Purchasing Rental Property

[Sydnie E.]

Hello BP,

I am new to investing and currently looking into purchasing my first rental property, four units. I am not sure what the first step should be. I plan to call and have the property inspected to see if there are any major damages to the property but I don't know if I am making a smart move or not. How do you evaluate rental property to see if it would be a profitable investment? Does the 70% rule still apply? The property is not in the best shape and from the looks of it all of the units will need repairs. I not sure what type of things I should run away from or just fix it and hope for a return.

I also would like to keep my investment adventures separate from my personal credit and have heard that setting up a c-corp is the best way. The internet people search will show any businesses that you have and I don't want random people having that information. As a newbie would it be smart to set up a c-corp with no current property income. Can anyone tell me the best way to go about this in the least expensive approach?

I welcome and appreciate all feedback.

Sydnie

[Harry M.]

Hi Syndie,
Welcome to BP! This site is absolutely awesome. I've posted/read here for about 2.5 years, and learned more than I would have thought possible. There are a lot of great folks here with a ton of real world experience.

I don't have enough knowledge to give you any advice on the second part of your question (separating your personal affairs from the business), but I can give you a couple of tips about the first part.

1. Find out what similar properties in the area rent for. Start out online, hitting sites like hotpads, realtor.com, craiglist, etc. Then hit the road and drive the area. Drive by as many of the properties you saw online as you can and try to get a better idea. Call some of the numbers (you may have to be pretend to be interested in renting, so don't use up too much of their time), and keep your ears open. Also, pay attention to what sort of amenities are standard. For example, if most similar properties in an area are marketed as "owner pays utilities", then you need to know this. If it's standard for a property to come with a fridge, you need to know this too.

2. Once you've done 1), you have a good idea what you could rent the property for. As you get further into the process, you need to firm this number up by asking your real estate agent to pull rental comps for you. This is particularly valuable, because by accessing the MLS, an agent can find what similar properties actually rented for, as opposed to the asking rent, as well as other useful statistics such as days on market (DOM).
Once you've got a good estimate, multiply by 12 to get your hypothetical maximum income, or gross rent (this assumes no vacancy - yet).
Now you've got to figure out expenses. One great rule of thumb is the 50% rule.
http://www.biggerpockets.com/forums/52/topics/17612-where-does-the-5-rule-come-from-

This states that over time, all of your expenses (vacancy, property tax, management, repairs, CAPEX, insurance, advertising, etc, but not mortgage principle and interest) will consume roughly 50% of your gross rent.

This is a good rule of thumb, but when you get serious about a specific property, you have replace the 50% with as many actual figures as you can. Some of them you can nail down precisely like the amount of property taxes, you can call around for insurance quotes (don't quit after 2 or 3 phone calls, there's quite a range), others have to remain estimates like vacancy and repairs, but it's important to be realistic/conservative.

3) That gives you your net operating income (NOI). Next you have to figure out what your financing costs will be. Figure on 25% down, and 4.5% interest over 30 years. There are a bunch of websites that will calculate your monthly principle and interest payments from that, and you can do it in Excel/Open Office too.

Once you've subtracted your P&I payment from your NOI, you've got your estimate of monthly cash flow.

4) Figure out how much extra you would have to spend after purchase to get the property into rentable condition, so it can compete with the other properties you looked at in 1). Talk to handymen, a GC, folks at Lowes/Home Depot once you have it down to specifics, chat with the inspector and see if he'll give you an opinion. Basically anyone you can find who knows more than you, talk to them and see what you can learn!
In addition to the larger rehab items, make sure you set aside money for getting the property rented, for paying utilities and stuff while vacant, and so on. Throw in an extra few grand for closing costs.

From all of the above, you can figure out a good estimate of what your total cash investment will be, and what your monthly cash flow will be once the show is on the road. A lot of properties won't make it all the way through the process before you decide that they won't work for you.

As far as what kind of repairs are ok to attempt, versus what to run away from - that's a tough one. It depends on your knowledge, and whether you've established relationships with knowledgeable and reliable people who are good at that kind of thing - essentially it boils down to how well you are able to estimate the costs involved. Certain things are a lot easier to pin down, and others are more likely to throw surprises your way. For example, you can estimate with a lot more confidence how much painting is going to cost than something like taking care of mold, or plumbing issues, etc. Personally, for a first property I would stick to a "lipstick" rehab (paint, carpets, random handyman fixes) rather than something more serious. That gives you time to learn, and once you own a property, there are more opportunities for building relationships with folks you will trust for more ambitious projects in the future.

Hope this has helped. Best of luck!
-Harry

Edit: Some of this duplicates what Jon Holdman just wrote. We were typing at the same time, but he typed faster!