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3 Must-Have Considerations Before Purchasing Your First Rental Property

by Tom Sylvester on May 12, 2014 · 14 comments

  
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I was at a local real estate meeting this past week.

After the meeting, a local investor working to get his first deal approached me for some insight and advice, wanting a second opinion.

There are a lot of things that go into analyzing a potential deal and after that encounter this past week, I wanted to share the advice and insight I gave that investor, with you, the BiggerPockets community.

1. It Starts With The Location

The overused but often so-true phrase in real estate is “Location, Location, Location”!

Location is not the only aspect, but especially when you’re purchasing a property that you plan to hold onto long term, it being in the right location is very important.

Not only does the location have to financially make sense, it also has to attract the right type of tenants.

There are a lot of factors that play into what location is right for you and your business.  One strategy that I really like is creating an avatar/persona for your target tenant.

Defining your tenant avatar will help you determine things like location and funds needed for your business.

“My ideal tenant is a young professional between the ages of 21-35.  They have a college education and prefer modern and trendy design.  They typically want to have laundry on site and prefer open floorplans.”

Once you have your avatar, it will now allow you to make decisions on things like location, type of house, what upgrades to make and where to advertise.

Note: This avatar is used to help you understand your potential tenants and to make better property/business decisions.

It is not to say that this is the only tenant that you will ever rent to and you cannot legally discriminate against potential tenants in protected classes.

Related: Does Your Location Foster Long Term Tenants?

2. Numbers Do Matter

Once you find your location and begin evaluating potential deals, it is very important to understand the numbers involved.  There are 2 parts to the numbers.

1. Getting The Right Numbers
There are a lot of ways to evaluate a property to determine if it is a good deal or not.  In order to use some of the calculation, you first need to make sure that you ask for the right information.

Understanding what formulas/calculations you want to use will help you determine what information you need.  Some examples include taxes, utility bills (if you will be responsible for them), current rents (and market rents) and vacancy rates.

2. Verifying the Numbers
The seller of a property may provide you with several or all of these numbers.  It is essential that you verify each number that the seller provides you.

By doing so, you make sure that the sellers numbers are indeed accurate.  Some sellers may just have outdated or incorrect numbers while others might just be trying to make the property look better than it is.

3. But Numbers Aren’t Everything

A property can appear great on a spreadsheet but there are many other factors that can either enhance or detract from the value of a property.

Below are a few of the key ones to look out for:

1. Get Copies of All Current Leases

When you purchase a property, you will inherit the tenant and whatever leases that they have in place and you’ll have to honor those prior agreements.  I know landlords who have purchased a property where rents were well below market value.

2. Beware of Deferred Maintenance

Looking at the “as-is” numbers, everything may look good but if there is deferred maintenance (ex. roof needs to be replaced), those renovation costs can quickly turn what appears to be a good deal into a bad deal.

Even if the deferred maintenance is made up of a bunch of small items, it could very easily end up developing into a deal breaker, so be careful!

Related: Deferred Maintenance – A Silent Cash Flow Killer

3. Are the Utilities Split?

If you are purchasing a multi-unit property and the utilities are not split, that  more than likely means that the owner is paying for utilities.  This means that your monthly expenses will be higher (and variable based on tenant use).

It is almost always better to have separate utilities and have the tenants pay them.

4. Can Rents Be Increased?

A great way to benefit from purchased a property’s cashflow is by increasing the rents, but that only works in some situations.  Rents need to be below market value and/or you may need to do some renovations to be able to increase the rents.

Also, rents can only be increased if you are not inheriting a lease/contract between the tenant and the previous owner.

5. Property Management

Either you will hire a property management company, or you will manage the property yourself.  Either way, it costs money.

Even if you do it yourself, you do not work for free.  The current owner may be managing the property themselves and thus might not be showing that cost.

Whether you will manage the property yourself or hire a property manager, it is important to include that expense in your calculation.

Conclusion

There is likely to be other criteria that you may want to consider when purchasing your first investment property beyond just the numbers on paper.  Some of the key items are listed above, although it is not a comprehensive list.

Is there any other criteria that you use or that you would recommend for someone who is looking to purchase their first rental property?

Be sure to share your thoughts in the comments below!

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{ 14 comments… read them below or add one }

Jeff Collins May 12, 2014 at 11:11 am

Hey Tom,
I am a newbie so this is a newbie question. If you are managing the property yourself, how would you count that as an expense?

Reply

Tom Sylvester May 13, 2014 at 4:55 am

Jeff – In the above example, I was talking about including the cost of property management as part of the purchase evaluation/calculation, not necessary the accounting aspects of it. If you always include property management expenses in your calculation, you do a few things. 1. Every deal is calculated the same with the same expenses, whether you actually use a PM or not. 2. If you begin managing yourself and eventually decide to outsource to a PM, you have already accounted for that expense.

Reply

Mika May 12, 2014 at 11:38 am

Ah, deferred maintenance… that’s been a PITA for me in many of occasion. I personally just expect that it will need everything unless it has been documented as repaired or replaced previously. I would also ask for proof – receipts, invoices, etc. Any records you can get will be helpful in understanding where it stands in that respect.

Looking at the lease very carefully is also a good idea. Some leases allow for outs based on the sale of a property, so you may be able to execute that. The tenants may have an out clause also. Research the tenants who are in there too.

@Jeff

My accountant has always just deducted actual management expenses, mileage, etc. I don’t believe my time would have been deductible in most scenarios but on the other side, you’re not paying a management company and reducing your profit (or increasing your loss) so there can be some benefit depending what you’re trying to accomplish.

Reply

Tom Sylvester May 13, 2014 at 4:57 am

Mika – Great added tips! I like looking at the lease carefully. Not only the dates, but what the landlord has agreed to and what the tenant has agreed to.

Reply

Eric May 12, 2014 at 2:20 pm

All great points. Always use actual numbers if they are available, but assume that expense are a minimum of 50% otherwise, plus the payment.

Find out what an expected return should be, based upon the target neighborhood. A Class D neighborhood demands a higher return that a Class B.

Location has nothing to do with geographic location. It has to do with the income levels of the people that live in the neighborhood. A low income neighborhood will never attract high-income people, unless you give up on rent.

Do not forget vacancy, and add at least 10% of the rents for maintenance. Plus any deferred maintenance. Often, people mistake deferred maintenance for profit.

Reply

Tom Sylvester May 13, 2014 at 4:58 am

Eric – Thanks for the addition, all great points! I typically start my evaluations with the 50% rule to initially get a purchase price or filter out properties. Then before we close I get all the actual numbers and make sure the deal still makes sense.

Reply

Arthur Banks May 12, 2014 at 4:20 pm

May I add: Get Copies of All Current Leases AND verify the current tenant actually signed the lease. On my first purchase, the owner gave me what I was told, were newly signed lease renewals. Turns out after I purchased the property both tenants did not renew and were actually moving out. I wondered why the seller was in such a hurry to sell. Lesson learned.

Reply

Tom Sylvester May 13, 2014 at 4:59 am

Wow Arthur, I have never heard of that one. Seems like a case of fraud. Did you ever pursue it after the sale?

Reply

Arthur Banks May 13, 2014 at 4:23 pm

I didn’t. I should have.

Reply

Sharon Tzib May 13, 2014 at 7:16 am

This is why Estoppel agreements are so important before close of escrow – this kind of thing happens way more than people think. These can also be used to verify agreed to rents, deposits, what utilities are included, if they have a pet/deposit, and if they own any of the appliances. Having the tenant commit to things before COE gives you the upper hand later.

Reply

Hannah Ash May 13, 2014 at 1:04 am

Interesting, Thanks!

Reply

Tom Sylvester May 13, 2014 at 5:03 am

You are welcome Hannah.

Reply

Sharon Tzib May 13, 2014 at 7:19 am

All great tips, Tom. I see a lot of investors failing to include maintenance/capex when they are buying a rehabbed property, or including too little, as if by some virtue of the rehab all of these expenses will magically stop. It’s also important to look at the level of rehab as well. If it was simply a “lipstick” job, your major structural and mechanical components (roof, furnace, a/c, etc) will eventually need to be replaced, so you need to budget for them. Great advice here!

Reply

Tom Sylvester May 15, 2014 at 4:39 am

Very good points Sharon. Thanks for adding to the list of items to consider.

Reply

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