Must Knows when Buying an Investment Property
Buying an investment property
(Jeff) In this video we will be talking about Almost everything you need to know when it comes to Buying an Investment Property. And in the end, I am going to give a personal example as to my advice on when to buy an investment property and what to think of it as.
(Jeff) Hey, it’s Jeff Chubb I am a retired investment banker turned real estate agent that has sold more then a 1,000 homes and am here with (Sammy) and I am Sammy Illiopoulos, I am one of the top 300 loan officers in the United States and work with Guaranteed Rate.
(Jeff) So, Sammy, what are some of the best reasons why people purchase investment properties?
(Sammy) The big three of investments are stocks, bonds and real estate. Stocks and bonds are a lot more of a mindless investment than real estate, however Real Estate offers an investor more with passive income, builds equity over time and can be a major write off.
(Jeff) When initially thinking about making an investment, I think there are 4 things to consider. You need to consider what type of tenant you are looking for, what type of involvement you are looking to have, what type of property you are looking for and whether you are looking for a large monthly return or if you are looking for a large asset value increase return.
(Sammy) Alright, so I know the other two, but you are going to have to unpack ‘type of tenant’ for me.
(Jeff) Sure. Maybe the type of tenant you are looking for are college students. My family’s investment company specifically looked for Section 8 tenants as the rent premiums were higher and it was a guaranteed check each month. Maybe you are looking for short term tenants like an airbnb or a vacation property. These different types of targeted tenancy would ultimately affect which type of investment property you are looking for.
(Sammy) That makes sense. And I think this type of involvement is a really important one. I see people all the time wanting to buy an investment property thinking they are just going to sit back and collect a check… And don’t get me wrong, you can do this, but you need to pay a property management company to manage the property if this is what you are wanting. And if that is the case, then know it will cost you a pretty penny each month.
(Jeff) 100%. Property management companies are great… But they are going to cost you. Which leads us to the type of property. Are you looking for a Single Family Home, a Multi-Family home or a condo? The interesting thing about a condo is that if you are looking for a passive , don’t do much investment, then you may be able to get away with no property management company if you are buying a condo with a professional management company.
(Jeff) Then there is whether you are looking for a high monthly return or a high asset return. Talk to me about that Sammy.
(Sammy) Yes, it’s hard to have both… At least in the short term. Because each type means that you are looking for a different type of investment property. Maybe it's a big asset return by investing in an up and coming area or investing in areas that provide for a very high monthly rental return.
(Jeff) Ya, there really is no wrong answer here. It’s just your answer. It’s what works best for your risk and return profile. I will say that generally they say, the older you are… Then the less risky the investments should be.
(Sammy) Alright, so let's talk about why people actually do this… They do it for the returns! But there are some things to think about when it comes to investment property returns. My list goes which area and Cap Rate you are looking in, how beds drive the rental premiums, work that you can do to create equity and increase your monthly returns and what to expect for a return right out the gate when you buy the property.
(Jeff) You are the finance guy, I think you are the one that should talk about Cap Rates and how the area you buy in drives those cap rates. First, I think you should explain what a Cap Rate is?
(Sammy) Cap Rate stands for Capitalization Rate. It is used to estimate the investor’s potential return on their investment in the real estate market. The Cap Rate is calculated by dividing the net income by asset value.
(Jeff) Okay, so that is what is. How is it used and how are different areas factored in?
(Sammy) Ultimately the higher the cap rate, the higher the return and the more risky the investment. So as an example, the cap rate for a property in the Back Bay will most likely be lower than the Cap Rate in Allston.
(Jeff) That makes sense. The more risky the investment, then the higher operating return that is demanded by the investor to compensate for that risk. So an investment in Brockton will ultimately lead to a higher operating return then an investment in the Back Bay.
(Sammy) So explain why someone might choose an investment in the Back Bay over Brockton then.
(Jeff) It would be because it is considered a more safe investment. Let’s turn back to 2008. The great market correction. The Back Bay was one of the best performing areas with a very small dip in values that bounced back very quickly. Compared to Brockton who saw values fall by more than half.
(Jeff) So Sammy, talk to me about how bedrooms work into an investment properties return.
(Sammy) Beds are one of the main drivers of revenue. So let's say you were looking at two investment properties in the same area. Both are about 1,000 square feet, but one is a 1 bedroom and the other is a 2 bedroom and the 1 bedroom is on the market for $490,000 and the 2 bedroom is on the market for $500,000. Speaking in generalities, the 2 bedroom is going to drive a higher monthly rent rate and therefore may actually be the better investment… Even though the 1 bedroom is $10,000 less expensive.
(Jeff) And I know from an appraisal issue which you have to deal with a lot… They are looking at the bedroom counts very closely when estimating rental rolls in order to get financing.
(Jeff) Let’s talk about equity. Because people buy these things to not only make money monthly, but also to make money on the asset value. So there are two ways to make equity. Make the market appreciation and to make equity off of improvements.
(Sammy) When you talk about market appreciation, that means you and your neighbors will essentially appreciate at whatever the market is. And to say it another way is that you are 100% receptacle to whatever the market does.
(Jeff) Then there is improvement appreciation. It’s important to know which improvements provide you a positive return. For example, updating a furnace will not provide any real gain in appreciation. But putting in a new Kitchen or Bath will provide you a return over and above your investment… Provided you stay within bounds.
(Sammy) What do you mean by stay within bounds
(Jeff) You don’t want to overspend for the type of property it is. Think of it this way… You wouldn’t want to put Marble Counters in a $300,000 investment property. For two reasons. The first is that it is an over improvement. The second is that marble is a soft stone that needs extra care and most likely would get destroyed with tenants.
(Sammy) That makes sense.
(Jeff) So let's talk about expected returns when you buy a property.
(Sammy) If you are using debt to buy the property in our metro market, then I feel that in the beginning, if you are breaking even each month.. Then you are winning.
(Jeff) Breaking even?
(Sammy) Yes, if you have gotten fixed financing then the biggest part of your expenses are locked. But with rental hike increases each year, the property in the long term will become a cash cow of an investment.
(Jeff) You know… I can’t agree with you more. I have a 2-family in East Boston. This was my first property. I lived in one unit and rented out the other at first, but then moved in with my now wife and rented out my personal unit as well. I remember at the time making something like $500 a month and being pumped. But fast forward 10 years later and we make something like $1,500 a month.
(Jeff) I don’t regret much.,, But boy do I regret not doing anything I can to buy more back in 2008/2009. That investment has become a grand slam.
(Jeff) Let’s flip the script for a second. What are some things for potential investors to be cautious of?
(Sammy) Well I think the most obvious is the prospect for a bad tenant. I wish I could guarantee every client who is buying an investment property that all will go well and there won’t be any issues, but that is not real life.
(Jeff) Ya, this is a serious issue and why banks require buyers to have reserves, no?
(Sammy) Exactly. Imagine you have a property and the tenant stopped paying. You aren’t able to just get that tenant out and re-rent the property. It takes time… And in states like Massachusetts, it takes a lot of time. You have to go through the entire eviction process. It could take 4 to 6 months before you have gone through the courts and gotten an eviction order.
(Jeff) Yes, that one has always scared me. That is why I am willing to accept my below market rents. I am bad at increasing rents because I know I have good tenants that are low maintenance and pay their rent. That is a trade that I am always happy to make.
(Jeff) So to go along with bad tenants, then we probably should take a second and talk about the friendly tenant laws.
(Sammy) Yes, the state of Massachusetts is very tenant friendly. They are almost always given the benefit of the doubt and a more favorable timeline when it comes to evictions.
(Jeff) Ya, when it comes to trying to get rid of a tenant, you need to cross your t’s and dot your i’s, because if you miss one thing… You are starting right back at the beginning.
(Sammy) Why don’t you talk about how not all improvements will pay you back.
(Jeff) Absolutely, I was giving the marble counters example earlier, but when you own an investment property, then you need to have a different mindset. You want to be smart with the improvements you make. Stick with Kitchens, Baths, Flooring and paint. Getting into structural changes or an addition is a losing proposition. Another example that I just thought of would be windows. That increases the energy efficiency of the house, but a tenant won’t pay you more for the property.
(Sammy) Alright, so you mentioned you wanted to talk about a personal example that could be some great advice.
(Jeff) Yes, the first property that I purchased was a 2 family. I put 3.5% down when buying the house.
(Jeff) I still own this house today. When I bought it, I told myself that this would be my kids' college education and that when they went to college, then I would sell it.
Almost some great advice. Over the years that has changed from selling it and now I would just refinance it. Ultimately, my kids will sell that property when I die someday.
My rent roll continues to grow and provides a nice bonus check to the family each month. My wife and I have never been worried or saved a dime for a 529 as it is all taken care of.
I have an exceptional investment property all for 3.5% down.
(Sammy) So what are you going to do when kid #3 comes along?
(Jeff) I figure this one multi-family can send two of my kids to college, but probably not the third. My wife and I will be looking to buy another investment property in the next 12 months. That will be kids #3 college education. If it breaks even on day 1, then that is a win. It will start positively cash flowing as the years go on. The tenants will pay down the mortgage and the property will increase in value over the long run.
(Sammy) I love it. Well I think we did it! That is what you need to know when it comes to buying an investment property.
(Sammy) If you are thinking about making a move in Massachusetts, then be sure to reach out to this guy (pointing to Jeff). He is one of the top agents in the state and will take great care of you. I can’t begin to tell you how much experience matters and finding a quality agent will make the difference between a good experience and a miserable one.
(Jeff) And if you are buying a home in MA or really anywhere in the country, then Sammy can help you! He works for the #2 lender in the country and is one of their top 10 brokers in the company. I have worked with a lot of mortgage brokers in the past… I say this, not because he is standing next to me… But he is the best in the business. You won’t regret reaching out to Sammy.
(Jeff) Our contact info is below, so let us know if you have any questions and until next time!