7 Things to Consider When Investing in Real Estate
Evaluating a real estate deal involves assessing the potential return on investment and the level of risk involved. Here are some key factors to consider when evaluating a real estate deal:
1."Location, location, location". Location is vital because it affects the property’s appreciation potential and ability to generate income consistently. Therefore, it is essential to consider properties in up-and-coming city areas with attractive school districts, convenient transportation access, and other neighborhood amenities.
In some cases, investing in class-A markets or the best areas of a city may not be financially viable as they are usually the most expensive. However, if the returns are significant enough to justify the increased risk, then it may make sense to invest in class-B or class-C markets instead.
Pro tip: Talk to local officials about potential zoning changes and upcoming projects in your area of interest that may affect the property’s value in the future.
2. Vintage Just Means Old. The condition of a property is as crucial as its location when generating rental income. Underestimating the capital needed to improve a property can result in significant financial losses for real estate investors. It is crucial to be cautious of older properties that have not been well-maintained. Instead, focus on properties in good condition or those that can be easily renovated or repaired to increase their value.
Pro tip: It's always a good idea to walk the property before buying it (believe it or not some investors just trust their brokers). If needed, hire an inspector to assess essential high-cost items like HVAC, plumbing, electrical, foundation, structure and roof.
3. A Good Tenant is Priceless. If you're planning to buy a rental property, assessing the rent income potential is essential based on current market comparables. Look for properties in locations where there is high demand for rental units. In some cases, renting the property slightly below market rates may be beneficial to attract an ideal long-term tenant. Having vacancies kills returns.
Pro tip: Find self-managed properties (vs professionally managed) with below-market rents. Avoid bad neighborhoods at all costs.
4. Cash is King. To determine a property's cash flow potential, you must estimate its income and expenses. Income includes rent, pass-through expenses and other tenant fees. Expenses include taxes, insurance, maintenance and repair costs, property management fees, and mortgage payments if you use debt to acquire the property.
Pro tip: Having updated tax information is key when underwriting a property. Check with the city or county appraisal district to confirm the tax amount after the close, as transactions will reset the city's assessed value. This is recommended because the seller may have had some tax exemptions for which the buyer might not be eligible. Never believe the seller’s broker's numbers! Do your homework. Always inquire about any prior flooding or natural hazards from the neighbors.
5. Respect Leverage. While banks may be willing to lend you more, it's wise to consider a conservative loan-to-value (LTV) ratio. This ensures that you can make debt payments with the projected cash flows.
Pro tip: To ensure that a property is profitable, a quick rule of thumb is to ensure that its stabilized cap rate (the net operating income divided by the total purchase price) is higher than the loan's interest rate. If the loan's interest rate exceeds the property's stabilized cap rate, the property will likely experience negative leverage. This means that only the bank will make money from the investment, and you will lose money.
6. Market Sentiment. To determine whether it is a buyer's market, you need to assess the current macroeconomic conditions such as interest rates and unemployment trends, along with the local supply and demand dynamics. If it is a buyer's market, you can be more aggressive with your purchase offers. However, if the market is too hot, waiting for a few months might be better.
Pro tip: Pay close attention to the local news and take the national news with a grain of salt.
7. Exit strategy. Have a clear exit strategy, whether selling the property for a profit, refinancing to access equity, or holding onto the property for long-term rental income.
Pro tip: Look for assets that offer multiple exit opportunities. For instance, if you plan to fix and flip a house, make sure you can rent it out or use it for personal enjoyment in case the market takes a turn. This will help you avoid being stuck in an unfavorable situation.
By carefully evaluating these factors and conducting thorough due diligence, you can make informed decisions and minimize risk when investing in real estate.