A while back, Zillow contacted me to see if they could write a guest article for Retire By 40. At the time, I was searching for a new rental property and I used Zillow almost every day. I also own Zillow stocks so you can see that I’m a big fan of the company. Anyway, I asked Tali to write an article about finding rental properties in an expensive market, so here it is. I hope this is helpful to new investors who are looking for an investment property.
How to Find a Rental Property in an Expensive Market
By Tali Wee of Zillow
Many financially-minded individuals hope to invest in rental properties for long-term passive income. Although rental income can provide consistent passive income, investing in real estate can be risky. As the housing bubble has shown, investors can lose quite a bit of equity if they buy at the wrong time. First-time rental property investors should keep their day jobs while transitioning to real estate.
Begin by researching healthy markets and establishing realistic rent prices and estimated profits. It’s best to invest enough in the investment properties to generate positive cash flow so investors don’t have to spend their other income to keep the place running.
Compare Market Affordability
Currently, first-time homebuyers are unable to purchase properties because the most affordable inventory is locked in negative equity. Presently, 18.8 percent of U.S. mortgaged homeowners are underwater on their mortgages, making them unable to sell their properties without bringing cash to the closing table. This low inventory paired with expensive national rents, up 2.5 percent in the last year, forces families to rent at high costs.
The market is ideal for landlords, but rental property buyers face high purchase prices in popular areas as well. Median home values along the west coast are steep, including cities such as Portland ($306,300), Seattle ($472,300), Los Angeles ($531,400) and San Francisco ($999,400). Buyers need significant capital to compete with other investors in bidding wars.
Fortunately, these same areas are highly sought after by renters willing to pay for great locations. Portland renters pay $1,521 monthly, and Seattleites pay $2,074. If buyers can purchase rentals in Los Angeles, local renters pay steep rents of $2,392, and $3,667 in San Francisco. Ultimately, buyers should save capital to make smart purchases in areas where tenants are prevalent and rents are high.
Seek Moderate Pricing
Rental property buyers must invest heavily upfront, with the hopes of property appreciation over time and positive cash flow from rents. Though major metros are expensive, property appreciation is highly likely, making long-term investing paramount for profitability. Consider realistic returns by subtracting operating costs ranging from 35 to 45 percent of the total rent income, minus monthly mortgage payments.
For example, a 30-year fixed loan on a $500,000 property with 50 percent down ($250,000) and a 4 percent interest rate would cost about $2,000 monthly, including estimated property taxes and insurance. Imagine this 10 unit rental brought in $3,500 each month. After 35 percent operating expenses ($1,225) the monthly yield is $2,275. Subtract the mortgage payment and the owner yields $275 monthly.
Greater upfront investment equates lower mortgages and higher monthly returns. Without capital to purchase rentals with cash, buyers should either wait to purchase or invest in lower-priced buildings. Avoid prize properties and aim for working-class neighborhoods charging moderate rents for moderate conditions.
Joe> Investors tend to underestimate the operating expense of a rental property, so try to be as accurate as possible when calculating that. It’s fine to assume 35% when you’re searching for a property, but you really need to get the operating cost nailed down before you make an offer.
Budget Operation Expenses
Buyers should plan their property management strategies before purchasing rentals. Some rental property owners with handyman skills prefer to run their entire businesses from lease signing to tenant requests to emergency upgrades. Although this method effectively cuts out the middleman for higher profits, it’s not the best approach for all owners. If on-call management doesn’t suit owners’ lifestyles, they should consider hiring property management companies to run their rental business.
Begin Searching Early
Serious buyers start their rental property searches three to six months before they plan to purchase. The lengthy timeframe allows them to properly research markets and familiarize themselves with current values. Buyers search online for available multi-family properties, visit units and examine comparable sales. Most hire buyer’s agents to access properties and narrow down location, affordability and must-have property features.
Consider Onsite Living
One method of selecting rental properties is for buyers to look for the characteristics they might choose for their own homes. The same amenities that appeal to buyers attract renters, such as close proximity to local parks, groceries and simple commutes. Buyers who purchase rental properties they love and plan to live in are more likely to maintain them and stay committed to their investments. Onsite homeowners understand the experiences of living at the properties, making them more apt to make improvements that enhance tenant experiences. Additionally, buyers who plan to live onsite get the most affordable financing options on mortgages.
Buy Properties in Quality Condition
When buyers compare properties, they should opt for rentals in the best possible conditions. Always invest in a property inspection before closing on a home. If properties require upgrades, buyers should estimate the costs of improvements before purchasing. Negotiate credits from sellers or require fixes prior to purchase. After closing, owners should rapidly complete remaining upgrades to ensure property safety, attract more applicants immediately and avoid countless, costly quick-fixes in the future.
Complete Due Diligence
When purchasing rental properties, buyers should carefully review the profitability of the operations. What are sellers charging for rent? How much are property repairs and insurance fees? Do sellers pay for onsite management? How frequent is tenant turnover? Are properties cash-flow positive? If local properties are charging higher rents, consider raising rents. Watch for property disclosures signifying damages or potential for expensive repairs in the future. Consider marketable factors of each property and weigh against the disadvantages.
Above all, think long-term. Find neighborhoods with histories of expensive rents and high populations. Avoid college towns where tenants commit to one-year leases instead of lengthy stays. Opt for family-friendly communities where renters plan to settle down for years. Even though the real estate market is prime for investors and big cities are secure investment locations, buyers should wait until they’re financially prepared for high purchase prices.
Joe> Thank you, Zillow, for this article. I think 2014 is the sweet spot for buying multiple-unit rentals. The price of single family homes has gone up a lot, but the multi-unit rentals are lagging behind. I saw this when I sold our 4-plex and during our search for a replacement property. If the housing market continues to heat up for the next few years, I’m sure multi-family residences will rise sharply. Or maybe we’ll see another housing market correction. I don’t think that’s likely in the next few years, though.
Are you looking for a rental property? What do you think?