A Proven Formula For Buying Rental Properties

Over years of learning about real estate investing, I’ve come up with my own formula for buying rental properties that produce real cash flow. Here’s what I’ve learned.

The following is a true story but names have been changed in case the parties involved read this!

It’s ten o’clock in the morning and John has just gotten another phone call from the property manager who’s currently trying to fill a vacancy in his duplex. He’s told that the existing tenant is breaking the lease because someone has broken in and stolen the tenant’s tools—for the second time in 12 months.

This property has been nothing but problems since John bought it a year ago. Here are just a few of the things that have gone on over the past year:

• John’s been unable to secure a tenant for longer than six months.
• John had to replace two broken windows from vandalism while units were vacant.
• John received three midnight phone calls reporting gunshots.
• There is a busted crack house across the street.
• The next-door neighbor (an elderly woman) was kidnapped from her front porch and is still MIA.

You would think that after dealing with these headaches, John would abandon real estate investing altogether.

But that’s not the case.

In fact, he’s more passionate than ever about acquiring rental properties.

Why?

Well, for one, John’s learned some very painful and important lessons from the above nightmare. In fact, over the course of the past year, he’s come up with a strict set of criteria that will ensure that many of these problems aren’t repeated. I’ve taken John’s formula, added a few notes, and even threw a couple of my own criteria into the mix.

The result? A near-perfect formula for buying rental properties that provide cash flow. And the near-perfect formula is even more streamlined with companies like Roofstock who help people just like John buy rental properties (yup, properties that are already rented out so you don’t have to find tenants) for investment purposes.

It sounds too good to be true, but it really isn’t. Trust me.

Before I continue, I just want to emphasize that this strategy is the result of HOURS of reading, multiple conversations with other investors, property managers, and real estate agents alike, and an in-depth analysis of our own investments —this strategy is a bi-product of our own personal experience and could vary depending on yours.

Here we go…

The first step to ensuring that you don’t end up with a real estate nightmare is:

Before getting into specific techniques, I’d like to re-emphasize that just like any other investment out there, if you don’t know what you’re doing, you will get burned and lose A LOT of money. I always recommend doing your homework and investing FIRST in your education.

Here are a couple of things I do to get educated:

Talk to other investors

Make sure you are getting solid advice from people who have accomplished what you are trying to do, not from broke family members! You will be surprised by how many well-meaning people are eager to give you free advice on something they know NOTHING about.

Read, read, read

I am a HUGE fan of reading. It’s advisable to read a variety of authors who have different approaches. Your job will be to read enough material to begin seeing patterns and to form your own opinions and strategies.

Consider buying courses

There is a TON of quality content out there; however, just like any other industry, there’s also plenty of snake oil salesmen peddling get-rich-quick schemes, so be careful. Usually, a thorough Google search will help sort out the bad apples.

Know your market

I recommend buying in an area that you are familiar with, at least for your first few properties as you get your feet wet. If you are not familiar with an area, try spending a few weekends in your target market over a period of months. Drive around in two to three zip codes you are interested in and talk to neighbors, local shop owners, property managers, etc. so you can get a feel for the area and the potential clientele you’ll be dealing with.

Well, each person’s strategy is different, but here is how I analyze properties and scout out neighborhoods:

I evaluate them as one of three categories…

A Class

These are in “pride of ownership” neighborhoods occupied predominantly by homeowners. The houses are typically well maintained with green lawns, tree-lined streets, etc.

These tend to make great homes to impress your friends, but don’t usually pencil out as great investments. I stay clear of these areas.

B Class

This typically has the largest range of products between the three classes. These houses usually serve the greatest number of people within the community and have the largest amount of inventory.

I usually try to target a neighborhood where there is a large portion of blue-collar workers and where there is a 35%/65% ratio of renter to homeowner. You can usually tell if you’re in one of these neighborhoods by the number of utility vehicles parked in driveways – cable repair vans, constructions trucks, etc.

C Class

These are in “run-down” neighborhoods occupied predominantly by renters.

These rental properties typically have a high renter turnover rate. People tend to RUN in these areas at night, NOT jog. There’s high crime, gang and drug activity, substantial cop presence, etc.

I am not saying these are poor investments; typically the cash flow on these deals can be high. But the successful investors taking these on are probably running a tight operation and have a specialized property management team in place. For someone looking to acquire one or two investment properties as a way to supplement income, I would recommend against this. I haven’t purchased one and I don’t think John is eager to buy another one either.

Buy below market 10%-20%

Think of this not only as a way to grow your net worth, but also as a way to ensure your financial security. If you ever have to sell due to an emergency, that 10%-20% is going to allow you to lower your offering price to move it quicker. On a positive note, if you don’t have to sell in an emergency, you’ve just made an instant return on your investment.

Property must generate at least a 15% ROI, cash on cash

That means the rent minus the debt (if mortgaged) and expenses must equal 15% or more. For example, a $20K down payment would have to yield at LEAST a yearly cash flow of $3,000. This is actually fairly low – most of my and John’s deals have been well above the 20% threshold.

Buy in a B-class neighborhood, 35%/65% ratio of renter to homeowner

The rent should be at LEAST 1% of the purchase price

For example, a $100K home should rent for at LEAST $1,000 per month.

Do your due diligence regarding repairs before buying

If the repairs plus your down payment exceeds 15% ROI, move on to the next property.

Maintain six months of cash reserves per property to pay the debt service

This should suffice for any unforeseen repairs or vacancies.

I’ve already covered the necessity of educating yourself about real estate investing. That includes taking courses, getting to know other real estate investors, and reading books on the subject. Even more important, is market knowledge. The market is what you are truly investing in, and you’ll need to know it well before you take the plunge. Make sure you can comfortably check the boxes on all the steps before making an offer on your first property.

Once you can, you’ll need the following to go live with rental property investing. 

Cash to close

If knowledge is critical to success in investing in rental properties, having sufficient cash is a close second. 

Here’s a reality you need to be aware of from the start: you will not be able to purchase investment real estate with 5% down, 3% down, or with the 100% financing offered by the Veterans Administration. Those no- and low-down-payment financing deals are only available to owner-occupants. (The exception will be if you purchase a two-to-four family home, live in one of the units, and rent out the others).

For most investment properties, you should expect to make a down payment equal to at least 20% of the purchase price. This is a typical requirement of traditional mortgage lenders.

That means if you’re purchasing a home for $250,000, you must be prepared to make a down payment of at least $50,000.

Closing costs, escrows, repairs, and cash reserves 

There will also be closing costs and escrows for real estate taxes and homeowner’s insurance. Expect that those will add another 4% to 5% of the purchase price to your down payment. The recommended option is to get the seller to pay the closing costs for you, which they may do in exchange for a slightly higher sale price.

I’ve also already mentioned having cash reserves equal to six months of house payments on the property, and this is also typically a requirement of traditional mortgage lenders. But you may also need to factor in additional cash to cover any expected repairs, which will almost certainly be the case if you’re purchasing the property for less than its true market value. 

Get a home inspection from a qualified home inspector 

The mention of repair costs is the perfect time to discuss the absolute necessity of a home inspection. Even if you know a good bit about investing in real estate, knowledge of the integrity of the physical structure of the property is its own specialization. It’s best to get a set of trained eyes into the property to see what’s lurking in places most buyers don’t look. 

For example, you may look at a wall and see what looks to be a minor crack. But a home inspector might see that as a tipoff of bigger problems, like water damage or termites. The same thing can happen with a sagging ceiling. Certified home inspectors are trained to see problems that aren’t obvious. You should have any property you want to purchase thoroughly inspected from top to bottom.

Pay careful attention to the inspector’s report – it can both reveal hidden problems and give you bargaining chips to renegotiate the price to a level that will accommodate the needed repairs.

Or, since you’re buying the house for rental purposes, you can use the report to have the current owner remedy the problem before closing. That will make the house easier to rent once you close.

Line up your financing in advance 

Unless you’re in a position to pay the full price of a rental property in cash, you’ll need to obtain financing to make the purchase. Since you’ll need to purchase a rental property for less than its actual market value, you’ll need to be a fully qualified buyer, ready to close in the shortest time frame possible. That means having both your down payment and your financing ready to roll.

Obviously, you can’t get a mortgage before you select a property. But you can get a pre-approval. That involves filling out an application for mortgage financing and securing approval based on your credit and income. Once you have your pre-approval, you’ll be able to make an offer and close quickly.

Your pre-approval should be confirmed by a written letter from the lender. It will not only indicate that you’re fully approved, but also the amount the lender will provide. A pre-approval letter is one of the strongest negotiating tools in any real estate transaction. It reassures an anxious seller that you’re fully qualified to close on the deal. 

It’s possible to get a quick pre-approval and closing through online mortgage providers. 

Applying for a mortgage on an investment property is easy. All you need to do is visit the site, fill out an application, get your pre-approval letter, and then begin shopping for your first rental property. 

Once you purchase your first rental property, the first order of business will be to find suitable tenants. You’ll need to get comfortable with this process because it will be ongoing. Tenants come and go, so you’ll need to have a system in place to quickly procure new ones if you plan to be a long-term rental property investor. 

Advertising your apartment or home

The most traditional way to find renters is by advertising your apartment or home for rent. You can do this on sites like Craigslist, Facebook, or Apartments.com. If you’re willing to pay a commission, usually equal to one month’s rent, you can also have the rental listed by a real estate agent who will place the property on their multiple listing service.

How long you’ll need to wait for a tenant will depend on how strong the rental market is in your area. If the market is tight, meaning rentals are in short supply, you’ll likely be swamped with calls and be able to rent the property in a matter of days. But if the local market is in oversupply, it can take weeks, or even longer. But hopefully, you’re purchasing a property in a strong rental market as a primary objective. 

Performing background checks on prospective tenants

Once you’re contacted by prospective tenants, you’ll need to screen them for suitability. At a minimum, you’ll need to gather the following information: 

• A credit report on each tenant –  A joint credit report if it’s a married couple, otherwise individual credit reports should be pulled for each tenant.
• References – A satisfactory rental reference from the prospective tenant’s previous landlord is important. You can also request copies of canceled rent checks for at least 12 months, proving the rent was paid each month and on time. (Previous landlord references aren’t always reliable because the landlord may give a good reference just to get rid of a bad tenant!)
• Verify income – Request copies of both a recent pay stub and the most recent year’s W-2 to prove income.

If the information above reveals a borderline tenant, you may want to request evidence of savings in the form of bank statement copies. (Think of savings as the tenant equivalent of cash reserves – if they have them).

Get renters who can provide the security deposit

If the tenant is satisfactory, you’ll need to get an adequate security deposit.

• Depending on the customs in your marketplace, that may be represented by a flat fee security deposit, or an amount equal to a certain number of month’s rent.
• You’ll need to obtain the security deposit, along with the first month’s rent, before the tenant moves in.
• The money should be held in an interest-bearing trust account specifically for the tenant and used to pay for either damage to the property not repaired by the tenant, or unpaid rent. Otherwise, the deposit will need to be returned to the tenant, with interest, within 30 days of vacating the property.

The security deposit also serves as a qualifier. A tenant who has the ability to pay both the security deposit and the first month’s rent is likely qualified. But if a prospective tenant doesn’t have the money upfront, it’s a tip that they may be experiencing a cash flow problem that you won’t want to deal with going forward.

Another alternative is to purchase rental properties through an online real estate marketplace like Roofstock. Not only can you purchase certified rental properties through the platform, but, as I mentioned above, you can also purchase homes that already have tenants in them. That means you’ll be purchasing a property that already has an existing cash flow. It will at least give you a break on tenant screening upon purchasing the rental home, though the process will be ongoing each time a tenant vacates the property.

» Read more about Roofstock in our list of the Best Real Estate Investment Sites.

Dealing with tenants

Properly screening prospective tenants will be your first line of defense in dealing with them. A tenant with a decent credit rating, a good previous rental history, and a stable and sufficient income will eliminate most potential problems.

But even if the tenant is solid financially, that doesn’t prevent the possibility they may cause other problems. For example, you’ll be relying on your tenants to take reasonable care of the property. That means both repairing any minor damage they cause, as well as alerting you to any major conditions that may need repair. As well, tenants have been known to disappear in the middle of the night, often with no known forwarding information.

The process should start with obtaining a pro forma copy of a lease agreement that’s legally compliant in your state. It will spell out the terms of occupancy, including who will occupy the home and for how long, what the rent and security will be, how many vehicles may be parked on the property, and any limitations, such as what can and can’t be stored on the property, or how long a guest can stay in the home. You can add in any and as many stipulations as you like. 

Know the laws in your state

Be sure to familiarize yourself with landlord-tenant laws in your state. Those not only provide certain protections for tenants, but also for landlords.

For example, you’ll need to know what the laws are regarding eviction, as well as your responsibility to maintain the property in a legally compliant way. In most states, you’ll be required to maintain the property in a safe and livable condition. If not, the tenant may have grounds to break the lease.

If you do get into an eviction situation, be prepared to lose money. Depending on the laws in your state, it may take longer to evict a tenant than you expect. Though the lease should specify the terms of eviction, it’s possible the tenant will legally be able to occupy the property for an extended period of time if there are young children involved or if there is a recognized disability.

This is another reason why it’s important for rental real estate investors to have adequate cash reserves. In certain situations, you may need to cover the costs of your property for several months during the eviction process. Not to mention that evicted tenants often leave rental properties in damaged condition. 

Since a rental property is for investment and not personal occupancy, standard homeowner’s insurance policies will be inadequate.

As a landlord, there are certain risks you’ll face in having tenants living in your property. For example, if a tenant – or one of their guests – is injured on your property, you may be held liable. 

1. Regular Insurance For a Rental Property – you can generally purchase a rental property policy through the same insurance companies that offer standard homeowner’s insurance plans. But you’ll need to alert the insurance company that it’s a rental property and expect to pay a higher premium for the coverage.
2. Extra Liability Insurance – you may need more than the standard amount of liability insurance provided by a typical homeowner’s insurance policy. And though it’s not required, getting an umbrella policy is an outstanding idea. An umbrella policy is a general liability policy that will provide coverage over and above the liability offered by your homeowner’s insurance policy. Fortunately, it’s pretty inexpensive coverage, but it will be extremely valuable in a high dollar value lawsuit situation.
3. Loss of Income Rider – another provision you should seriously consider adding is a loss of income rider. It won’t cover periods of time when the property is vacant, but it will replace the rental income if the property is damaged or destroyed, and therefore not capable of producing rental income.

Though there is a multitude of books and courses on buying rental properties as an easy way to get rich quick, the opposite is much closer to the truth.

You should be in it for the longer term

To be successful, you have to have the right outlook. That means you’ll need to be a long-term investor, looking for profitable properties, but doing so with a full understanding that the real payoff may be years away.

A 15% return on your cash investment in a property will certainly be a welcome income source, but it won’t make you rich. But if you hold the property for several years and the combination of price appreciation and loan amortization increases your equity, you’ll be able to sell the property for a big profit.