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Dos and Don’ts for Buying Investment Property

In the last 15 years, renting and flipping houses has become the new hot and sexy moneymaker of real estate investing. Real estate is easy to understand and less risky than stock market investing. However we rarely hear the stories of people who lost everything including their personal investment portfolios and homes through bankruptcy due to a bad real estate investment. Despite the lessons learned during the economic crisis of 2008, there is a rising crop of new investors buying rental property without understanding the risks. In the unfortunate event that an investment does not go as planned, you should be prepared to walk away with little or no harm to your personal finances. This post contains a list of do’s and don’ts for new investors interested in using real estate to build wealth.

 

Do’s

  1. Create a separate business entity (Limited Liability Company, Limited Partnership, etc.) for each real estate property purchased.

This is a very small legal detail but it is very important. Using a separate legal entity to purchase each property will protect your personal assets from being liquidated in the event that the investment goes wrong. If someone attempts to sue you for something that happens on the property, they will not be able to reach your personal assets. New investors often avoid this because banks increase interest rates for mortgages on investment property. Remember that mortgage interest and real estate taxes are deductible. The added protection is worth paying the additional cost. 

  1. Buy a property that has at least 2 to 4 units.

Buying a rental property with more than one unit is similar to the investment practice of diversification. Although your responsibility as a landlord will increase, you have the benefit of receiving rental income from multiple tenants. In a property with one unit, your rental income solely depends on one tenant. If a tenant loses their jobs or has an unexpected life change, a tenant’s payment behavior may change. Having more than one source of rental income can ensure you are able to pay the property’s expenses while working to resolve the situation with a nonpaying tenant.

  1. Run a credit check and rental history check on every tenant to reduce the risk of having nonpaying tenants. Choose tenants that have sufficient savings and investments.

This tip speaks for itself. As a landlord, do everything to ensure you have tenants that are responsible with their finances. Charge new tenants a fee to run a background check to avoid racking up fees on ineligible applicants. Prospective tenants are accustomed to paying these fees. If you are worried about losing a good renter by charging fees that other properties don’t charge, offer the tenant an incentive such as a refund or a rebate in the first month’s rent.

  1. Require your tenants to maintain renter’s insurance. Request a copy of the policy.

In the event, there is a fire or other disaster on your property, there will be less pressure on you as a landlord to cover your tenant’s personal losses.

 

Don’ts

  1. Never sign any of property’s legal documents (mortgage, leases, maintenance services, etc.) in your personal name. Sign all contracts as the authorized manager for the legal entity.

If you sign any document using your personal name rather than a business entity, you defeat the purpose of creating a separate entity. In the event an accident happens on the property or you need to walk away from the investment in a short sale or bankruptcy, you could forfeit the personal protection offered by the business entity.

  1. Don’t buy a property where the income can’t cover all expenses and provide excess profit for unexpected expenses.

In a sellers market, prospective buyers overpay to purchase properties under the assumption that property values and rental rates will continue to rise in the future. Remember, all markets have cycles of ups and downs. If there is a market slowdown that causes rents to temporarily decrease for 1-3 years, you want to have sufficient cash saved from your rental income to cover deficits.

The only exception to this rule is if you buy a property as an owner-operator. An owner-operator is a person who buys a property with the intent of living in one unit and renting out the remaining units. Owner-operators typically get additional tax deductions for properties up to four units. If you are an owner-operator using rental income to cover the full mortgage, make sure you have a sufficient emergency fund that covers at least 6-12 full months of mortgage payments for the property.

  1. Don’t buy properties in secondary markets. Start with properties in primary markets that are close to a mall, supermarket, public transportation or highways.

In a recession, rents decrease when tenants cannot afford to pay. Properties in primary markets become more affordable, and properties in secondary markets struggle to attract renters. As a result, the first properties to lose value are properties in secondary markets. Properties that are far away from convenience centers suffer even more. 

  1. Don’t pay down the mortgage principal with excess funds.

This piece of advice is likely opposite of what you have heard from other sources. In the world of personal finance, debt is considered negative. Most people acquire personal debt to purchase a home and car for personal use. Unless you are running an Air B&B in your home, or using your car to run a taxi service, both your car and your home are non-income-producing assets. Since these assets don’t produce income but require money to be maintained, they can be considered liabilities.

In the real estate and business world however, debt is typically used to buy income-producing assets such as a manufacturing facility or a truck to transport goods. Debt gives investors and business owners the ability to expand business, which increases their profits. If an investor spends $10,000 in cash to buy a $10,000 investment property, the investor can only afford one property. However, if the investor uses 50% debt and 50% cash, the investor can now afford two $10,000 properties.

Investor can only afford one property without debt

$10,000 Cash   Buys one $10,000 Property |

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Investor sells property in 5 years for $20,000

 

100% return on initial investment

(excluding rental income)

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When an investor uses debt as part of an investment strategy, the investor has more cash available to invest in other income producing investments. The investor can achieve a higher Return on Investment (ROI) / Return on Equity (ROE) on a $10,000 investment.

 

Investor can now afford two properties with debt

$10,000 Cash   Buys two $10,000 homes |

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 Investor sells two properties

in 5 years for

$20,000 each

$40,000 – $10,000 Debt =

$30,000

 

200% return on initial investment

(excluding rental income)

$10,000   $10,000

 

 

 

 

 

 

 

 

 

50% Equity / 50% Debt

$5,000 Cash + $5000 Debt

(Equity)             (Liability)

  50% Equity / 50% Debt

$5,000 Cash + $5000 Debt

(Equity)             (Liability)

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