How Do I Know if an Investment Property for Sale is Right for Me?
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Summary:
You’ll have to make many decisions when looking at investment properties, from your overall strategy to your time frame, financing, renovation needs, and a slew of others. Then there is the question of where you want to invest — domestic vs. international, urban vs. rural, etc. Furthermore, investors should be wary of taking on too much debt and develop a plan to protect themselves from volatile interest rates.
A good investment property can be one of the best decisions you ever make while a bad investment property can be a frustrating and expensive nightmare. Real estate can be in exotic locations, have cool features, and perhaps even have a history that will lead to storytelling at dinner parties. However, investors should consider the many risks before taking the plunge and buying condos in downtown Denver or vacation rentals in Buenos Aires. An investment property sale, no matter the location, is not right for you until it checks ALL the boxes. What are those boxes? Let’s find out.
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How do I know an investment property for sale is right for me?
An investment property must, first of all, fit into your overall budget. This includes all the costs associated with the purchase of the property, such as taxes, lending fees, renovation costs, etc. There are upgrades you can make, such as adding an in-law suite, that can add tremendous value to a property, surprisingly quickly. But only if you can afford them.
Pro Tip
Dale Wills is the CEO of Centra Companies, one of the largest developers in the Minneapolis area. He gives the following advice when looking at an investment property: “There are many points of information that we review before buying an investment property. Some of the primary data we look at are property rental rates and vacancy rates in the area. Specific to the property, we review the condition of the property and improvements that may need to be made. We also look at what the return on our investment will be along with the long-term ability to sell the investment with a profit.”
An investment property might be right for you if it checks these boxes
- Overall Strategy
- Location
- Maintenance and Management
- Exit Strategy
When trying to make money via real estate, there are effectively two ways for most retail investors to do so: bet on the property value going up or obtain an income from renting the property. This doesn’t mean these have to be exclusive, however, as there are real estate investments that both appreciate in value and produce a significant yield.
Appreciation strategy
An appreciation strategy, or “growth strategy,” is one in which your primary objective is to see the value of the property rise. If getting a mortgage or using leverage is part of your overall strategy, then you might want to use an appreciation strategy. In our article about HELOCs and investment property, we went over what an appreciation strategy would look like using a HELOC. Here’s an example.
| New home price | $600,000 |
| 30% down payment | $180,000 |
| Value in 3 years | $700,000 |
| Mortgage (70% after down payment) | $420,000 |
| Borrowed from HELOC | $180,000 |
| Interest on HELOC | $32,400 |
| Additional costs and fees (buying & selling) | $21,000 |
| Maintenance costs (HOA fees, property tax) | $25,000 |
| Total costs | $678,400 |
| Total profit (based on $700,000 value) | $21,600 |
Income strategy
With an income strategy, your goal is to produce a return on investment from renting your property, or a yield (yearly rental income vs. property price). Again, we can use our income strategy using a HELOC.
| Home value | $120,000 |
| Nightly rental | $60 |
| Gross income from rental | $21,900 |
| Occupancy at 70% | $15,330 |
| Gross yield | 12.78% |
| Yearly fees & costs | $3,000 |
| Total income after fees & costs | $12,330 |
| Net yield | 10.27% |
| 3-year total net | $36,990 |
| Interest on HELOC | $21,600 |
| Total profit | $15,390 |
In this example, we use a long-term tenant, but short-term lets are also growing in popularity.
Scott J. Wheeler, an experienced real estate investor and agent, suggests you keep a few things in mind.
- Figure out how much rental income you could get for the property by looking at comparable rentals in the area.
- Apply a vacancy factor to the income (lenders will require some amount like 7% for a cushion).
- Add in any extra sources of ancillary income (i.e. parking or laundry fees).
Wheeler goes on to say, “Then from that net income, you would subtract all expenses for routine maintenance, insurance, marketing, HOA fees (if there are any), etc. That will show you the net operating income (NOI) available to either pay a mortgage or keep in your pocket at the end of the day.
Different people will have different goals and objectives for property investment, and thus, it’s crucial to have an overall strategy before you delve in.
Location
Many people will put location even above strategy when determining if an investment property is right for them. There are many aspects you need to consider about the location: Does it need to be within driving distance? In the same city or state? In the same country? Here are some considerations regarding the location of your investment property.
Domestic vs. international
The amount of Americans looking overseas for real estate has steadily grown in the past decade. It’s nowhere near the amount of money flowing from Asia into international property, but as interest rates have been climbing recently, investing in other countries may be more appealing.
Pros and cons of domestic property
Pros and cons of international property
Urban vs. non-urban
Another factor that you must determine when looking at an investment property is the type of location where you want the property, regardless of the country. Do you want to put your money into a first-tier global metropolis? An undeveloped plot of land? A ski or beach location that might make a great Airbnb?
Pros and cons of buying in an urban location
In many cases, people will align their urban vs. non-urban strategy with their income vs. appreciation strategy. As a rule of thumb, urban centers, particularly first-tier ones like New York City, Los Angeles, or London, will hold an increase in value but produce a low yield. Likewise, if you were to buy a property on the beach in Nicaragua, then the yield would be high, but the value will not hold as well as it would in an urban center.
Maintenance and property management
Once you devise a strategy and decide on a location, you must now consider what it takes to maintain the property. This pertains to not only the upkeep of the property but the ability to manage tenants and acquire new ones when existing tenants’ leases run out. Here are some questions to consider regarding maintenance.
- Is the rental going to be short-term (Airbnb) or something longer-term?
- Who is managing the property? Will it be the investor, or will it be a third-party management company?
- What type of maintenance does it require? Will a first-floor unit require more maintenance than a second-floor unit?
- How is the money being collected for rent? Are there currency exchange restrictions if it’s a property generating forex?
- Is the property located near an area with natural disasters like floods?
- Is it in a location where it’s difficult to kick a tenant out if need be?
“It’s important to run comparable rental properties in the market and get a rent analysis to see what the average home rents for, before the purchase,” says Suzanne Seini, owner of Innovate Realty. “There are fees associated with renting a home, between listing fees, maintenance fees, and property management. So, the rental income needs to be higher than just your monthly mortgage payment.”
Remember, this tenant is paying off your mortgage and building equity in your home for you — you don't always need to see a major profit monthly to still see a major profit long-term. - Suzanne SeiniClick to Tweet
Leverage
Can you get a mortgage, and if so, at what interest rate? If you get a 70% mortgage, does this affect your break-even assumptions and therefore, you would consider a 50% mortgage? Again, maintaining the mortgage will be a cost you have throughout your ownership of the property. In terms of a loan-to-value ratio, if you can afford to borrow 50% rather than 70%, you might want to consider taking a lower LTV if it makes you more comfortable with your break-even point.
Tenants
What type of tenants would you consider? Are you looking for yuppie types, or are you trying to rent out a cabin in Colorado to hippied-out students at CU? The better the tenant, the lower the chances of potential damage to the property. This is also significant in how it pertains to short-term vs. long-term lets. Although short-term lets can often produce a better yield, there is significantly more risk of damage to the property caused by the revolving door of tenants.
Taxes, fees, other costs
Every single location in the U.S. has a different tax system, whether you are looking at the state, city, or county level. Furthermore, different states have different requirements for insurance, such as flood insurance requirements in the state of Florida. High property taxes and other high prices in places like Chicago can greatly dissuade people from investing.
Exit strategy
The last aspect to consider when deciding if an investment property is right for you is to determine what your exit strategy is going to be. You might want to eventually sell the property, keep the property and draw down equity, or just keep it as an income-producing asset if it’s always tenanted.
Sell the property
Is the point of the property to sell it for a profit? That might make you more concerned about the quality of tenants, as you want the property to be spick-and-span on any resale. Furthermore, you might want to consider buying in a popular location where it’s easy to resell.
Cash-out refinance
A cash-out refinance is usually associated with an appreciation strategy, but you might also be able to take a cash-out refinance on an income-producing property that has built up equity. You could then use this money to purchase another property.
Keep the property
Of course, your strategy might be to just keep the property forever, which is what you find with some income-producing property enthusiasts. You can own the property in perpetuity, and its income could provide for generations of your family, inheritance tax and upkeep excluded.
FAQ
How do you know if an investment property makes sense?
You’ll have to consider a number of factors. First, you should make sure that the cost is within your budget. Then you should choose your overall strategy, desired neighborhood, management, and maintenance. Finally, you should determine your exit strategy.
How much profit should you make on a rental property?
There is no exact amount of profit you should make on real estate or other investment opportunities. If you make a profit and are in the green, that’s a good start. Some investors use the 1% rule, which states that the monthly rent you take in should be at least 1% of the purchase price of the property. So if you paid $200,000 for a property, you should be able to charge at least $2,000 a month in rent in order to make a good profit.
How to determine the fair market value of an investment property?
First, start with getting an appraisal and see what it says. Then a good rule of thumb is to see how much the properties within easy walking distance are selling for. Those comps will tell you a lot about what’s happening in the local market.
Key takeaways
- The first rule of thumb when deciding if an investment property sale is right for you is to be sure you can afford it. This includes a mortgage and any additional costs, like taxes and fees.
- You should also make sure that an investment property fits into your overall investment strategy, and that you are comfortable with its location and upkeep.
- For an income or yield strategy, investors should make sure that the property will be occupied and that they can make a good net income. For a capital appreciation strategy, your costs must be covered, and the property value must grow.
- Remember, a solid exit strategy is beneficial regardless of what you are trying to achieve with the property. The more options you have, the better your chance of exiting if/when need be.
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