During part 1 of this series on acquiring a rental property, we discussed the importance of developing a target property type. It is possible to remain open to buying any “good deal”, but much more efficient to zone in on a single property class and then set selection criteria within that class. For the purposes of this discussion we are going to assume you’ve decided to search for single family homes within 30 minutes of your current residence with a brick exterior, concrete foundation and preferably 3 bedrooms and 2 baths.
You call up your friendly real estate agent and ask them to search the MLS for properties that meet your selected criteria. You get an email which contains 223 properties for you to review. Wow, now what? You could limit your search criteria further. Perhaps you could limit this set of houses by using a price range, square footage limitations, school district, etc. Once you get a list of properties that seems manageable, you’ll need a quick reference point in order to know if the house will make money or lose money as a rental.
The first metric I employ is the 1% rule. In order for this tool to work, you’ll need a good grasp of the rental market in your chose area. The monthly rent should be at least 1% of the sales price for the property to make a decent return. So a house you buy for $100,000 must rent for at least $1,000/month or you can move on to the next deal. This is a quick and easy way to screen properties. Keep in mind it is only a screening tool, there are multiple other steps you’ll need to take once you get a list of properties that meet this initial criteria.
Let’s discuss a few issues with this rule. The price you use for the house needs to be the “rent ready” price. If you need to spend $20,000 before a tenant can occupy the property, that will need to be added to the purchase price. So now the $100,000 house is a $120,000 house. At a rent payment of $1,000/month, you will not make money. Be sure you know the rent ready price of the property also called the “after repair value” (ARV). Other issues to keep in mind would be any expenses that will be higher than typical, such as property taxes. Some areas have higher property taxes than others. Home Owner’s Association (HOA) dues would be another expense not all properties have. Remember the 1% rule is simply a screening tool that helps you know whether to spend more time crunching the numbers on a potential purchase. I hope this helps give you some ideas on financial screening of rental properties. We’ll focus on the next step, due diligence, with Part 3 of this series.