“If you fall, pick something up while you’re down there.” – New England proverb

Yesterday, I told you a story that highlighted just about every mistake you want to avoid when buying real estate for rental purposes. Today, let’s talk about what you should do.

It seems to me that there are two big secrets in making rental real estate work for you. One has to do with the old “location/location/location” axiom. The other is about the condition of the property you buy.

Let’s start with some rules, keeping in mind that rules are made to be followed until you understand the principles behind them.

1. Buy properties in your local area.

To be a successful investor, you have to know what you are doing. And if you have been living where you are living for any number of years, you already have more knowledge about local real estate than you think. You already have a clear idea of the good neighborhoods, the not-so-good ones, and the ones you need to stay out of. You may have developed a feeling for the up-and-comers. By staying in your local area, you give yourself the chance to really know the market. And this is the most important factor in limiting your risk and increasing your chances for profits.

2. Invest in good or up-and-coming properties.

I can tell you from experience that the old saying about the three rules of real estate being “location, location, location” is true. But there are two kinds of good locations: those that are already established as good and those that are on their way to becoming good. You can make good money with both.

Here’s how …

* In good neighborhoods, buy the least-expensive property you can find. That way, any money you spend fixing it up (if you fix it up wisely) will bring you double or triple your invested dollars. When you buy a poor piece of property in a good neighborhood, you get the benefit of the neighborhood to lift your selling price once the property looks acceptable. Of course, it’s not easy to get the least-expensive piece of property in such a good neighborhood cheap. Most of the time, the property owner realizes what’s going on. But with really dilapidated homes, and sometimes with owner-sold properties, you can get a real bargain.

A quick example: A couple of months ago, I brought a 1,200-square-foot, two-bedroom apartment in my hometown for $62,000 and rented it out for $1,000 a month. That’s a very good deal, even after considering the three grand I spent fixing it up.

* In up-and-coming neighborhoods, buy properties in clusters — either by yourself or with a consortium of buyers. That way, when you all renovate, you will upgrade the look of the area you are in — and this will bring up prices, sometimes even more than you’d guess.

* Whenever possible, buy newer, solid structures. There’s nothing worse than managing a rundown building. The tenants complain. They are reluctant to pay the rent. They treat you like a crook. It’s bad. Be extra careful about the critical and costly things. Don’t buy any property that has major problems — a bad roof, rotten plumbing, or burned-out electrical. The cost will eat up any profit you can make.

* Develop a network of reliable contractors: a plumber, an electrician, an A/C guy, a painter, a landscaper, and — most important — an inexpensive handyman.

As in so many businesses, real estate is all about buying right. If you get a property for a good price and don’t over-invest in fixing it up, you’ll be 95% certain to do well in the long run.

My own very general guideline on buying rental properties is never to buy a property if the total cost (sales price plus fix-up expenses) exceeds nine times the rent. Usually, I try to do — and do — better than that, though that’s not easy in good and up-and-coming markets, where there is a lot of sophisticated competition vying for limited properties.

Say, for example, you found a building that could be bought for $90,000. And say it would require $10,000 to bring it up to where you want it. (Where you want it is in a condition that will enable you to get a decent rent and keep your tenants from complaining because things are breaking all the time.) That’s $100,000 total.

In such a situation, following my rules, you’d want your total monthly rents to be $11,000 or more.

Say you could get $11,500. Here’s how it would look, from an investment perspective, if you paid for everything in cash: Your total investment would be $100,000, and your net cash flow, after paying property taxes (say $1,000 a year) and upkeep (say $1,500 a year), would be $9,000. That’s a 9% return on your money.

That’s a pretty good deal if you believe, as I do, that real estate is safer than stocks.

But that’s not the whole story. If you buy right and in the right location, you’ll get a very significant appreciation in the property value. This can vary widely. Historically, it’s about 4% to 5% — which would give you a total cash return of about 13% to 14%.

But that’s just the average. If you know what you are doing, you can do much better than that. A rental property I bought three years ago for $195,000 just sold for $395,000. My return on investment (ROI) was astronomical.

If you finance rental property, the ROI is sometimes even better. In a future ETR, I’ll tell you more about that.

But I think you understand the point. Owning rental properties — if you own good ones (which means better tenants and fewer complaints) — can be a very manageable way to make a lot of extra money on the side, while you are working for someone else or running your own business.

Of all the things I’ve done “on the side,” rental real estate has definitely been among the very best.

I began buying local properties in Boca Raton, Florida (where we had moved) and also, about 10 years after that, in Baltimore (where I was working). I never had to come up with a lot of money at any one time — never was it more than 25% of what I saved that year, even when I was saving less than $10,000. But the small investments added up. Frequently, I was able to swap a piece that had appreciated (in some cases doubled in value) for another one that I thought had greater potential. Sometimes, I traded one unit for two.

Piece by piece, I put together what has turned out to be a very nice collection of properties. Their rental fees have been good, and, because I never quit my day job, I’ve been able to use those rents not only to pay down my mortgages but also to buy other properties.

It has been a painless experience for the most part. And a profitable one. In what seems (in retrospect) like no time at all, I’ve acquired enough income from my real-estate rental property to retire on. That is — if I believe in retiring.

If you want to get going, you’ll need a lot more information than I’ve given you here. Fortunately, there are reams of advice about real estate at your local library. I’m working on putting together a program that will be available sometime before next year. While you are waiting for that, go out and get to know your local market. Saturday mornings, take a walk or bike ride. Start looking at those ubiquitous home-sale catalogs. Talk to a few brokers.

Don’t buy anything this weekend. Just look around and get familiar with the your local market. Take your time. Have some fun. Acquiring a good feeling for local property values is one of those skills that only experience can teach you.

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