For many investors, buying a rental property is something that happens later in life. Generally speaking, most people don’t start investing in property until they have already secured their own primary residence. If that is indeed the case, you must be careful to avoid falling into this trap — Never evaluate a rental property using the same metrics you would use for evaluating your own residence!
Avoid the Trap
It’s easy to fall in love with a piece of property. Unlike stocks, most people have the desire to tour the grounds and “see for themselves” before buying. Just looking at a Proforma sheet is typically not enough, no matter how great the cap rate, or cash-on-cash numbers look.
The problem with seeing a property with your own eyes is that you can easily become emotionally attached to it. This is why real estate agents love hosting open houses in the summer — they deliberately do so to create bidding wars! They know that if they stage the setting just right, you’ll lose your senses and eagerly overpay. When you fall in love, you become blind and irrational. And there’s simply no place for that in your investment career. You do not want to be a sucker and overpay for an “investment” that is actually making your poorer!
When Buying YOUR Own Home
If you were to purchase a property for yourself, you would probably be most interested in the home itself. More specifically, you would want to verify the following before signing any papers:
- Is the house big enough? Is there enough square footage?
- Is there a nice backyard? Enough room for the kids and dogs to play in?
- Is the house single-story, or two-story?
- How old is the home? Is it modern or starting to show its age? What about aesthetics?
- Any special amenities? Swimming pool, storage unit, gazebo, etc.
Sure, you would also pay close attention to the important details surrounding the house (nice neighborhood, good school district, easy access to freeways/public transportation, etc.), but I’m guessing the house itself would make or break the deal. In other words, if the house wasn’t up to your standards, it wouldn’t matter how great everything else around it was. When buying your own home to live in, a crappy house will not overcompensate for a fabulous neighborhood.
When Buying SOMEONE ELSE’S Home
When you’re buying an investment property, remember that you aren’t buying your own home. Don’t lose sight of the important fact that you won’t be the one living here, so it really does no good to evaluate the property as though you would be. When I look at rental properties, I desire the following attributes, instead:
- The house shouldn’t be too large. If it is, that means there’s more damage to be done. More walls to paint, more carpet to clean. These costs will come back to bite you when the tenant moves out and you have to make it rent ready for the next tenant. Further, if the house is big, you’ll end up paying more for it. Not only will the downpayment be higher, but so will property taxes and insurance. This all eats into your bottom line.
- I don’t want a nice backyard. Again, smaller is better. The single family home I bought in Indianapolis doesn’t even have a fence in the backyard… the entire backyard is shared among many neighbors. That sounds lovely to me! No fence means one less repair bill to worry about.
- I prefer single-story homes. This decreases the total square footage of the home and typically reduces the sales price. Again, property taxes and insurance should also be reduced as a consequence of the smaller size. In addition, I prefer single-story homes because I worry about things like potential lawsuits happening… So, I try and avoid stairs whenever possible. The last thing I need is for a tenant to take a tumble downhill and then come chasing after me to help pay for their medical bills and trauma!
- Beauty is in the eye of the beholder. Some people love the more modern look (cookie cutter, mass manufactured homes), while others prefer the “character” that older homes provide. I must remember, just because I’m a fan of something, it does not mean that someone else will be as well. For example, an older home might have old, rundown hardwood floors, vintage crown molding, and even an old-school chandelier in place. It would be naive of me to think I could simply rip up the old stuff, install something more modern (laminate flooring, recessed lighting, etc.), and proceed to charge more for rent. If it isn’t broken, it might be a better to just leave it in place. When it comes to aesthetics, you just never know what someone else might like.
- For rental properties, I don’t want any special amenities. More special features mean more repair costs to pay when they inevitably breakdown. Further, I make it standard to not furnish certain appliances like washer and dryer. None of my rental units come with these appliances. In Indianapolis, it’s even customary to not provide a refrigerator or stove. Unfortunately, it’s difficult to get away with this in California…
As you can see, the mentality of an investor buying a home is completely different from that of a prospective homebuyer purchasing for themselves. You can never forget about the cash flow, because ultimately that’s what will make or break your investment.
Focus on The Surrounding Area
There’s a popular saying in real estate investing — It’s better to own an ugly house in a great neighborhood than to own a beautiful house in a warzone.
So, instead of focusing on the finer details of the house itself (however, do focus on the expensive items: stable foundation, good electrical, plumbing, roof, etc.), I would encourage you to perform your due diligence and make sure to verify that the surrounding area is up to stuff. It is important to ascertain the following critical pieces of information before purchasing a rental property:
- Is the property located in a good neighborhood?
- Are the properties primarily owner occupied or rented out by investors? (Buying into owner occupied neighborhoods can be a great strategy to reduce competition for renters. Property values should hold up better as well.)
- What type of people live here? (Working class, affluent, college students, Section 8, etc.)
- What’s the local economy like? (Jobs, wages, stability, etc.)
- Ratings of nearby schools? (Applicable to SFH’s, since many renters will have small children.)
- Is the property located near public transportation? How far away from the main city/jobs?
The bottom line is that your investment home needs to be located in an attractive enough area where people will want to live. It will be of absolute no use to you, as an investor, to hold a gorgeous home in your portfolio that nobody wants to rent because it’s located next door to a meth lab.
Go Where the Jobs and People Are
When buying investment properties, I also make an emphasis to buy in large metropolitan areas where the people are living. For instance, in my own situation, Bay Area rentals are no longer affordable, so I would have to drive inland to find anything that remotely cash flowed.
But then I asked myself this important question — Do I really want to be buying up a ton of properties in Stockton, Modesto, or Lodi? (no offense). Are there lots of jobs out there? Is this a growth area where the people are moving into? I couldn’t answer that question with a convincing “YES“, so I opted to invest out-of-state, instead.
The importance of location cannot be overstated when deciding where to purchase an investment property.
The primary objective of an investor is to make money. This seems pretty obvious, but can be overlooked and completely forgotten about when you are first starting out. It’s understandable too, because houses will ALWAYS appeal to our senses and emotions.
As an investor, though, you must not lose sight of your goals and objective. Most importantly, don’t invest in “too much” property. You don’t want to be the person with the portfolio containing the prettiest homes, but worst cash flow! So, invest in rental properties, but do so while looking through the lens of an investor, not homebuyer.