5 Rules for Evaluating an Investment Property

JANUARY 07, 2014
James M. Dahle, MD, FACEP
Many physicians will own rental property at some point in their investment career. However, they often fail to analyze it properly before making the purchase. Applying five rules of thumb will help ensure a favorable investment outcome.
Rule 1: You make your money when you buy
Experienced real estate investors know that the secret to making strong returns on real estate is to buy a property at a fair price or, better yet, at a discount. You simply cannot pay “retail” and expect a good return.
Retail is the price at which an inexperienced home purchaser would purchase the property to live in, and can easily be demonstrated using recent sales of comparable properties in the area. That means you cannot shop for a property using the Multiple Listing Service (MLS) and expect outstanding returns. By the time a property hits the MLS, the most experienced investors in the area have already taken a pass at that price. That doesn’t mean you cannot purchase a property listed in the MLS, it is just that you need to pay 10% to 20% less than the retail price listed there.
When you buy a house to live in, there are a lot of factors that go into it. Do you like the neighbors? Are the schools good? How long is the commute? How will your furniture look in the house? Can you see yourself growing old there? These and a dozen other issues come into play.
But when you buy an investment property the purchase is all about the money. What kind of a return will you get on your investment? You do not care about the color of the carpet, only about how soon until you will have to replace it. You should not care about the school district or the distance from the hospital, only about what you can get for rent.
Rule 2: Use the 55% rule to determine your net operating income
Perhaps the most important number to know for a rental property is its net operating income (NOI). This is the amount of money you get after all expenses, except financing costs like principal and interest payments. You don’t actually need to know all the expenses a property may have in order to estimate this.
A seller obviously has a great incentive to report that the expenses are very low, but very low reported expenses may mean that you have some large expenses coming up, such as replacing the roof, air conditioner or windows. A good rule of thumb is to multiple the gross rent for the year by 55%. Approximately 45% of the gross rent will go toward vacancies, insurance, maintenance, property taxes, snow removal, lawn maintenance, repairs, and management costs (whether you pay them to someone else or use your time to avoid that expense).

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