Investors frequently inquire about the best type of investment property to purchase? I always respond and say, “it depends.” Every investor has different goals and should choose a property based on goals. Some investors will leverage rental property for monthly cash flow and tax benefits, while others purchase for future appreciation. This article will focus on properties that can produce positive cash flows, build wealth, provide lower cost of ownership, and reduce owner risk.
When analyzing a rental property, you must estimate market rent and mortgage payment. I know this sounds silly. You would be shocked how many times I get a call from an investor who has already closed on a home and never reviewed leasing data. He or she used a Realtor who promised a rent range without providing documentation. I can’t stress how important it is to use a professional who is experienced in leasing investment properties.
Assuming there are no defects with property (home not on busy street, in good neighborhood with good resale values, schools, etc.), and rent covers debt service and even cash flows, it is a probably a pretty good deal. It can be challenging to find a cash flowing property. However, investment property mortgage rates are now below 6%. Record low interest will help you find a property that produces positive cash flows. If you need help with a mortgage or an option on an investment property, call our office. We provide real estate sales, leasing, mortgage and property management services.
I frequently see investors use cost per sqft when analyzing a rental property. This may be a good metric in establishing a market value for a home for sale, assuming your sample data has an average square footage close to the subject property. However, it really is meaningless when purchasing an investment property.
We recently helped an out of town investor purchase his second investment property. He went online and selected about half a dozen listings and selected some foreclosure homes selling in the $150,000 range below $60/sqft. The investor was convinced we should start our focus on these properties.
We analyzed a 2,400 square foot foreclosure home built by a value builder listed at $155,000 in Leander. We ran numbers to determine the mortgage payment and market rent. Property tax rates in the Cedar Park/Leander/Round Rock/Austin areas range from 2% – 3.4%. Some neighborhoods are in a MUD district and have higher tax rates. The county tax assessor will not lower the tax assessed value for a foreclosure property to what the buyer paid, because it is not considered an arms-length transaction. You must use the current full tax assessed value to determine the mortgage payment. We estimated the mortgage payment on this home with an 80 LTV (loan to value) mortgage was about $1,120 per month, and market rent was $1,050 per month.
The investor was certain this was a great deal, and it turned out to be a negative cash flow scenario. What he failed to realize is rents do not increase much as square footage increases. We searched MLS and found a small 1,200 square foot home with an asking price of $125,000 in Round Rock. The property tax rate in Round Rock is a little lower than Cedar Park. We ran numbers and determined mortgage payment was slightly less than $900 with an 80 LTV mortgage, and fair market rent was $995 per month. We negotiated a contract for $122,900, and leased the home for $995 before he even closed. This home sold for over $100/sqft, and investor paid just below market value. However, the property produced a $100 positive cash flow.
Many investors overlook the costs of repairs and maintenance when purchasing investment property. In a worst case scenario, investors may have to replace carpet and paint interior walls of home when getting property ready for lease. It costs about $1.50/sqft to replace carpet and $.75/sqft to paint interior walls plus materials costs. These are just rough estimates.
We usually collect a security deposit equal to one month’s rent. For the small 1,200 square foot home with 300 square feet of sheet vinyl and or tile and only 900 square feet of carpet, it will cost about $1,200 to replace carpet and $1,000 to paint interior walls. For the larger 2,400 square foot home, it would cost about $2,500 to replace carpet and $1,800 to paint interior walls. Yet, the larger home only brought in $50 more in monthly rent. The $995 security deposit of the smaller home would covers 45% of the overall damages, and investor is out of pocket $1,200. The $1,050 security deposit for the larger home would covers only 24% of the damages, and investor is out of pocket $3,250.
As rents increase, the pool of qualified tenants shrinks. There are fewer tenants searching for a $2,000 per month property than a $1,200 per month property. In a bad economy like the one we are now experiencing, higher priced rental properties can drop hundreds of dollars in monthly rent. I am not worried about a $995 monthly rent for a small single family residence dropping $200 per month. More expensive homes can depreciate significantly in a down market, while less expensive homes are more resilient to price depreciation and rent drops in a recession.
In our market, a $350,000 suburb home may bring in $2,000 in monthly rent; a $250,000 home may bring in $1,600 in monthly rent; and a $150,000 may bring in $1,100 in monthly rent. Our smaller $122,900 home purchased a year ago now brings $1,050 in monthly rent.
Investors must consider their goals in purchasing an investment property. If an investor wants to minimize risk, lower maintenance costs, cover debt service, and have positive cash flow, he or she should consider purchasing a smaller home at a lower price point. A smaller home may not appreciate as much as a larger, more expensive home. However, a smaller rental property with a lower price point is a bullet proof investment and easy to rent or sell in any economic cycle