Due Diligence Checklist for Buying a Rental Property

When you invest in real estate, you are investing in a physical asset.  For your investment to be successful, you need to ensure that your asset is in workable condition.  While the property doesn’t need to be perfect, you need to do your best to avoid unexpected expenses.  If you skip your due diligence, you could be setting yourself up to lose money down the road.  Due diligence falls into three categories: financial, physical and legal.

Complete all these items, and you can ensure that your rental property will meet your expectations.

Financial Due Diligence
Financial due diligence is much more than making sure you have enough money in the bank to make the down payment.  Before purchasing a rental property make sure:

  • The property qualifies for conventional financing (if you aren’t paying all cash)
    • You receive a copy of the past 12 months of utilities and/or any other expense items
    • You have copies of the lease and rental history if the property is currently rented
    • You research the tax history of the property

All of this financial due diligence will lead to you being able to complete this equation:

Rent – (Monthly Expenses + Mortgage Payment) = Cash Flow

You want the final cash flow number to be positive after your due diligence.
Physical Due Diligence
A home inspection is an important step in the real estate process.  Unless the property is a brand new construction, it is unlikely that it is in perfect condition.  As an investor, you should expect minor cosmetic renovations with each purchase; however, it’s the big-ticket items you need to look out for.  A home inspection will reveal when you need to replace expensive items such as the:

  • HVAC
    • Roof
    • Furnace

Major repairs like this can dramatically impact your monthly cash flow as an investor. The condition of the home contributes to its value, so make sure the condition of the home matches your monthly cash flow goals.

Legal Due Diligence
If you are purchasing a distressed property, legal due diligence is incredibly important. Make sure that there are no liens or judgments placed against the property.  Many liens convey with ownership of the property and will be your responsibility once you own it.  Consider hiring a professional title company to research the title and ensure it is free and clear.

Due Diligence + Buying a Rental Property
In the fast-paced world of real estate investing it’s easy to see a low-priced property and have the urge to jump on it! Making a snap decision on purchasing a rental property can have long-term consequences so be sure to complete this due diligence checklist before submitting an offer.

How to Run Numbers to Get Your Desired CAP Rate

When investing in cash flow or rental properties it is important to understand what your return on investment is going to be. Investors refer to this as a CAP rate. Investors will target a specific CAP rate to make sure the properties they are buying are going to give them the desired return they are targeting. We will go through numbers to show you how your offer amount will be able to give you your desired CAP rate.

CAP rate is defined by Net Operating Income (NOI) divided by the cost of the asset. I’ll call the cost of the asset the all-in cost, which may include rehab costs as well. To get the NOI, I have to know the amount I can rent the property for minus all the expenses associated with owning that property. Let’s go through some numbers to show you how to calculate CAP rate.

Let’s say I need an 8% CAP rate to buy a rental property. The property will also need 15K worth of work to make it rent ready. Once it is fixed up, the property will rent for $1,100 per month. Taxes and insurance will cost me $150 per month. This is information I will need to get my numbers dialed in.

First, let’s get our NOI. We are getting $1,100 monthly for rent but we have to take off the monthly expenses.

  • $1,100 – $150 (taxes and insurance) = $950
  • $950 – $110 (10 % property management company) = $840
  • $840 – $110 (5% for maintenance and 5% for vacancy) = $730
  • $730 * 12 = $8,760 (Yearly NOI)

Now we have our NOI. Here is the rest of the calculations to get our offer amount:

  • $8,760 / .08 (desired CAP rate) = $109,500
  • $109,500 – $15,000 (rehab cost) = $94,500
  • $94,500 – $2,835 (3% closing costs) = $91,665

This formula has given me an MAO (maximum allowable offer) of $91,665. This offer will give me an 8% CAP rate. Now, if we go one step further and want to wholesale this to an investor that wants an 8% CAP rate, we only have to subtract our assignment fee.

  • $91,665 – $3,000 (assignment fee) = $88,665 (MAO for an assignment)

By using this formula you should be able to calculate whatever CAP rate you or your investors are hoping to get from a rental property.

How to Accumulate Rental Properties with Very Little Money Down

Do you want to own rental properties but have very little money or none at all? Then you need to listen to the following article on buying rental properties using seller and existing financing. In today’s seller’s market, it can be difficult to purchase properties to fix and flip because you have to buy the property for a price that allows you to make a quick turnaround profit and that usually means making offers at 25-30% below the asking price with very few offers accepted. Rental properties, on the other hand, can pencil out financially, even if full price offers are made, as long as the rental income is sufficient to justify the investment and especially if seller’s financing is put into place.

 

Here is what you do. Look for properties that are already rental properties with tenants that are taking good care of the property so there are no rehab costs. Then make offers on the property at no less than 90% of the asking price so that sellers are interested. Ask the seller to carry a note for 99% of the offer price. Then take the property subject to the existing loan so that the owner is only carrying paper for the difference between the 1st mortgage and your offer price minus the 1% down payment. An example is as follows:

The asking price is $100,000 so you offer $90,000 and ask the sellers to carry a note for $89,000 with a $1,000 down payment and take the property subject to the existing 1st mortgage of possibly $75,000. You will then pay the seller a month fee based on the total loan amount of $89,000 at an agreed upon interest rate amortized over 30 years with a balloon payment at the end of 5-10 years. You will set up an escrow account with a bank or title company (neutral third party) who will collect your payment and make the payment on the 1st mortgage. You now have a rental income property with a loan in place for 1% down, no origination fees and a reasonable monthly loan payment in place. You have no out of pocket cost for rehab and the place starts paying rental income immediately.

 

All you have to do is make sure the rental amount is sufficient to return a positive cash flow that makes you a sufficient return on your investment. An example is as follows:

The house cost $90,000 to purchase with only $1000.00 down. The monthly payment on the seller’s financing at 6% interest amortized over 30 years is $539/month or $6,432.00 annually. The rental is $1,000/month or $12,000.00 annually with a net income after expenses of $7,800. 00. The net income minus the mortgage payments equals $1,368.00 annual income along with paying the principle debt off. Since your investment is only $1,000.00, the income of $1,368.00 equals a 136% return on investment.

 

With $10,000.00 you can purchase 10 homes and let them pay themselves off over time until you eventually have 10 homes bringing in $7,800.00 each annually for a total annual rental income of $78,000.00. Plus the original value of each home will increase over time by 3-5% annually.

Common Tenant Issues

Each of us encounter problems every day. Sometimes we enounter the same problems every single day. For example, a landlord may have to deal with the same issues over and over again. As a landlord, you would love to have the best tenants to occupy your properties: tenants who pay rent on time, keep the area clean and pleasant, treat their neighbors right, and so on. But, more often than not, no matter how well you maintain your properties and how much you care for the welfare of your tenants, some problems will arise and, if you are unfortunate enough, these problems may bug you every day.

Rental Payment Issues

One of the main issues causing disputes between tenants and landlords is delayed payments or withheld rents because of countless reasons: temporary unemployment, health issues, cash flow shortages, repair or maintenance refunds, and a lot more. Whatever the reasons are, cases like these can’t happen all the time. What landlords and tenants can agree upon to solve issues like these are: transfer to smaller and cheaper units, an improved payment arrangement, and adding penalties for late payments. It is up to you on how you will react and solve this issue.

Maintenance and Pest Problems

To avoid high turnover in properties, it is the landlord’s duty to maintain the property in the same condition as it was on day one. On the other hand, it is the tenants right to have a surrounding that is well-maintained and conducive for living. Pest problems can easily be solved with the help of exterminators and a clean environment. Both parties are in-charge of maintaining the areas in the property that are within their scope of liability. Responsibilities such as maintenance, repair and redecoration may also depend on their lease agreement.

Neighbors

If you’re a tenant who lives in a building with other neighbors, you may find it both a good and a bad thing. It may be good to have others to talk to, spend time with and enjoy the pleasure of belonging to and living in a community. On the other hand, others may find it bad because sometimes your neighbors may give you headaches and things to worry about like excessive noise, dirty or smelly surroundings, security issues and more.

Knowing the troubles that can come from tenants can help you ready yourself for being a landlord.

The Importance of Rental Market Prices to Purchases Prices

If we are going to decide between renting a house or flipping one, we only make the right decision when we consider the appropriate guidelines. These guidelines include the aspect of home prices, mortgage rates and rental rates. By considering the above aspects, you will be able to understand if it’s more sensible to flip or rent a house on a long-term basis, economically.

We are dealing with prices, which automatically means doing math. And it is very important that you do the math correctly to avoid financial waste in the end. This is where the rent ratio comes in. A certain property will always have a fundamental price, and that fundamental price will be divided by the rental price. The product is the rental ratio. And according to experts, the tipping point of rent ratio is 15-20. The higher the ratio, the more it would require a spike in housing prices in the coming years to justify the price you are paying today. For example, in a market where a 2-bedroom house costs $250,000 and the annual rent for a similar home is $12,000 ($1,000 per month), then the ratio is about 21. It would make sense to consider flipping the property.

One more thing that should also be taken into consideration is our current financial stand. Buying a home always comes with a financial impact, especially when we are talking about mortgage rates, property taxes and homeowner’s association fees. If you are compromising future plans when buying a home, then it’s best to set aside rental ownership for the time being.

We will never know when high levels of economic uncertainty hit us. It is just prudent to make lifestyle changes that would suit your financial status. Be knowledgeable about the proper guidelines when deciding whether to rent a house or flip it. The financial income that comes with renting is always assured if you know how to calculate certain elements together with rental market prices and purchase prices.

Why Hire a Property Manager

Having a competent property manager on your power team can add substantial value to your investment. I would recommend investors who are planning on doing a buy and hold strategy to get a good property manager to work with them. They can save you time, money and legal issues from tenants. I will outline eight reasons you should hire a property manager.

Screening Tenants: PM’s (Property Managers) have a lot of experience in screening for the right tenants for you. They know how to quickly analyze a good tenant from a bad one, saving you hassle in the long run.

Tenant Retention: It will be important for you to have long term tenants and one way to insure the tenants are happy is to have a good PM taking care of the tenants needs. A good PM will have general business practices that will ensure good tenant retention, so be sure to ask them what programs they have in place.

Rent Collection: Too often when investors try to manage properties themselves they let tenants walk all over them. A good PM will be your barrier between yourself and your tenants. PM’s are doing a job and will follow the terms of the lease and tenants know they don’t make the final decision, you do, and they don’t have access to you. Therefore, this process keeps you out of the light and lets the PM do their job.

Maintenance Cost: Knowing who to call to fix problems with your property is huge. Most PM’s know experienced contractors who have already been vetted by them, who can also give you price discounts on repairs. Keeping the properties in good condition will save you on costly repairs and keeps your tenants happy.

Vacancy: Shorter vacancy time is better for your revenue. A good PM can help improve and prepare the property for rent to maximize profits. They can determine proper rental rates to maximize the units. Lastly they can effectively market your properties to potential renters via many advertising mediums.

Legal Problems: Seasoned investors can tell you that a troublesome tenant can cause enormous legal problems. That’s why a good property manager is important to have because they will have knowledge of the most current landlord-tenant laws and can save you from any potential law suits.

Taxes: Most PM’s can help you understand what tax advantage you can claim. They can also help organize all your paperwork to give to your accountants.

Owners Benefits: A good PM will keep your stress level low because they will handle all the day to day activities on your properties. They have a network of people they will utilize so you don’t have to go searching around. They can free up your time so you can focus on other aspects of your business.

It will take time to find the ideal PM, so use this outline to find the right one for you. They can help protect your assets and keep your cash flow coming in. Make sure to interview several to get an idea on whom to go with.

Buying a Rent Ready Property

When looking for properties to purchase as rentals, many investors prefer to focus on “rent-ready properties”.

The first and most important part of buying a rental property should be to learn about the current market conditions of the area. Always keep in mind that this is a rental, not a high end home. However, the way that your property stacks up to the direct competition in the area determines your rental amount and occupancy rate. You should make an effort to learn about what type of rental properties you’ll be competing for renters with, to make sure that you’re buying a property that’s in a comparable condition. This should of course be done before you even make an offer on the property to begin with.

 

Always keep in mind that this is will be your own property even though you are not going to live in it yourself. Make sure that the outer shell of the property is sound and in good condition and that all necessary improvements are completed. If the exterior of your building is compromised in any way, then the inside will be at risk as well.

Also decide what appliances you are going to provide by learning what other rental properties in the area are providing. As you evaluate a prospective property, look for possible liability risks more than minor blemishes. If you can’t physically visit the property yourself make sure that you get a copy of an inspection report.

 

Here are some issues to look for

  • Are all of the electrical plates present and in good repair?
  • Are there enough smoke detectors and are they placed properly?
  • Are there any issues with lead paint, mold or asbestos?
  • Check the handrails for a good tight fit.
  • Assure that the there are no plumbing leaks.
  • Pay particular attention to the big replacement cost items such as:
  • the Heating system – boiler, furnace, heat pump, etc.
  • air conditioning/cooling system
  • water heater
  • dish washer
  • garbage disposal

 

Make sure that the house you’re buying looks good so that you can retain the best tenants but you shouldn’t expect custom cabinets and granite countertops in a rental. High end fixtures are typically not required. Just make sure that it looks nice and clean. It’s ok to buy a lower grade home to use as a rental but make sure that it is actually livable.

 

Remember, if you agree to buy a property in “as-is condition” then you will need to make any necessary repairs that are needed. If you don’t want to do that, you should negotiate with the seller to fix things before closing.

 

Once you’ve owned the house for a while you may need to replace or repair some things. When you need to replace something in the house, try not to be too cheap. Some investors will take the attitude of “It’s a rental, we’ll just put in the cheapest products that they make and call it good. After all, renters typically are not as careful with houses as they would be if they owned the place.” Unfortunately for you, plastic faucets and cheap door locks break easily and can cost you more in the long run. If while your renter calls you to say that the faucet is leaking, or a locked door handle won’t turn, {because they’re cheap}, you have to fix it. Consider putting in just a bit higher quality than the absolute cheapest, especially if it doesn’t cost a whole lot more.

Selective Tenanting Through Marketing and Promotion

Tenants have a “Shelf-Life,” because they need to be replaced from time to time. They move on or you move them out. Show me a cash-flow investor with a two-year track record of making money and paying the bills and I will show you someone who bankers want to take to lunch and discuss low interest mortgages. There are plenty of rental properties where the numbers can work. The key is having quality tenants who take care of the property and pay their rent on time.

All the promotion you may need for a rental unit that caters to University students might be a giant big screen TV and computer with high speed Wi-Fi. A property on a busy street may only need a simple sign in the front yard. But, in most cases, to rent for top dollar and select the highest quality tenants you want to reach a lot of people in a hurry.

Response
Selective Tenanting Strategies

Anyone can throw money at the problem with lots of expensive ads. Here are some things you can do on a ZERO or near ZERO-dollar budget:

  1. Zillow.com/Rental-Manager – Here you can place a complete ad with lots of pictures and full disclosure information. You will get a link to your own page that you can even email to people while you’re visiting with them on the phone. Zillow may be the biggest name in real estate. I have never run an ad here that didn’t get my phone to ring.
  2. CraigsList.org – The secret is in timing. Place your ads at 11:45 AM and/or 6:30 PM so you can stay “above the fold” during peak view times. “Above the fold” means your ad can be see without scrolling. People click they don’t scroll. Do not repeat the same ad or anything close to the same ad before the required 48 hr. wait time. They tend to not post ads till they are “below the fold” for people who abuse their system.
  3. Print flyers that present not just your rental unit but puff up the neighborhood as well. The back of your flyer can include Elementary, Jr. High, and High School Principals or Vice-Principals contact information. Do the same for Churches, Boy Scouts, Girl Scouts, Town Hall Meetings, Health Clubs, Little League, Police, Fire, etc.
  4. Be creative in where you place your flyers. Got a washer and dryer included? Hit the laundromat bulletin boards. Got the big screen TV? Hit the University bulletin boards.
  5. Visit other rentals especially where your property appeals to a different kind of renter than they cater too. They could send you leads. Visit the Section 8 Housing Department. They will give you the lay of the land on how to work with them so you can have half or more of your top dollar rent put in your checking account on the first of each month.

 

Regardless of how you market or promote for tenants, your future depends on getting good tenants who take care of your property and pay you on time. History repeats itself so here is what you can do to protect yourself:

  1. Have prospective tenants fill out and sign an application allowing a credit report.
  2. Run a credit report. Anyone under 600 probably has late rent pays.
  3. Walk out to their car with them and see how they take care of their car.

Section 8 Vouchers

A Section 8 Voucher, also known as Housing Choice Voucher is a program set up by the federal government to assist low income, elderly and disabled Americans to rent properties at a reduced rate by subsidizing a portion of the monthly rental fee. This program is available in every major housing market within the country and is administered by local public housing agencies. Those who qualify for this assistance can find housing available almost anywhere in the city, not just in subsidized housing projects.

Pros

  • Landlords like the program because they don’t have to hassle with collecting monthly rent, following up on late payments or dealing with excuses about why tenants can’t pay.
  • Renters that have financial hardships, like a job loss or illness, that cause them to have unpaid absences from their work, don’t need to be evicted. Instead, the Section 8 Voucher program will pick up 100% of the monthly cost, until the tenant is able to work and pay again.
  • The Section 8 Voucher program matches prospective tenants with 1, 2 or 3 bedroom properties. The rent is pre-set by the local public housing agencies and tends to be higher than non-Section 8 rental properties.
  • In order to qualify for this program, tenants must consent to annual property inspections. These inspections are performed by a third party at no cost to the property owners. Although these inspections will turn up repairs that are needed, they also help spot damage done by tenants and will assist the landlord in getting rid of the abusive tenants.
  • With over 3 million low income households participating in this program, there is no shortage of possible renters. Many areas have huge waiting lists for Section 8 Housing, so vacancy time is virtually non-existent.
  • Some states provide websites that can be used to advertise properties at a substantially lower cost than other marketing methods.

Cons

  • Section 8 Voucher programs, like any other program managed by the government, has its share of regulations and paperwork.
  • Each property is required to be inspected before a tenant moves in and annually thereafter. The inspection criteria are stringent and sometimes can be costly.
  • Depending on the area that the rental property is located, the Section 8 housing rental caps may be less than the going rate for renting the same property in the normal market. In this case, it may not be financial feasible to go with Section 8.

The Section 8 Voucher program is a win-win situation for by landlords and tenants. It ensures the tenants are getting move-in ready properties and the landlord is guaranteed rent.