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What to Know When Buying a House: An Investor's Guide

Real estate investing can be a great way to build wealth, but you first need to learn the basics. Here are six of them.

Apr 14, 2021 by Laura Agadoni
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Buying a house to flip or rent can be a great way to earn some extra income, and it might even lead to a career in real estate. The basic concept regarding buying a house as investment property is simple: You find a house, buy it, make any needed repairs or renovations, and then sell it or rent it out. A real estate investor can make money knowing nothing more than that, but they could also lose money if that's all they consider. To have the best chance of success in real estate investing, here are six things to know.

1. How much is it?

The old adage of the stock market -- buy low, sell high -- applies to real estate investing as well. Getting a low price for a house becomes more important if the exit strategy is to sell the house quickly for profit. But even if your plan is to rent the property, not find a buyer, you still don't want to overpay. Flippers usually buy fixer-uppers, and they typically pay no more than 70% of the after repair value (ARV) minus what repairs are likely to cost.

For example, if the ARV of a home is $250,000 and you figure it needs $50,000 in repairs to sell for market rate, you'd want to pay no more than $125,000. ($250,000 x 0.70 = $175,000 – $50,000 = $125,000).

Rental property is more flexible regarding price. You can buy a fixer-upper, renovate it, and rent it out, or you can buy a move-in-ready home to rent out. Instead of focusing on purchase price as much as you would if you're looking for a quick sale, you'd want to know what market-rate rents are in the area.

You would then run the numbers to determine your net operating income (NOI) -- how much you'll earn after calculating your income minus expenses (not including the mortgage payment). If you'll carry a mortgage, also determine your cash flow to determine whether you'll be making more than your total expenses. (See below.)

2. Where is it?

Location is the most important factor in real estate. Consider whether you'll have a market to buy or rent your home. Generally, people who plan to buy a home look for a safe neighborhood with good schools, and renters look for nearby amenities, such as public transportation and walkable shopping, dining, and nightlife. Houses might be cheaper to obtain in high-crime or rural areas, but you limit your market.

3. What shape is it in?

If you're buying a fixer-upper, you need to accurately assess the costs to bring the house to code and get it in comparable shape to area homes. Here are some areas to consider:

  • Upgrades: Look at area homes to determine whether you'd need to upgrade the kitchen with luxury appliances, new countertops, and new cabinets, or if you can use budget materials. Evaluate the bathroom the same way.
  • Major systems: Check the major areas to see their condition: roof, foundation, and HVAC, as well as whether there's mold or termites.
  • Move-in ready: Walk the rooms and note necessary repairs: carpet replacement, paint, etc.

After you've noted all the repairs and renovations needed, you'll need to accurately price the job. If you don't have the skills, it's worth it to hire professionals who do. Underestimating repair costs can mean the difference between a winning or losing deal.

4. Are there renter restrictions?

If you plan to use the house as a rental, first make sure you'll be allowed to rent it out. If the neighborhood is governed by a homeowners association (HOA), there might be rules regarding renting out the house. Some HOA neighborhoods have renter restrictions where they don't allow rentals at all or limit the number of rentals allowed in the community.

It's best to pick a real estate property with no renter restrictions, but if there are such restrictions and there are still available spots, put your name in so that you can rent the house. For example, if the association allows 10 rentals and only eight homes are being rented, you can still buy your rental property there, but you'd need to put your name in as soon as possible to reserve the spot.

5. How to calculate numbers

You'll need to run numbers to determine whether the deal is worthwhile. If you plan to flip, you'll need to know the property value of the home and whether you can make a profit by buying and renovating for less than what you could sell for. It's a bit trickier to determine profitability if you plan to hold the property and rent.

Here are some formulas to use:

The 1% rule

The 1% rule is the TLDR (too long; didn't read) version of real estate math. You want to get as close to 1% of the purchase price of the home in rental income as possible. For example, you should get as close to $2,500 a month in rent for a $250,000 home.

Cash flow

Determine your monthly income minus expenses. Some expenses to consider are property taxes, landlord insurance, repairs and maintenance, vacancy rates, HOA dues, property management, and mortgage payments.

Net operating income (NOI)

NOI is determined the same way as cash flow. Determine your monthly income minus expenses, but without including the mortgage payment. This is to determine the profitability of the investment. (You can do this yearly as well.) You'll need to know your yearly NOI to determine another valuable metric: capitalization rate.

Capitalization rate (cap rate)

Cap rate lets you know your return on investment (ROI). You divide your NOI by the property's current value, assuming you paid cash. This is to help you compare whether you'd be better off investing in this deal or investing elsewhere. Let's say the home costs $250,000 and your yearly NOI is $12,000. Your cap rate would be 4.8%. (12,000/250,000 = .048).

6. Learn how to use leverage

Real estate investors often use leverage, getting an investment loan through their bank, mortgage lender, or a hard money lender. Let's say you have $200,000 to invest in a rental property. You can buy a house with that and have no mortgage payment. And let's say you figure you'll have a positive cash flow on this property investment of $1,000 a month or $12,000 a year. That's a 6% return on investment. (12,000/200,000 = .06.)

Using leverage, you could get say, five properties worth $200,000 -- when your mortgage interest rate is low, this becomes more attractive. Let's see how those numbers work. You put down 20%, or $40,000, per property. Your cash flow will be less on each home since you'll have a monthly payment to make. Let's say you get $300 per month, or $3,600 a year in positive cash flow. But that's per house. In total, you're now earning $1,500 a month, or $18,000 a year, and that's a 9% return on investment. (18,000/200,000 = .09.)

But with reward comes some risk. It's riskier to be leveraged. What if you have tenants who won't pay rent and you can't evict them, either from government eviction moratoriums or just normal lengthy eviction proceedings? If you're overleveraged, you might not be able to make your mortgage payment, meaning you could lose the home. Or what if the real estate market tanks and the home depreciates in value? If you have a mortgage, you could be underwater. So weigh the risks with rewards when investing.

The Millionacres bottom line

Investing in real estate can be your road to success. There are many ways to do this: be a house flipper, a landlord, or invest in a real estate investment trust (REIT), which allows you to invest in real estate without buying physical real estate by investing in companies that do. You'd receive dividends that way. Whichever way you decide to invest in real estate, first pick an investment strategy and understand the ins and outs.

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