Many investors find rental income property a good way to build wealth. As an investor, it is essential to have income producing properties as part of your portfolio. The idea of owning real estate is gaining popularity as investors tire of the stock market’s volatility. However, not everyone has what it takes to be a landlord. Correctly investing in rental income properties requires an effort to acquire knowledge which is crucial to your success. Don’t be completely dependent on so-called “experts” to make decisions for you. Remember, it’s your money, not theirs. Timing is a critical component because buying in an overheated market will require a bigger potential annual return to make up for that risk. You should also have a good idea regarding how long you plan to own a rental property. The longer you plan to own the property, the more you’ll probably need to invest in maintenance, repairs and improvements. A 20 year old property will require more money to maintain then a 5 year old property. Avoiding the expense of any major improvements will naturally result in a better investment.
Lenders and their requirements
During the last 25 years as a mortgage banker, my career has evolved around lending, underwriting and approving loans to potential clients. Lenders look at any loan as an investment and the stability of that investment and the applicant seeking financing to is part of that approval. Potential investors should understand what and how lenders look at applicants and what it means. The better your credit rating, the better the chance of having your loan approved. This translates into the less credit card and other consumer debt you have, the better your prospects for getting a decent loan. Lenders also look at the down payment towards the purchase. A bigger down payment is an indication of strength as a borrower and that is important. Lenders look favorably on a large down payment because they see you as an investor that has the resources and ability to save by properly and efficiently managing your finances since the default ratio on investment property tends to be higher. The amount of cash reserve left over after buying a property is as important as the initial down payment. Lenders need to approve the borrower as well as the investment property. Know that the property will be thoroughly scrutinized before approval is given. It is extremely important to understand the Debt Coverage Ratio (DCR). It is also known as (DSCR). Debt Service Cover Ratio is a widely used benchmark which measures an the income producing property’s ability to cover the monthly mortgage payments. A debt coverage ratio of 1 to 1 or 1.0 indicates that the income generated by a property is insufficient to cover the mortgage payments and operating expenses. A DCR of.95 indicates of a negative income. A property with a DCR of 1.25 generates 1.25 times as much annual income. Let’s use the DCR of 1.25 as an example. The property creates 25% more net operating income (NOI) than is required to cover the annual debt service. It is imperative to get a good interest rate as the interest rate has a direct impact on the DCR. Verify the current interest rate given by your local lender on a similar property prior to your purchase. Start asking you lender what they prefer to lend on in terms of the DCR and down payment. This step will alleviate most of your problems early in the process and allow you to present the proper offer to meet your lender’s requirement.
Overpaying
Keep in mind that profit is made when you purchase the property, not when you sell it. It is important to spend some time researching the property and the area in which you are interested in buying. The rental real estate market is generally tougher on investors who overpay for an income producing property. This is not an emotional purchase. Successful investors look strictly at the numbers to see if their investments will pay off. If you pay too much for a rental property, don’t count on getting bailed out by another fool. Some investors tend to use a single formula to analyze their purchase such as a gross multiplier (GM), Net Multiplier (NM) or cap rate (CR). Others try to estimate what the property could be worth after needed repairs and upgrades. All that is fine but it is really not enough. The truly successful investor examines all of these factors and more in order to make a correct calculation. A comprehensive assessment achieves the desired result: a clear picture of your investment. The good news is that it’s never been easier to do just that. Such products are available to help with the analysis, Smart Property Analysis (SPA) provides a comprehensive system to analyze investment property.
Expense
Analyzing the expense of any income property is tedious and can be an inaccurate presentation. The national average operating expense in the US is approximately 40 to 45% plus or minus 2% which includes management fees, vacancy rate of 3 to 5%, operating expense, maintenance, property taxes, legal fees and so on. It is important to verify the information before you commit to the purchase of the property and all offers should be subject to proper verification and validation of the income and expense statement. If not properly verified, false information will skew the numbers and result in an incorrect analysis of the property. You also should know how repairs and improvements are treated for tax purposes. Understand that some improvements can also mean an addition to the amount you paid for the property to determine your tax basis when selling. The higher the basis, the lower your taxable profit. Any property income-expense statements prepared by the seller that typically show operating expense of around 30% or less is called the “Liar’s Statement”. An income property’s expense usually runs at 40% to 45% depending upon the age of the property. Many property buyers tend to ignore or overlook expenses such as vacancy, collection loss, managing the property (time that it takes you to manage the property has to have a value attached to it of about 6%), eviction fees, attorney cost replacement of capital such as ( water heaters, repairs, roofs), and other non common expenses. Utilize 40% to 45% as the percentage to use for calculating operating expenses, regardless of what the seller gives. Another option is to employ the percentage used by lenders in your area since it will probably be more accurate than the figures issued by the seller.
