How To Evaluate A Potential Investment Property.

There are 3 important aspects of a property you need to evaluate… these are the same for almost every investment property.  

Physical Characteristics

The first aspect of a property is its physical characteristics.  This includes things like:

• square footage,
• number of units/rooms/bathrooms/etc.
• amenities (stainless steel appliances, gym, pool, etc)
• architecture
• class of property
• property condition
• location, etc.
 
The size, characteristics, and location will determine who wants to be your tenant, how much they’re willing to pay, what kind of appreciation you’ll be able to get.  When you’re assessing a property you want to consider all of these characteristics and what it means for your rental price.  

You will also want to assess how you could improve the property to it’s highest and best use or to get the highest and best rents.  Sometimes the best investment property is one that is not in the best shape when you buy it, but can be relatively easily improved to get great rent relative to your purchase price and the price of renovations.

My client Julie asked me “I found this great property in New Orleans that I want to use for an AirBnB.  Is this the right property for me?”   The property Julie was considering was a beautiful Creole townhouse in the French Quarter that needed quite a bit of rehab.  These historic properties with gorgeous architecture are sold at a 20%+ premium because people who live there prioritize the historic properties.  For an AirBnB property, we realized that what was most important was (a) its location relative to the sights, and (b) the accommodations on the inside.  AirBnB focuses on the look of the property inside.  It didn’t necessarily make sense to pay the premium for a historic property… especially one that would require a lot of extra funds to fix up.  For what Julie was looking to do, it made sense to buy a newer property in better shape that was still in a great location.  With the savings on the historic property, Julie was now able to find a bigger place that could afford better rates on AirBnB.

Purchase Price

The second aspect is the purchase price.  If your goal is to purchase a cash-flowing, money-making property, you can’t pay too much in order to do so.  The property may be gorgeous, but if you pay too much you’re losing money.  Or the property may be a mediocre ugly duckling, but if you’re able to buy right it can turn out to be a real cash cow. 

It’s important to know how to properly evaluate a property (e.g., understand the differences between assessing value on a 1-4 unit property versus a 5+ unit property) so that you don’t pay too much.  

One of our Real Estate Investor Goddess students Dana was debating between purchasing a 4-plex property and a 5-plex property in her neighborhood.  The 4-plex was selling for $200,000 and the 5-plex for $230,000.  the 4-unit was selling for $50,000 per unit and the 5-plex was selling for only $46,000 per unit.  The rents per unit were comparable, so was it a better deal for the 5-unit?  

 A 4-plex is considered a residential property and assessed value is based off of comparable properties sold in that market.  A 5-unit is considered a commercial property so the way of valuing the property is completely different.  They look at that type of property as buying a business. The value of a 5+ is based off of the property’s net operating income divided by the cap rate, and the terms on commercial loans are very different.

The big challenge with a commercial property is that the downpayments tend to be substantially higher (often 25%+), the loan periods are shorter (10 years is much more common than 30 years), and there are often substantial pre-payment penalties.  These factors often make small multifamily properties (5- or 6-units unattractive as compared to a 4-unit).  When you are getting into larger properties, some of the benefits of commercial loans start to become more beneficial (e.g., being able to purchase as an entity, the income of the property being more important than the buyer’s personal income, etc.)

After discussing it, Dana realized it made more sense for her to buy the 4-plex.  Because Dana was planning on occupying one of the units, she could get an FHA loan and only put 3.5% down ($7000) versus 25% on the 5-plex ($57,500).  Also because she was able to amortize over 30 years, versus 10 for the 5-plex her monthly mortgage payments would be much cheaper.  So, even though she might be able to save $4,000/unit on the front-end, she’d end up saving a lot more money every month by going for the smaller property.  

Seller

The third aspect is one that many people don’t think about, but is potentially the most important of the three aspects.  This one has to do with the seller/current owner.  This encompasses three things:

the seller’s management of the property.
the seller’s savviness
the seller’s motivation for selling the property

When you are purchasing real estate, it’s never really about the property… it’s always about the people. Who the seller is, how he/she has been running the property, how motivated they are to sell, and how savvy they are can and will make all the difference in whether you can do this deal and how much you can.   

If they’ve been a poor property manager, that can be an opportunity to add value by improving management.  It can also be a challenge if you inherit some terrible tenants and lots of deferred maintenance.  If they’re not very savvy, they may expect far too much for their property or conversely be willing to take far less than the property is worth.  If they’re very motivated to sell, they may be willing to take less money, do seller financing, or take care of more deferred maintenance before selling.  

Also, it’s important to note that sellers will not always sell just to get the highest price.  Sellers often have other motivations like … who will be able to close faster, who will take the best care of the property going forward, who will be the best neighbors, etc.

So you definitely want to ask “why is the seller selling?”  And you want to try to find out what is most important to him or her, so you can find creative ways to get to YES.

***

It’s important to fully understand all 3 aspects of a rental property and their repercussions so you can acquire the best property for you at the best price.