Buying an investment property is a great way to diversify your portfolio, create cash flow, receive tax deductions, build equity, and hone your business skills. In Portland (as of 2019) there were approximately 248,000 renters or 38% of Portland's population according to Census ACS data. This means there is no shortage of people you can rent your new investment property to. Whether you are looking for a single-family rental or a multi-family property there are some important questions you must ask yourself that could save you thousands of dollars.
1. Who is on my team?
You will want to build a rock star team to help achieve your real estate investment goals. The key players should include a Real Estate Agent, a Lender, a Property Manager, a Contractor, and a Lawyer. If you already know someone who is awesome in one of these categories, ask them for referrals to fill your missing positions. And if you are in the Portland area you can always reach out to me to help get you started!
2. How will I pay for this property?
Most first-time investors will have to finance their property through a lender, hard money lender, or private investor. Ask your real estate agent for their favorite lenders and go talk to them. Find out who has the best rates, best service, and best loan products.
If borrowing money from lenders won't work for your situation. You can get creative. Some home sellers will act as the bank and offer "seller financing". For the seller to do this they will need to have their mortgage paid off, so it won't work for every deal. However, if this sounds interesting, you will want to do more research on the topic because it is a great tool to hang on your belt.
3. What is my strategy?
There are many strategies to consider when purchasing an investment property i.e. buy and hold, fix and flip, house hacking, BRRRR (Buy Rehab Rent Refinance Repeat), short-term rental, etc. Talking about your goals with your real estate agent will help reveal which strategy would be best suited for your unique situation. It is important to pick a strategy because it will help determine how you underwrite deals.
4. How will I underwrite properties?
Understanding what deals make financial sense is mandatory for investing in real estate. If you underwrite a property incorrectly, you might just find yourself in a money pit.
Underwriting a property is critical to evaluate your risk. You will determine how much money a property can make at a given price and if the risk is too great you will need to adjust the price, adjust the terms, or walk away from the property because it's not a good deal.
While there are many online calculators I will quickly teach you how to do a back of the envelope evaluation to solve for:
A. Cap Rate which is important for determining if you are paying a fair price.
B. Cash Flow (Before Taxes) which is the money you earn each year.
C. Cash on Cash Return which is the percentage you earn on your initial investment.
D. Debt Service Coverage Ratio which will tell you if a lender would loan on a property.
Start by estimating several numbers:
1. The total yearly income of the property
2. The total yearly expenses for the property (Utilities, Landscaping, Insurance, Taxes, Management, Etc.)
3. Average vacancy for the neighborhood or use 5% (the industry standard)
4. Estimated total yearly mortgage payment
5. Initial Investment (Down payment + Acquisition Fees)
To solve for Cap Rate follow this formula:
(Total Income * Vacancy) - Total Expenses = Net Operating Income (NOI)
NOI / Purchase Price = Cap Rate
Ask your real estate agent what a fair market cap rate is for the type of property you are buying. This indicator is helpful for determining if you are overpaying. Typically, safer investments will have lower cap rates while riskier investments will have higher cap rates.
To solve for Cash Flow follow this formula:
(Total Income * Vacancy) - Total Expenses = Net Operating Income (NOI)
NOI - Total Yearly Mortgage Payment = First Year Cash Flow
Cash Flow is the money that the investor earns for owning the property. They can take this money and spend it how they wish. Although many owners, choose to reinvest their cash flows to further improve their property's Net Operating Income because this increases the value of their property.
For example, let's say there are two identical 5 unit buildings for sale at a 5% cap rate, however, building A has an NOI of 50K / year and building B has an NOI of 60K / year. We can take our formula to solve for Cap Rate and instead solve for purchase price because we know the cap rate is 5% and we know each building's NOI.
NOI / Cap Rate = Purchase Price. Building A is worth $1M. However, Building B is worth $1.2M. Can you see how increasing NOI might be more important to some investors than collecting cash flow?
To solve for Cash on Cash Return follow this formula:
Cash flow / Initial Investment = Cash on Cash Return
Some investors use the Cash on Cash Return to quickly filter through deals they would like to pursue. If it has their minimum required return they submit an offer, if not, they move to the next opportunity.
To solve for Debt Service Coverage Ratio follow this formula:
NOI / Total Yearly Mortgage Payment = DSCR
If the mortgage payment is greater than the NOI, there is a major problem. It means that the property doesn't generate enough income to cover the mortgage payment. Typically this would happen when a property needs major improvements to increase income (referred to as value add) or it's simply a bad deal.
In my experience, lenders like to see a minimum of a 1.2 DSCR before they will loan on the property. If the DSCR is above a 2.0 you may consider re-estimating your expenses because they are likely too low.
5. Will I live in this property?
"House hacking" has become a popular phrase for investors who purchase multi-family properties and live in one unit while renting the others. This strategy can be an amazing opportunity for new investors looking to purchase a 2 to 4 unit building. These "residential" multi-family properties are typically eligible for financing as low as 3.5% down and what's even better is that lenders allow the buyer to use a percentage of the income generated by the property to help you qualify for the loan. You'll want to consult with your lender for exact details on how this can be accomplished.
6. Where should I buy?
Location, location, location! You can never go wrong with a great location, however, the same can't be said for the latter. So be careful!
Depending on your strategy the answer to this question will vary dramatically. So first decide how you'll invest. This should help determine where you'll invest. For example, if you are going to be "house hacking" you probably won't want to buy somewhere you perceive to be unsafe.
Now get out there and invest. I hope this helps you get started on your journey to becoming a real estate investor! If you have any other questions, be sure to let me know.
AND if you got some value from this blog, I'd really appreciate it if you'd share it with one other person who you think would enjoy it!
Licensed Oregon Real Estate Broker
Disclaimer: For educational purposes only. This is NOT financial advice.