Investors looking for portfolio diversification, tax advantages, and a steady stream of income often consider adding real estate holdings to their portfolios. While the right property can potentially bring all these advantages and more, it’s critical to evaluate each potential investment property before making a purchase. Here’s a look at some of the factors you’ll want to consider.
The age and condition of a property can have a significant impact on its potential return. It’s also important to consider whether the current owner has kept up with necessary maintenance and repairs. Before making an offer, have one or more qualified inspectors check the entire building. It’s critical to have formal inspections of the electrical wiring, plumbing, and roof, as well as inspections for pests, environmental issues, and any other potential problems. If any issues are found, be sure to get quotes so you know exactly how much it will cost to remediate them.
Keep in mind that while you may be able to get a fixer-upper for a lower upfront price, a property that is older or needs work will likely require additional investments. Depending on the extent of the issues discovered during your inspections, you may negotiate the price down, ask the seller to share in remediation costs, or decide to move on to a different property.
The neighborhood where a property is located can impact the type of tenant you’re likely to attract and the amount of rent you can recharge. Ideally, you’ll want to choose a property that is in an area that has both low crime rates and relatively low property taxes.
Areas that are still affordable but are poised for future growth and development can be a smart choice. If you’re considering a residential rental property, the relative rankings of schools in the immediate area can also make a difference. Residential properties in areas with highly rated schools generally attract higher rents and may appreciate faster than properties in lesser-rated school districts.
You’ll also want to consider the overall “vibe” of the neighborhood. Does it feel friendly, clean, and safe? Does it have nearby amenities that will attract quality tenants?
Remember that you can do a lot to improve a property, but you can’t pick it up and move it. In some cases, it may be best to choose a neighborhood that meets your needs and then start searching for available properties in the area.
The amount of nearby competition can also impact the potential return on your rental property. When evaluating your options, consider how many similar rental properties are in the nearby area and the current vacancy levels. Generally, the higher the vacancy rate in the neighborhood, the greater amount of risk you may be taking on. In most cases, you’ll want to choose a property that is an area with a low vacancy rate over one where general vacancies are higher.
After evaluating a property’s general characteristics, it’s time to pull out a calculator and look at the numbers. This can help you make sure that the property you’re considering meets your big-picture financial criteria, such as the amount of net income it’s likely to generate. Two helpful calculations include net cash flow and cap rate.
Net Cash Flow
A property’s net cash flow helps you evaluate your anticipated return on investment (ROI). To perform this calculation, begin by adding up all revenue from the property, then subtract the cost of any debt service and all reasonably necessary operating expenses, including needed repairs and upgrades.
Once you have this number, you can use it to compare the estimated ROI of the rental property you’re considering to that of other potential investments. Projecting the anticipated net cash flow over your anticipated holding period will also give you a better idea of how the rental property may perform over time.
Capitalization Rate (CapRate)
Your CapRate indicates the property’s returns, independent of financing. In other words, it’s the return you would generate if you paid cash for the property.
To calculate your capitalization rate, begin by calculating your net operating income by adding up the property’s income after operating expenses and before loan payments. Then, divide this number by the current fair market value of the property.
For example, assume you’re considering purchasing a property that is listed for $325,000. The property currently has tenants who are paying $2,500 per month and has annual operating expenses of $6,000. In this scenario, you calculation would be as follows:
Based on these calculations, you can expect this rental property to produce a cap rate of return of 7.38%. Comparing cap rates of potential rental property investments can be helpful in determining whether you are paying a fair market price.
If you’re not comfortable comparing these types of calculations on your own, you may consider consulting with your accountant or a financial professional.
It’s also important to decide whether you’re comfortable living the “landlord life.” Owning and caring for physical properties is a big responsibility. It can take a physical, financial, and emotional toll and can start to feel like having a part-time job. Hiring a professional property manager can ease some of the burden but won’t completely eliminate it.
If you want to minimize management responsibilities, consider investing in a Real Estate Investment Trust (REIT) or a Delaware Statutory Trust (DST). These passive investment options provide many of the potential benefits of property ownership without the need for active management.
A REIT is a company that makes investments in income-generating real estate by purchasing, operating, or financing properties. Rather than owning the underlying properties, investors own shares of the REIT. The REIT company handles all the property acquisition, maintenance, and management. It also collects rent from the property’s tenants and distributes it in the form of income dividends, rather than as rental income.
A DST is similar to a REIT, but instead of being a company, it’s a legal entity created under Delaware state law. DSTs allow investors to acquire larger institutional quality properties with in-place management by pooling funds from up to 2,000 investors. Rather than owning the underlying properties, investors acquire a beneficial interest in the trust and receive distributions from the DST. For tax purposes, the DST trust interest has been deemed by the IRS to equivalent to holding title. Investors in DSTs do not have any responsibility for managing the underlying properties and less legal liability for issues that may occur at the property e.g., a tenant lawsuit.
One potential benefit of choosing a DST over a REIT is that DSTs are considered “like kind” properties that can be used in a 1031 exchange. Investors who are selling traditional investment properties can defer taxes by reinvesting proceeds in a DST via a 1031 exchange. When the DST is sold in the future, investors have the option to complete another 1031 exchange and further defer taxes.
To learn more about adding passive real estate investments to your portfolio, contact the professionals at First Guardian Group for a no-cost consultation. Our team can help you evaluate your options and determine whether a real estate investment might be appropriate for you.
See IRS ruling explaining the Delaware Statutory Trust: https://www.irs.gov/irb/2004-33_IRB#RR-2004-86