Buying Investment Real Estate: Knowing When the Price is Right

“You have to have confidence in your ability, and then be tough enough to follow through.” – Rosalynn Carter

To scout for potentially profitable real-estate deals, begin by looking at the actual sales prices in the neighborhood you’re targeting. Your local tax assessor’s office should have this information, and it’s usually available online. Once you get the info, it simply becomes a matter of organizing and making sense of it. Here’s how to do that …

Make a list of a dozen recently sold properties, along with the square footage and selling price of each. By dividing square footage into the sale price, you come up with a price per square foot for each home. You then average those to come up with an average square foot price for the neighborhood. This immediately gives you a benchmark.  The first step to judge a deal is to see if your mortgage payments on a property — plus taxes, insurance, and maintenance — are more than covered by the rental value of the property. If that’s the case, given the average sales price per square foot in your neighborhood, there should be many potentially profitable properties to choose from.

To get an extra-sweet deal, try to buy 10% below the benchmark number in a normal, gradually rising market. And try to buy at least 5% below the benchmark number in a fast-rising market (assuming the rental yield is right).

If you’re in a market that’s soaring, however, it may be next to impossible to buy at 10% below the average sales price. In that case, a 5% discount may be a more reasonable goal. And if your market’s moving so fast that you find it difficult to buy even at the average sales price (since the average is constantly moving up at a rapid clip), that may be a sign of a bubble brewing. In that case, it will be all the more important to make sure you don’t buy a bubble property but instead have a large margin of safety in the form of a big rental yield.

In all cases, you want to be very thorough and careful when you put your money down on a house. But you want to be extra careful when prices are soaring. You don’t want to chase a fad or try to get in on the “easy money” by paying the latest price just because you’re convinced prices will continue to soar. To use two metaphors that are particularly appropriate for real estate: You’ve got to keep it real and keep your feet on the ground.

With residential real estate, rental values depend mostly on location, number of bedrooms, and size. And when you’re looking at properties that are all in the same general area, these numbers should give you a good yardstick you can use to quickly estimate the rent you might receive on any property you buy in that neighborhood.

All other factors being equal, a 1,250-square-foot, 2-bedroom house will get a higher rent than a 1,000-square-foot, 2-bedroom house. But it’s not likely to be 25% higher just because the square footage is 25% higher. It might only be 5% or 10% more. Similarly, a 3-bedroom house is not likely to get 50% more rent than an otherwise-identical 2-bedroom house. Even though there are 50% more bedrooms, the rental value may only be 20% more.

By analyzing a dozen properties for rent in your neighborhood, you’ll quickly develop a sense for what any given property could rent for. And if the property you’re looking to buy currently has tenants, your task is easier. There’s an established rental value on the property — the amount the tenants are currently paying.

Once you’ve figured the monthly rental value of your target property, multiply that number by 12. That would be your gross annual rental income. Divide that number by the asking price, and voila! You have the gross yield you’d get if you were to pay the asking price.

Now, you’re going to use yield to figure out the maximum price you’d be willing to pay. I suggest you shoot for a minimum gross yield of 12%. Get that, and you should be able to realize a net yield (net rent after mortgage, taxes, insurance, vacancy, maintenance, and all costs) of 6% to 9%, depending on the property’s condition and whether or not you manage it yourself.

To figure how much you’d pay to end up with a particular gross yield, simply divide the annual rental income by that yield. So, let’s say you’re looking at a house with a $1,200 monthly rental value. That’s the same as an annual rental value of $14,400. So, if you want a 12% yield as a minimum, you can pay no more than $120,000 for that property ($14,400/0.12 = $120,000).

It’s that simple.

To sum up, there are two principal reasons that having the right rental income is so important. First, it can add substantially to your total profits. Second, it gives you the all-important margin of safety. If you have to hold onto the property longer than you had planned, for whatever reason, you won’t be hemorrhaging big bucks in the meantime. Instead, you’ll be making a steady income that will grow over time.

And here’s another huge bonus when you get the rental yield right: You don’t waste time having real-estate agents drag you through properties that aren’t close to being a deal! That in itself can be worth a small fortune to you in time saved.$

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