What investors should know before taking the risk Out of all of the diversity found in the 1 percent — the most wealthy in history — the one common thread is that they owned real estate. Building a real estate portfolio and becoming a landlord can be one of the best wealth creation tools available. But, if you’re not careful it’s also one of the easiest ways to lose a lot of money. Cash-on-cash. Market comparables. The 70 percent rule. It is easy to fall into “analysis paralysis” with the investor vocabulary. When it comes down to it, there is a shortlist to look at when choosing a good investment. This list begins with an honest look at your financial situation along with specific goal setting. Below, I’ve listed 11 characteristics that will help you filter out the money pits from the money pots either for yourself as an investor or for a client that is a potential real estate investor.
1. Face the facts. Before you can even set goals, you must take an honest look at where your finances are presently. Make a balance sheet and a cash flow statement for yourself. Though, this can be difficult, it presents a tremendous opportunity to advance your emotional health and thereby your financial health. I recently did this and found a loser property in my portfolio. With this new knowledge, I can dump the property and 1031 into another. Never stop reviewing financials. They will provide new insights and opportunities regularly. Remember, a balance sheet has all assets in one column and all liabilities in another column. It will help you measure principal paydown over time, debt to equity ratio and net worth. Remember, a cash flow statement looks at money going out and subtracts it from money coming in. I recommend you do this with each investment individually so you can measure individual performance. This exercise will help you set expectations for each new investment. It will also help you decide whether you should keep a property or trade it for one that will perform to a higher standard. Remove emotion and take an honest look at your financial position.
2. Set a goal. Now that you are armed with the facts and you have taken on your emotional and financial health head on, set a goal. Keep it simple. Examples:
- Increase net worth by 3 percent in the next quarter.
- Increase cash flow by $4,000 over the next year.
Remember, the reason you are here is to increase financial freedom.
3. Know your financing for the property Most small time investors begin with 30-year fixed notes that require 20-30 percent down. Talk to a couple different mortgage brokers or officers. You should be able to answer:
- How much can I qualify for?
- How much will payments be?
- How much cash do I need?
This will save you time in your property search. Any properties that are outside your loan qualifications on the loan or cash available are automatically disqualified from your list of potential investment properties.
4. Perform a proforma Whoa! That was a mouthful. In simple terms, you are going to estimate a budget next. Before you buy a rental property look at what comparables properties are renting for in the neighborhood and then check how many of those properties are actually rented. This will tell you two things — gross potential cash flow and likely vacancy expense. Next you will need to estimate expenses. Taxes, insurance, and maintenance will be the most common. You may have others to address such as utilities or homeowner association fees depending on the property. Do not get too overwhelmed with this section. Ask another investor in the area or talk to a property manager about expense ratios in the area. Age of the property will be a significant indicator of the likely expense ratio. Now, shove this proforma into your balance sheet and cashflow statement that you already created. Ask yourself, is this property going to provide a step toward my goal? Note: If your goal is freedom, doing your own maintenance to increase returns does not meet your goal.
5. Location success factors Real estate markets are constantly in flux. National real estate trends might set the overall tone, but it’s all about local conditions. In order to secure long-term rental demand, you need to make sure you’re buying properties near sustainable supports — hospitals, universities, transit hubs, shopping and entertainment. Identify up-and-coming areas. These are areas that are likely to see above market increases in value (net value increases more quickly). Identify areas that are likely to see below-average increases in value. Take a drive, and these areas will become more apparent to you. If you want to go in-depth here, talk to your planning and zoning department. They will be able give you information on commercial and residential growth plan for your city. This information is invaluable when considering where the up and coming areas are.