A Guide To Buying Investment Property

When owning real estate, it’s important to focus on the big picture. Do you want to rent out your property immediately? Or, would you like to enjoy it for a few years then rent it out after you’ve accumulated enough funds to live somewhere else? Regardless of your future home plans, accurate valuation of your target property will ensure you’re entering into a financially sound real estate investment. Here are some specific steps to go through before purchasing any property.

1) Calculate your annual gross rental yield. By calculating the annual gross rental yield, you can get a quick “apples to apples” snapshot of what the blue sky potential is for a property if you paid 100% cash with no ongoing expenses. Take the realistic monthly market rent based on comparables you find online and multiply by 12 to get your annual rent. Now take the gross annual rent and divide by the market price of the property.

2) Compare your gross rental yield to the risk free rate. The risk free rate is the 10-year bond yield. Investors say “risk free” because there is practically no chance the US government will default on their debt obligations. All investments need a risk premium over the risk free rate, otherwise, why bother risking your money investing. If the annual gross rental yield of the property is less than the risk free rate, either bargain harder or move on.

3) Calculate your annual net rental yield (cap rate). The net rental yield is basically your net operating income divided by the market value of the property. In other words, we are calculating the actual bottom line annual profit.

4) Compare the net rental yield to the risk free rate. Ideally, the net rental yield should be equivalent or higher than the risk free rate. You will pay the principal down over time thereby increasing the net rental yield and spread over the risk free rate. If all goes well, rents will also go up and your property will appreciate.

5) Calculate the price to earnings ratio of your property. The P/E ratio is simply the market value of your property divided by the current net operating profit (NOP). The answer will provide you with the number of years of NOPs it would hypothetically take one to recoup your investment.

6) Forecast property price and rental expectations. As a real estate investor you want to take advantage of fear and unfortunate situations such as a divorce, company relocation, layoff, bankrupt city, or natural disaster that creates motivated sellers. As a real estate seller you want to sell the dream of forever rising prices. The best way to forecast the future is to search for comparable transactions on DataQuick, Trulia, and Zillow.

7) Be mindful of taxes and depreciation. Almost all expenses related to owning a rental property are tax deductible including mortgage interest and property taxes. If you live in your property for two out of the last five years, $250,000 of the profits earned are tax-free for individuals, $500,000 for couples. The 1031 exchange also allows investors to rollover proceeds to another property without realizing any gains and therefore taxes.

8) Check the financial health of your HOA. If you are going to buy a condo, it’s imperative to ask for the HOA’s financial statements. Take particular note of its reserves and read the meeting notes taken by the HOA secretary. You don’t want to be stuck buying a condo with HOA litigation either. Things can get messy, quickly.

Over time your rent should grow and the interest portion of your mortgage payment should decrease. If you can hold onto your property for the long term, chances are high that you’ll have another fantastic asset as part of your overall net worth. Don’t forget you can now track your property via Zillow on your Personal Capital dashboard.

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