Properly evaluating a real estate investment opportunity can sometimes be a tricky endeavor. There are many factors that can come into play, and it can be hard to focus in on the things that really matter. While I don’t propose to have a magical formula for finding great real estate investments, I do have over 15 years of experience investing in real estate, and have bought and sold hundreds of homes. Along the way, I’ve learned a thing or two about what makes a good investment, and a bad one. In this article, I plan to share some of these things I’ve learned with you. (My investing expertise is with rental homes in particular, so for the purposes of this article, I will focus in on that specific type of real estate investment.)
Look Beyond Yields
One of the biggest mistakes a real estate investor can make is to get so enamored with the yield a property appears to be netting, that they forget to look at all the other factors. Sure, high yields are great – that means they property is making more money. But, typically there is a reason why the yield is so high. After all, if the property was raking in a ton of cash for the owner, why sell it? If you look deeper, you can generally find out why. Some common reasons you might encounter are:
- The neighborhood is on the decline (think “Rust Belt”). There are a lot of negatives that come with this scenario, but the biggest ones to keep in mind are falling home and rental values. As people leave these neighborhoods, things get worse before they get better. People no longer want to live there, and finding tenants or buyers for the property can become nearly impossible. One number that can give you an idea of where a neighborhood is going is the proportion of rental homes to owner occupied homes. As the rate of rental homes in an area increases, typically this signals the area is on the decline. There is good reason why many lenders won’t lend in communities that exceed certain rental to owner occupant thresholds.
- The property is in disrepair. This one you can typically spot with a good home inspection, but not always. While legally the home owner is required to disclose any known defects with the house, that doesn’t always happen. If the home is a known fixer upper, just make sure you are prepared for what that means. If you are planning to rent out the home in its current state, make sure you fully understand the laws in your state. Typically landlords are required to maintain the home a “safe and livable condition”. Keeping a property in less than excellent move-in ready condition is also asking for poor quality tenants, and the various issues they can create. If you aren’t sure what exactly that means in your state, find out before you move forward on the deal. In addition, make sure to factor in that the home will most likely be vacant while you make the necessary repairs.
- The rental market is saturated. If an area has become, or will soon be, saturated with an abundance of rental properties, you can rest assured that rental rates will fall. The more options potential tenants have, the less they are going to be willing to pay - the law of supply and demand. Make sure to do your homework on this one. Before purchasing a rental property in a certain area, make sure you fully understand the supply coming on market, along with how many new tenants are coming into the area. If the supply outweighs the demand, make sure you take into account that rents will likely fall. Ideally you want to find an area that is exactly the opposite. Demand is increasing, but supply is flat or shrinking. I specifically look for this trait in areas I invest.
Yields can tell investors part of the story when it comes to evaluating real estate opportunities, but don’t get caught up solely in this one number. It is great if the property is cash flowing now, but make sure it is still going to be cash flowing a year down the road.
Speaking of looking down the road, properly evaluating a potential real estate investment opportunity must include planning your exit strategy. An exit strategy can be anything from holding the property and eventually passing it on to your children, to remodeling and selling it when the market rebounds in two years. There are lots of ways you can plan to exit a real estate investment, but the important thing is thinking them through at the beginning. If you choose to purchase a home in a neighborhood consisting mainly of renters, don’t expect to be able to sell it to an owner occupant down the road. Make sure you plan realistic exit strategies.
If there is one thing I can share from experience, is that investments don’t always go as planned. For this reason, I always make sure I have two realistic exit strategies before I move forward on a property. If for some reason Plan A doesn’t work out, I need to have a Plan B, and maybe even a Plan C. If you don’t think these through now, you are asking for trouble later on.
Investing in real estate can be an extremely rewarding experience, or it can be a dreadful one. Properly evaluating a potential real estate investment opportunity from the start will undoubtedly increase your odds for success. Don’t focus in on one factor – like yields – but rather look at the full picture. In addition, remember to plan out multiple exit strategies. Hopefully you only need Plan A, but if that doesn’t work out – which unfortunately tends to happen a lot – you’ll be glad you have another plan to fall back on.