4.0 Selecting an Income Property

Based on the model pro forma in the earlier chapter, you have a basic understanding of the value of the property you can afford and required average rental rate. It was determined you needed to find a home for around $100,000 in a neighborhood with average rents around $1,100. So now you can focus your attention to looking for the appropriate neighborhoods. Chances are though; you will not find exactly what you are looking for - not a problem. The pro forma will make sure the return objectives are kept in line. However, there are other issues that must be understood prior to the actual search for property.

4.1 Location and Property Type

You should have seen that coming…location, location, location. There are obvious reasons why location is important on the specific property, such as; schools, neighborhood, and commute time. What is less obvious to some is the importance of the economics of the region. The economics affects all property values.

Note to flippers, the section is basically the same with a twist toward rental rates verses property values. If you are astute you'll find that the terms are virtually interchangeable in location theory. This stuff is important so skim through again and note the similarities - in fact, location theory is also known as Ricardean Rent; look it up.

4.1.1 Regional economics and property income

In order for property values and rental rates to grow, a region must have a current and future positive economic outlook. The local industries must be in demand to generate the employment and income needed to increase property values and keep rental units occupied. "How?" By providing the locals and the newly relocated a steady income and expectations of either a better or steady future income. With growth expectations, the region will attract more workers looking for jobs, and also recruit workers from other regions. All of the new workers need a place to live, and most would like a house but many will initially rent. There is now an increase in demand on the housing supply and rental stock. The more demand for housing, the higher the prices sellers can get from buyers due to competition. The more demand for rental space, the higher the rental rate can go.

Even with a good economy, how much the value of property and rental rates rise depends on the geography of the region. A region in the middle of a large plain with little geographic constraints (lakes, mountains, etc.) will always have less property value and lower rents than an area on a peninsula. In fact, two of the highest priced property and rental regions in the United States are San Francisco and Manhattan in New York City - both are on peninsulas confined by large bodies of water. The simple reason being is that they cannot make any new land, so the property will end up going to those willing to pay the most for it - purchase price and rental rates. For a region with no geographic constraints, high demand will cause development further away from the metropolitan center where land is cheapest. As long as the highway and road system provide a reasonable commute, development will continue outward. With the competition of the new development on the fringes of the region, properties in the center cannot raise rental rates too much.

So in a nutshell, with a positive regional economy a geographically constrained city with limited access to new land will increase rental rates faster than a region with no constraints. There is an exception though. If demand is from a population moving in looking for work in a flat economy, the rents will rise very little. In this situation the new workers typically take jobs at equal or lower pay. There is no new money to throw around, and most of the workers will end up moving away when they find no real work, thereby leaving excess vacancy - decreased demand and rental rates.

So you need to make sure the region you are considering has a positive future economic outlook. With a very long project time frame, take note of future economic developments, factories, etc. Also, if you see factories and businesses moving out of the region you can expect rental values to drop instead of rise. Follow the money, follow the workers.

"So how do I know the health of a regional economy?" There are many good indicators about the health of a region's economy, but unemployment seems to be a great litmus test. If unemployment is growing, you can surmise that wages and demand for housing (for sale and rental) will be less. If unemployment stays constant, as long as the rental supply is constant, rental growth will probably be flat. With falling or low unemployment, businesses are hiring and you would hope to see rental demand growing along with rental rates.

"Rental supply and demand, how can I keep on top of that?" In income properties you need to dig for information on local rental and vacancy rates. Sometimes local apartment owner (landlord) associations will have decent statistical data on rental rates, vacancies, and expenses. Property managers may be another good source for data. When all else fails, you can seek out government data or pay for a marketing report (canned not custom).

So your last step before heading out the door, and perhaps this should be your first step, is to determine if there is a market for rental units. No use in buying a property that will not cover it's expenses and lose money.

4.1.2 Property Type

You should be asking, "I am looking to invest in a $100,000 what?" Good question. There are duplexes, triplexes, condos, and various other property types. For you moguls, there are hotels, office buildings, retail, and industrial parks. Quite honestly, you just need to start searching the web and calling realtors. Soon you'll have a good idea of which areas you will most likely be purchasing your property in - mostly due to price. Just be sure to run a quick pro forma on each property of interest to see if the deal is "in the ballpark". If you cannot get your numbers to pencil out - lower the property price until it works. This is what you can afford to pay.

"Is a duplex better than a single home?" For risk purposes only, yes. If you have a house (single tenant) and the tenant leaves, you have no income. With two or more units, it is less likely to lose all your tenants at once. Ideally, you will have some income to offset the expenses. If the facility is large enough you may even be able to produce a positive income with some vacant units. Needless to say, the management of the property becomes more involved with each unit you add.

We wish we could give better guidance on property type, but it is highly market dependent. Small income properties come in so many shapes and sizes that you will need to let your pro forma guide your decisions. The best investment properties are simply the ones that produce income.

4.1.3 Psychographics, know your customer

At this point you can go online and search for local areas that meet your criteria. Online sites such as Zillow have maps and data available to help you find prospective areas. Your best source of neighborhood selection will be a local realtor, they probably can help guide you best toward neighborhoods that are stable and avoid deteriorating ones. They are on the ground everyday and see much more than you will be able too. So get some help, and get a few neighborhoods to consider. With locations known, you can dig a bit deeper.

Psychographics are personal traits that help marketers categorize individuals into set groups. Typically the researches who put the data together give each category a descriptive name, such as, "Urbanites" and "American Dreamers". The categorization has taken thousands of variables into account. Income, education, entertainment preferences, clothing, etc. What is really interesting about the research is that the researchers found that like individuals tend to live in areas with similar folks. Remember the old adage "Birds of a feather, flock together"? Well, it turns out to be somewhat true. This may not be so important for very large projects, but smaller apartment projects tend to cater to folks desiring the regional traits.

Psychographic data on specific regions is available from providers such as Nielson for a small price. However, the information and customer insight is invaluable. If you know the areas you are looking to purchase a property, you will know roughly what type of renter will be interested in your property. Of course, your realtor will be able to do this too, but hard data backing up field observations is never a bad thing.

If you don't wish to bother with this research, just remember you are not the customer. You need to purchase a property that a customer will be willing to rent. It is good if you like the house too, just don't lose focus. For instance, if you are looking in a blue-collar family neighborhood you probably should avoid buying a one bedroom loft. It could be the coolest loft ever - you can see yourself living there. If the neighborhood is full of families with kids and pets you would be the wiser to focus on a property to accommodate their needs. Therefore, rent a single family house instead.

"What does all of this have to do with property types and economics" Glad you asked. The amount of money you have to invest limits the size of project you can do. Next, you determine if the local economy is in good shape - if so, continue on. Now, looking at regional rental and vacancy rates, you can figure out what to purchase in your price point. All of these findings can now be used to narrow down the actual neighborhoods you should be looking in. These neighborhoods are going to have some common characteristics that you could find with some psychographic data - or local realtor. You will now limit your search in those neighborhoods to what the natives in those neighborhoods prefer and desire. If they want studios, rent them studios. If they prefer single story ranchers, try and stick with single story ranchers. Give them what they want.

4.2 Finding a Deal

Time to finally look at some properties. Looking for income properties can be quite time consuming. They are not as much fun as looking for a house to flip since rental rates tend to push down our expectations a bit. You won't spend much time figuring on what to renovate as much as how little can I leave alone. There are many online sites that allow anyone access to thousands of listings. For single family homes you can look at typical residential real estate sites. For multi-tenant (and single family - sometimes) the commercial real estate sites such as Loopnet may be your best starting point. However, most of these properties are listed at their estimated market values on the seller's side. No doubt the price is the current premium and not a good deal. If you see a property priced far below the market - watch out, there may be a reason nobody wants it; so proceed with caution. "Where do I find a deal?" Finding a deal takes time, finding the right deal takes even longer. As a investor you need to focus on income. You can only afford to pay what the property can currently produce to meet your investment return.

Now and then, a good deal is listed in the online sites - so keep looking. However, there are very good deals to be had at your local county tax auctions, bank REO's (real estate owned), and government auctions (FHA, HUD, Fannie Mae, etc.). Don't forget to check out IRS and law enforcement auctions too. All of these deal resources need to be checked because at these venues you are likely to purchase a property at a deep discount from current market value. Bingo. Unfortunately, the auctions want to be paid immediately so financing becomes difficult. Speak with some of your local community lenders and see if they would be willing to set up a line of credit for the auction. Just remember to determine the maximum price you can afford to pay from the line of credit and your pro forma on the property. Do not bid past your maximum price - period. Don't lose heart if you can't get the financing, and always remember to keep these venues in mind. One day you may be able to put the credit together to buy homes at auction for deep discounts.

Next, find a local realtor you that you trust. Again, they drive through the neighborhoods all the time and have some great intelligence regarding local goings-on. Many times they know what homes are in trouble and would be willing to consider your cut-throat offer. In fact, because you took the time to determine exactly what you want to purchase and the price point you can pay - your realtor is going to be even more helpful. "Why?" Because they won't waste time trying to figure out what you want and what you can pay. You explain your looking for a rental property and what you want, they do their best to find it. Even if you are considering an auction to buy a home, if you work with your realtor friend (pay them a commission if you buy cheap skate) they will help make sure that you are actually buying a good property.

Don't be afraid to get out and walk the neighborhood. If you are, then perhaps your renter will be too. Homes that look run down in a nice neighborhood are showing signs of distress. When money becomes a problem, the lawn and landscaping seem to always be sacrificed. Take note of the addresses. If you are really brave you can go knock on the door, but nobody likes a stranger - especially one trying to take their home away (don't nose around the property unless you wish to get shot or arrested). Back online, you can easily find out the owner of the property from the county property appraisers website (most are online these days and very informative). On the site you can find out the owner and their address if different from the property address. Also, on the site you will see what the last purchase price of the property was and when it was made; and the property taxes (need this for the pro forma) and if they are being paid. If you see the owner as a financial institution, you have a REO and can contact that bank for sales information. Take your realtor friend to lunch and show them the properties in the neighborhoods that you found that look as if they are in distress. The realtor can help you parse through the meth labs and serial killer homes to see if there are any deals worth pursuing.

"Doesn't my realtor friend have a conflict of interest here? They make more money if I buy a more expensive property, won't they just dissuade me from the better deals?" Possibly, but if you found your realtor through trusted friends and acquaintances you should be alright. The realtor knows that a client that buys a house or more every year is better than a customer just buying one house. You are potential cash flow. If you feel you are being led astray discuss it with them openly. If you cannot get it resolved you need to find someone else. You are trying to build a trusted relationship.

4.3 Making the Offer

Here is where real estate becomes frustrating. You will never be able to understand why that owner is not willing to be reasonable and accept your cut throat deal. Without you they are doomed, what are they thinking? You really want to give them a piece of your mind and set them strait. Here is where you really want an impartial party to the deal - the realtor. These people take abuse daily during negotiations. For some reason property sellers and buyers fight tooth and nail over stupid things. The realtor is your ambassador who takes your frantic ranting and conveys it to the other side in a professional manner, and transfers their responses likewise. The realtor strives to keep the deal a business transaction where it may otherwise tend to get personal and kill the deal.

4.3.1 Pre-Offer

With the property(s) selected, it is time to do a preliminary walk through. If you have a contractor friend take them along - offer to buy them lunch or a drink afterward. Your goal is to make sure the deal is not a dump. Turn on lights and facets; look at the air conditioning and heater to make sure they work. Does it smell moldy? Are the bathrooms and kitchen in good shape? Any leak stains spotted on the ceiling? Any repair work that looks like its hiding something? Walk around the exterior looking for major cracks in the foundation or signs of structural deterioration. This is why you have your contractor friend with you. From experience they should be able to spot most issues that are readily apparent. Ask them to give an estimate of the repair and renovation costs - if any. Take the contractor's estimate and revise and update your pro forma. If you cannot get access to the property or are denied access, just move on to the next deal.

As an aside, the auctioned properties can generally not be visited or inspected - buyer beware. They do have reports of issues with the home which are helpful. Still, try and visit the site if possible and only poke around if it seems acceptable. Dress nice and carry a camera and notepad - look the part, so the police believe you. This is not the time or place to pull of your new gangster look.

To pull off your deal, you are going to need financing. So start calling your finance friends and keep them in the loop. Make sure they would be open to lending on your project. In fact, now is a good time to put your project package together to show them your intentions. This is a simple document to describe the deal to your financial institutions, and make a great first impression.

Your finance package can be the deciding factor in whether or not your deal gets funded. So, strive to put the most professional package together possible. It does not need to be a thousand pages full of gibberish, but it does need to cover the facts. A package should contain the following;

  1. Title page
  2. Table of Contents
  3. Investor Background
  4. Property Information
  5. Local Market Information
  6. Project Pro forma
  7. Appendix

Title page - keep it simple. Just the property address and your contact information. Feel free to use a nice format, just remember that you are submitting to financial institutions - keep it conservative. A table of contents is always helpful to those looking through the package, and they will.

"Investor Background ?" In the flipping section you called yourself a developer, feel free to take the moniker if it makes you feel better. Investor sounds safer though, and perception in this game is everything. Take any relevant experience that you have and highlight your competence to pull the project off. If you do not have any experience then do not include this section. No need to highlight inexperience.

Property Information. In this section you should show a location map, a few building and property pictures, and describe the property. Again, keep it conservative and limit your building pictures to the front of the property and perhaps one interior - always the pool if it exists. Describe the building as far as square footage, how many bedrooms, baths, number of cars the garage can hold. Do not write elaborate prose as if you are writing a sales advertisement, these folks really just want to know what you are buying.

Local Market. Here you will describe the area and what properties similar to yours are renting for. You can demonstrate demand by showing the independent market research (the cheap one you bought cause they won't trust you), and how the region's economy is projected. The goal is to show our financier's that you have considered market forces: supply and demand. Prove to them there is demand, and show them how you are supplying to that demand. Back up your opinions with references to the documents and websites that you got them from. If you show you have done your homework, this section will make you shine. They may even believe you.

Project Pro forma. Nicely format the pro forma for the property to match the document. Although your numbers are still preliminary (we don't even know if the seller will sell us the house), the pro forma will represent your current expectations for the project. Also, it shows the financier's that you not only looked at the market, but you took the time to analyze the specific project. Even if they never give you a dime, they will consider you as a thorough investor. Nothing wrong with banks thinking you do your homework. Just be sure to be honest and conservative in your projections. Be careful and thorough.

Appendix. The appendix is a good place to put any information from outside sources. If your contractor friend gave you a repair estimate - include it. Have any appraisals or goodies that helps prove your numbers? Put them in. Just try and keep it to the essentials. Avoid placing in multipage articles and reports, just a page per item at this stage.

Have a meeting and give the package to the financing institutions. Go over the package and graciously except and comments or changes they recommend. Ask them if they are still willing to loan on the project. Believe it or not, events happen that can change an institutions ability to loan quite quickly. See if you can get pre-qualified for a loan. At this point you are going to know which bank you'll try and do business with.

"Holy moly! You have me doing a ton of paper work, and I don't even have a deal yet!" Welcome to the world of investment planning and risk reduction. Your goal is to make a profit. In order to do so you need two things. First, financing - unless you have rich family members. Money is the fuel in your real estate engine. No money, no go. To get your hands on financing you need to demonstrate the project and yourself are acceptable risks to the lender. By the way, if your credit score is low you need to find a partner with a good one. Sorry, just the facts of life. Second, you need a deal that has the best chance of generating a return. You limited yourself to projects that met your investment goals and budget. So again, the risks have been reduced from running blind with a few numbers on the back of a napkin.

"Can't I negotiate a offer first then do all this stuff? At least the numbers would be correct, and I could have only one meeting instead of two." It is really a personal preference of how you like to deal. Some folks like to get the property locked up, then scramble around looking for financing. Others, like to get their ducks in a row and only make offers on projects they know they can finance. It is up to you; however, if you find the lender is now unwilling to lend on the project you may have to cancel the agreement. If any money went "hard" (a non-refundable deposit) on the deal, it now belongs to the seller. If you wish to lock in the deal up front, just be sure to have a clause that allows you to exit the deal if you cannot get financing.

Once you put a package together, it is easy to modify it for other deals in the future. The package is also a good check on your logic. If you are finding it difficult to explain why the deal makes sense, it may be a warning that it does not.

4.3.2 The offer

With your financing in place and pro forma guiding the investment decisions, you now make an offer and wait for a response. How you make the offer varies from state to state. Some states have standardized contracts that are widely used and accepted as industry standards. In the offering, which may be a sales contract, everything needs to be spelled out; sale price, due diligence period, reasons to kill the deal during due diligence, how long the seller has to vacate, etc. If it is not spelled out in the contract it is not legally enforceable, or at least as enforceable. Make sure to thoroughly read the contract and understand the provisions. Once executed, the agreement is a legal document which must be followed. If you default from the agreement you can be personally liable for damages to the seller.

If you really want the scoop on your local real estate law, find a real estate attorney at a cocktail party or other social gathering. People love to talk about their work and knowledge, especially to somebody who is interested. If you are socially impaired, then you can cough up a few bucks and meet with one. You only need to do this once to get a good handle on your states laws. If you love to read, most real estate statues are also available for free online. Do take time to become familiar with the basic laws - these are the rules you must play the game by.

OK, you submitted the offer to the seller, and now you are waiting to hear back from your trusted real estate agent if the offer was accepted. Chances are it will not be in the first round. You are about to meet your perpetual nemesis, the phantom second offer. Nobody knows where they come from, but they seem to always show up right after you submit your offer. Amazingly, this offer is always higher than what you were willing to pay. In fact, the phantom's terms seem to suspiciously match what the seller is trying to get out of you. "Is this just a tactic to manipulate me?" Perhaps. In any case, it is probably a good defense tactic to always offer 10-percent less than what you are willing to pay. Then the seller can feel they did their best by pounding the last ten percent out of you.

Once an offer is accepted, you are in your due diligence period. Now you have the right to have the property inspected by a licensed inspector and any other professionals needed. If anything you find during the due diligence period is serious, you have the right to renegotiate the price or walk away. This is also the point where money starts being spent - the inspector is not free. Be sure to choose a very reputable inspection firm that has experience. Once they have completed their inspection you will get a report of the findings. Buy your contractor friend another lunch or drink and go over the report. See if anything would increase or reduce the prior repair estimate. Verify that the repairs would not take longer to complete. Also, go over it with your realtor to see if there are any hot topic issues that your future buyers would be concerned about (i.e. asbestos, lead paint, lead pipes, mold, etc.). Revise the pro forma to make sure the project still meets the return requirements. If not, find the purchase price that would make the project acceptable. Then revise your offer.

More than likely the seller will tell you to blow it out your ears. A bank selling a foreclosed property may be a bit more flexible, just don't expect a response too soon. If the seller refuses to budge, you need to make a decision whether or not to continue on. If the pro forma shows you can make 15-percent profit in lieu of 20-percent, it may not be the end of the world. Time to consider what you are really willing to accept as an investment hurdle. Just remember our earlier discussion on how in the end the returns tend to be half of what is initially projected.

If everything is acceptable you proceed to closing on the property. All you need to know is that no matter what they promise, something generally goes wrong with the paperwork at closing. As long as you and the bank transfer the money, you will get the property. Chances are any major issues such as a clouded title (liens on the property) would have been found by the bank during the title search and hopefully addressed. If you don't know what a title to your property is, now is a good time to Google or Wiki it. In any event, go to your closing with predisposed to a long drawn out process with errors. If things go smoothly you will feel better.

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