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Posted about 7 years ago

7 Things to Consider When Purchasing a Cash Flowing Investment

If you're considering a real estate investment purely for cash flow, pay attention to these seven important factors before deciding if you've found the right property:

#1. Market Growth and Appreciation

Look for markets with high population growth. Population growth drives up the price of real estate in any market. The reason is simple: high demand usually equals low inventory. Look at the rate of job growth in the cities where you may invest. Find out if any large companies are moving into your market. New companies mean an abundance of jobs and an increase in demand for housing. When a market is experiencing job growth due to migration of companies and employees, it may take a while for the market to balance out the demand for housing inventory. As an investor, market growth due to job growth is the perfect recipe for a winning investment.

#2. Cash Flow

This article is all about cash flow, but it’s important to consider what cash flow really means to you before investing in a “cash flowing” property. Let’s start with the “paper yield.” A paper yield is something that looks profitable on paper, but is usually based on a high risk, high reward scenario. Lower-grade properties in distressed neighborhoods typically offer a higher potential return on investment, but these properties do not always perform as expected. The tenant quality is usually lower, resulting in higher vacancy rates and turnovers. Also, these properties have less room for capital growth and appreciation. Distressed properties as described above are generally found in and around the major inner cities across the United States.

Higher-grade properties in good neighborhoods may provide a smaller return, but they are a consistently safer asset to own. These properties are typically located in suburban areas of large cities. They produce a higher quality tenant and tend to show higher appreciation and capital growth. Although the higher-grade properties may not provide big cash flow numbers, they are considered a more “passive investment” because of how they consistently perform.

#3. Tenant Profile

As mentioned above, lower-grade properties tend to attract less reliable tenants, and higher-grade properties attract more reliable tenants. When you are purchasing an income producing property, you are also purchasing the type of tenant this property will attract. Not only are you assuming more risk of things like break-ins and theft when you purchase a home in a distressed neighborhood, you also increase your risk based on the type of tenant that will occupy the home. It is more common for a tenant in a lower-class neighborhood to go delinquent on rent payments, move out without notice, and damage the property. One bad tenant can erase an entire year of cash flow due to missed rent payments, unwanted vacancy, and tenant induced damage. Investors MUST take the tenant into consideration when investing in a cash flowing managed asset.

#4. Vacancy

Vacancy is a factor that should always be considered when calculating your return on investment. With lower-grade assets, make sure to account for a larger portion of net income to vacancy. Research shows that properties in more distressed markets produce a higher rate of vacancy. High rates of vacancy are due to many factors, not the least of which has to do with the type of tenant attracted to a lower-grade property. In most cases, these tenants are section 8, which means they receive government assistance for low-income housing. When tenants don’t pay their own money to live in the home and have no financial liability associated with the property (such as a security deposit), they are more likely to vacate the property without notice. Statistics show that tenants who rent lower-grade properties in more distressed markets only occupy the property for an average of 6–12 months. Reasons for short occupancy include eviction resulting from non-payment of rent or breaking lease guidelines. High turnover rates can cause a lot of headaches for investors. Each time you turn over a property, it costs money in repairs and leasing fees.

On the flip side, properties located in more stable areas rent for higher prices and produce more reliable tenants. Generally, these tenants have higher paying jobs and bring in a larger household income. In most cases, these types of tenants take better care of the property because they are concerned with getting their security deposit back. These generalized statements about tenants and neighborhoods aren’t always true, but there is merit to mitigating risk by investing in higher-grade properties with lower vacancy rates.

#5. Rehab Quality and Maintenance

When considering a potential cash flowing investment, make sure the property has gone through a quality renovation and been inspected by a 3rd party company. A property that has undergone a total renovation and passed a 3rd party inspection should cost much less in maintenance and upkeep (especially in your first year of ownership). Pay attention to the estimated life left on the roof and all mechanical equipment (A/C, furnace & hot water tank). Avoid purchasing a home with a roof that has less than five years of life remaining. Ideally, you want your roof and mechanical equipment to have at least 5-10 years of life left. I have found that these numbers are a good benchmark to help avoid costly repairs in the future.

#6. Property Management

Property management is arguably the most important factor in maintaining a high-performing, long-term investment. As an investor, you should consider your property manager as your eyes and ears on the ground. A good property manager watches over your investment like it is their own. When deciding on a property manager, it is best to interview at least three different companies before making a final decision. I have seen many investments fail due to poor management.

When searching for a property manager, look out for these 5 key things:

  1. How many homes do they manage?
  2. How many property managers do they employ, and how many homes are allocated to each property manager? I have found that the best number is approximately 200-250 homes per property manager. If a property manager is responsible for too many homes, there is a higher likelihood that each property, tenant, and owner is not receiving the necessary attention they deserve.
  3. What type of infrastructure does the property management company have in place? I always recommend a company that has departments to manage each aspect of the business (i.e., leasing, marketing, maintenance, utilities, customer service, insurance) to make sure all aspects of your investment are properly managed.
  4. What type of properties do they manage? Many property management companies specialize in a specific type of property (i.e., single family, multi-family, commercial). Some companies will only manage properties that rent for a specific amount. Ask the property management company for a description of their average property. Make sure they manage properties that match your investment.
  5. Does the company have an online system to manage their properties? We all want information fast. We like to track our packages to see when they arrive, we like check our bank balance from our phones, so why shouldn’t we keep track of our real estate investments online as well. Most of the property management companies I have worked with over the years have an online portal for their owners and tenants. This portal is a place where owners can track rental payments and maintenance requests, and tenants can submit maintenance requests and pay rent. Property management software helps to keep everyone on the same page, from the owner to the tenant and the property manager.

#7. Exit Strategy

When investing in any asset, especially real estate, it’s important to have an exit strategy in place from the very beginning. So, how do you create your investment strategy? Ask yourself, what are you trying to get out of this investment? Are you looking for long-term cash flow by building a portfolio of properties? Or, are you seeking a short-term investment in an appreciating market where you can cash in on the capital gains? Whatever your investment strategy is, you need to have a plan to exit at the right time. If you plan ahead, you will be well on your way to a cash flowing real estate investment.



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