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An Uncommon Method For Identifying a Great Rental Property

Great Rental Property

What Makes a Great Rental Property

Investors have wildly contested what makes a great rental property over the years.

This is because there are so many variables to consider, and everyone’s goals for what they want to accomplish through rental property investing are very different.

Some people focus on the “1% rule,” ensuring that the gross rent that they can collect is at least 1% of their all in cost.

Others focus on the “cap rate,” dividing the income, after all their expenses, over the total cost, to get a rate of return before financing costs (most commonly used on commercial properties).

None of these conventional strategies are bad or illogical, but I have used a slightly more outside the box method for my selection criteria over the past several years, and have been really pleased with the results

It’s based around my specific goal of what financial freedom meant to me when I began this strategy in 2016.  I set out to accumulate $1mm dollars of equity in my properties, and $12k per month of cash flow (after expenses) over the following two years. 

By setting that specific goal with a specific timeframe, I was able to figure out how many properties I needed to buy, how often, and what each property needed to provide in terms of equity and gross and net cashflow. I outline one of my typical deals in this article if you are interested in more information on it.

A Couple Things To Consider

I’ve always viewed rental properties as income that I “someday” could live on, but while I’m (fairly) young and able bodied, my goal has been to live on income produced actively, through a job, flipping properties, wholesaling properties, or consulting. 

The longer you can delay living off the income from your property and continue rolling the cash flow into more deals, the quicker you will get to your end goal.   

There are also typically two types of rental property investors.  One is the “turn key” buyer who is usually very hands off, buying properties that are either already rented or ready to rent from day one.  This strategy is common amongst people who have accumulated savings and understand all of the benefits of owning real estate, but aren’t’ real estate nerds who love looking at properties every day I am (and maybe you are).

This article is intended for the active real estate investor who plans to be very involved in educating themselves, searching for deals, managing rehabs, and renting out units.  In doing so, you will spend a lot more time and energy on your investments, but will also be able to capitalize on all the different ways that it is possible to make money in real estate, rather than just a few available through turn key investing.

So here is my unsophisticated approach to building a portfolio of single family homes that has significantly increased my family’s cash flow and net worth over the past few years.

Cashflow

Let’s start with what I consider to be the most important aspect of a great rental investment.

I calculate cashflow simply by figuring out what is left over after at all my expenses and set-asides.

This is specifically how I determine what my expenses and setasides will be.

  • Monthly mortgage payment PITI (Principle, Interest, Taxes, and Insurance)
  • 10% set-aside for vacancy
  • 10% set-aside for maintenance/improvements

You can also add in any other expenses you may have like management fee if it’s not self managed, snow removal, grass cutting, or utilities you pay as the landlord (I personally have the tenants pay utilities and I manage the properties myself).

Once I know all my expenses, I subtract this from my gross monthly rent, and ideally there would be $500 per month left over of free and clear cash flow. 

Finding deals that meet this criteria is a challenge which is why being an active investor analyzing lots of deals to find the needle in the haystack will payoff in higher returns. I do sometimes buy a property if the cash flow is as low as $300 per month, if the equity in the property is substantial and I really anticipate appreciation in the area.

The reason for wanting to find properties that produced $500 per month in cash flow relates back to my goal of creating a portfolio over a two year period that pays $12,000 per month.  This is possible if you buy one property per month that produces $500 each.  Using this criteria is much more motivating to me than the “1% rule” or cap rate method, because I can logically see, in straight forward numbers, how much closer I’m getting to my goal with each property I purchase.

So before you start buying rentals, think about what cash flow number you want to achieve and how many properties it will take you to get there.

Because high cash flow often means purchasing at lower prices, in markets where there is enough population to support higher rent rates, you will need to really think through where you are buying to make sure you can achieve the cash flow you are projecting.

Here is a link to a map of some of the most sought after cash flowing markets right now.  Some of which aren’t as intuitive as you would think.

Equity

The second most important component of a great rental property in my opinion, is the amount of equity in the property. 

Equity is simply calculated by the value I could sell the property for today, minus all my costs. Whereas cash flow provides a sustainable living over the long run, equity is the main driver of wealth creation.

This is where being an active investor can lead to a significant increase in return compared to the turn-key investor.

As an actively involved investor, you can target properties that are in really rough shape, update the property, and if you select the right property and the right repairs, the home will be worth significantly more than the total you have invested.

Most turn-key investments are going to be sold at market value, because there is no incentive for the seller to provide a discount.  If you want initial equity, you typically have to earn it through the improvements you make to a property.

On each new property I purchase, I am always looking to be able to create a difference of $30,000-$50,000 of value between what the home would sell for post-rehab, and my total costs to purchase and rehab it. 

Again, these numbers relate back to my original goal of creating $1mm in total equity across the entire portfolio, which the “1% rule” or cap rate don’t really tell the whole story when it comes to the value created by this upfront rehab. Knowing exactly how much equity you are adding to your net worth with every rehab you do can create the motivation to work through the challenges of rehabbing a home.

The great thing about real estate is that it has always appreciated over time, so if you shutter at the thought of managing renovations, you will still be able to see the benefit of equity growth between appreciation and principal pay down over time.  I, however, always like to start with some equity momentum, which you can typically achieve through an up front rehab.

Final Considerations

I never want to give the false impression that this is easy or quick money.  With any investing there are always trade offs of time vs return. 

The most passive investment that I know of, is putting money into a non-managed index mutual fund that mirrors the market.  Having to spend any amount of time on an investment that returns less than you can get through an index fund doesn’t make much sense.

So the thing to think about when developing your plan is how much return over an index fund you anticipate achieving compared to how much time and effort you will need to put in.

To me, someone who loves real estate and analyzes properties for fun, this strategy is the ultimate way to super charge returns.  There is no possible way to create the type of equity and cash flow outlined above through mutual fund investing, but it comes at the tradeoff of time invested.

So decide up front how much time you are willing to invest into things like educating yourself, finding deals, rehabbing, and managing rentals, and demand that your investments compensate you accordingly by setting rigid investment criteria up front.

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