There is a quick and dirty calculation that you can do to see if a potential rental property might cash flow. If the monthly gross rent is 1% or more of the purchase price then this property is a good candidate. You still have to investigate and run the numbers further to be sure but this is a good initial test.
With that in mind you should be able to see areas in your town or city where you have a greater chance of finding positive cash flowing, rental real estate and, vice versa, areas where you will have little chance of cash flowing. Typically this means you will have to focus on properties with a lower purchase price. It is hard to cash flow a property worth $600,000 or $700,000 when you have to have monthly rents of $5,000 or $6,000 to have a hope of cash flowing.
You might even have to go outside of your local town or city to another municipal area to find things that cash flow. This is especially true if you happen to live in an expensive, major metropolitan area. Sometimes smaller towns / cities have more opportunities.
I can see this happening more and more over the next few years as house values increase all over, quite significantly in certain cities. The days of finding a multitude of positively cash flowing properties in your own neighborhood might well be behind us.
As you go outside your local area make sure that you:
- Buy only in areas with a strong rental market and an active economy. You don’t want to buy in ‘one horse towns’ or areas with only one employer. Look for a strong local GDP with multiple industries and good prospects for long term growth.
- Buy in areas where you can find strong property managers. The farther you go from home the less active managing you will be able to do.
- Try not to buy in areas where you have to travel farther than 2 or 3 hours either via car or plane. Factor in travel costs into your purchase and operating costs.
- Keep in mind that any renovations will be more costly and take longer if you are not there to physically manage the work. Buy properties that require less work the farther they are from you.
- Save the higher positive cash flow in strong economies to help pay for higher vacancies and lower rents when the economy turns.
I know of one fellow investor that happens to live in a part of town where you can buy rental properties relatively cheaply. He owns several single family homes, all within four or five blocks of his own home. That is the way he wants it. He has a very nice little retirement portfolio set up.
I have another friend that went with me to a real estate seminar a couple of years ago. He came out all excited to do something and he spent the next month looking at all options. However, he lives in an area where all of the properties are valued at around $600,000 and up. He did not want to go outside his local area and as a result, after a month, he had found no valid candidates. I counseled him that he would have to buy elsewhere in the city and he refused. To this day he has not bought a rental property.
Because I am self-employed and often have trouble finding traditional financing I have had to learn to ‘follow the deal’. I have to go where I can find properties that have some physical or managerial problem that I can buy at a deep discount. As a result I have properties all over the place. However, this allows me to buy properties significantly cheaper than I could have bought the same property in my own (expensive) home city.
If you do end up buying in smaller towns you should be aware that:
- Banks will have more concerns about lending in secondary or tertiary markets – especially in a slow economy. You might be able to finance it in the first place (albeit at a higher interest rate or a higher loan to value) but have trouble refinancing it years later if the economy takes a dive.
- Properties in smaller centers tend to appreciate at a slower rate than a similar building in a larger center.
- You have a better chance of converting multi-family properties to condominiums in a larger center than a smaller one.
- If you are developing land or building new homes in a smaller center the absorption rate will be less and it may take your longer to sell your new lots / homes. i.e. A smaller town might be able to accommodate 15 new home sales a year. If your plan is to create a new 25 unit development it might take two or three years to sell out. Make sure to phase the project and account for this extra time / carrying costs to offset this.
Once you get your feet wet in real estate investing don’t be scared to branch out and buy in areas that may not be real close to home. Just do your homework first. Buying outside of expensive cities can be very profitable.
Read more about this in Cash Management in Real Estate Investing.