore. Unless you have bottomless pockets, or are extremely handy, enjoy huge projects and have access to lots of free help, you will want your first investment to require little repair. Also, you will not want to have to worry about squatters or vandalism between tenants.

Once you have seen both the interior and exterior of a property and are convinced it is a good deal because you have verified this by checking comparable area sales (comps) with a Realtor or free Web resource like Yahoo! Real Estate or Domania.com, have a professional inspection done (if you are working with an agent, know that you have the right to select the inspector of your choice rather than one recommended by them). A professional inspection for a three or four bedroom house in the Midwest typically runs no more than a couple hundred dollars, and is money well spent.

Pay more attention to structural matters and the plumbing, heating, and electrical systems, and less attention to cosmetic details such as the need for paint or landscaping. Foundation problems, for example, have been known to be deal-breakers, as they can be very expensive to remedy. Cosmetic issues are generally cheap fixes and are almost a given with investment property.

A common theme in packaged real estate courses is, “Find motivated sellers – that’s where the deals are.” Yes, you do want a motivated seller, but the reason he is motivated should not be overlooked in your enthusiasm. Avoid ads with lots of exclamation points, as they scream desperation. Be leery of the seller who says he is “letting go” of a property because he is retiring, or wants to move close to the grandkids (typical reasons given by anxious sellers). Retirees want to make money too – income is often more of a concern with them than those active in the workforce – and if an investment has positive cashflow there is no reason to get rid of it. A more likely scenario is that the area has gone downhill, the seller is no longer able to get good tenants, and retaining the property has become a costly nightmare.

In short, what you want to look for are:

• Undervalued properties in areas where the majority of residents are homeowners
• Properties in good condition, or which do not require extensive repairs in order to rent
• Areas with reasonable property taxes, which insurance companies don’t shy away from.

A property for sale that is tenant occupied can be a plus or a minus. If there is a tenant, ask to see the lease and rent roll, in addition to the seller’s Schedule E from her last tax return, or other document detailing expenses for the past year. Every landlord should have some kind of written record of expenses and income. If the seller hedges about producing either, she could be avoiding eviction of a problem tenant and planning to leave you holding the bag with a non-paying deadbeat. If this isn’t something you want to deal with, you can specify in your offer that the seller must have the tenant evicted by closing.

Don’t be afraid of “lowballing” your offer.

There is not a lot of psychology involved in this, though entire chapters in books have been devoted to the subject. If you are not comfortable negotiating, learn, because it can save you thousands. Know the maximum you are willing to spend on a property, and offer about 20% less. Anything accepted at your predetermined maximum or less means you’re a successful negotiator! If the seller turns your initial offer down cold and does not counter in any fashion, be prepared to walk. If she knows you are serious and can afford to buy, meaning you have informed her of how you plan to pay for the property, and have not presented some ridiculous scenario like her holding a 50% mortgage at 4% interest for 25 years, it is likely she will open the door for negotiations from your starting point.

In the real world, if you expect a lowball offer to be entertained and you know you stand to get a sweet deal, you don’t want to push your luck. You should be able to handle financing independent of the seller’s involvement. Requesting a number of seller concessions, combined with a far-below-market offer runs the risk of insulting the seller and cutting off further communication, as they will view you not as a real “player”, but someone wasting their time who cannot afford to buy their property.

These are some of the key things to consider when buying investment real estate. As a buyer, keep in mind that the seller has the advantage of knowing any and all issues involving the property you are interested in. In order to make an informed decision, you will have to think and act like a detective to ensure you get that same information. It can make or break you.