My Process for Determining a Suitable Rental Property (Free Money ...

In a recent post I gave the background on how I've decided to invest into rental real estate. In this article I will detail the process I go through in determining whether or not a property is a suitable fit for me. I've only progressed far down this road a couple times, so my process may change/mature as time goes on.

For now, here's what I do:

• I generally become aware of a property either through the automated email of new listings I get daily or from a specific listing found by my real estate advisor "Bob."


• We discuss the property a bit, covering the basics to determine if it's worth seeing in person. These include what part of town it's in, the age of the property (which could hint at fix-up costs), any history of being rented (or at least estimated rents), potential costs (including real estate taxes), potential selling price, and so on.


• Assuming all of the above are at least somewhat acceptable, I do a quick calculation to see if the financials of the property are in line with my expectations. At this point I find the Gross Rent Multiplier (GRM). The GRM is the sale price of the property divided by the property's annual gross income. It works like this:

• The property sells for $90,000.


• It's a duplex (two apartments) and each could rent for $500 per month (or $1,000 per month total.)


• Annual gross income is therefore $12,000 ($1,000 x 12 months).


• The GRM is 7.5 ($90,000 / $12,000).

Wikipedia says that a GRM of under 9 is acceptable, but I look for one that's around 5 or less. In addition, I play with the numbers to see what's possible if the selling price goes down or the rents go up. If the property passes this measure, then it's worth a look. (FYI, I have seen properties in our market sell as high as 8 GRM and as low as 2 GRM, the latter are generally in very sketchy neighborhoods. I see a lot for sale with GRM of 15+.)

• We then go check out the property in person -- me, Bob, and my wife. We look it over, discuss issues/options along the way, etc.


• If all looks good after we see it, I develop a pro forma income statement for the place. I created a spreadsheet that has spots for various inputs (including purchase price, potential rents, all costs, and so on) to look at the profitability of a property. Bob gets me cost estimates either based on his experience (which are especially helpful if we've seen the property and know what needs to be fixed) or, if available, financial statements from the seller. We then make adjustments as needed and end up with an estimate of profitability.


• In the course of developing these estimates, I put in every cost I can think of including both a management fee (I have found a good property manager who charges 8% -- a decent going rate) as well as a plug fee of one month's rent for vacancy reserve.


• If, after all these costs have been added in, it still delivers 10% before personal income taxes (not property taxes -- these are expenses already included) and depreciation, then it makes financial sense to move ahead. (FYI, we've discussed this in comments to other posts as the capitalization rate.)


• At this point we discuss pricing, what we'll offer, terms (like inspections), and we make an offer.


• Then we sit and wait for a response and respond ourselves as needed. We've only made it this far on one property to date, and next time I write on this subject I will give you the details of that transaction.

BTW, early on in the process I set up an LLC to handle the financials for this endeavor to shield me from potential personal liability (I also have umbrella insurance personally too). My CPA helped me register the LLC as well as get an Employer Identification Number (basically a Social Security number for the LLC). I set up a checking account for the LLC at my local Chase branch (which was free -- my credit union wanted to charge me $12 a month for such an account with no additional benefit over the free Chase account.)

Source: http://www.freemoneyfinance.com/2012/08/my-process-for-determining-a-suitable-rental-property.html

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