What factors should you consider when buying an investment property to rent out?

QUESTION:

We have been considering buying property for renting, despite all the horror stories. We like the idea of running our own business and having some investment diversity.

The price of a property we're considering is reasonable and it has stable tenants that are interested in staying. The property is in an up-and-coming area so appreciation looks good. It is also close to us, so we can easily check in.

One issue we are debating is cash flow. Because we have to use financing, we have a mortgage (+IPT) which at current rents, has low positive cash flow (really, considering all expenses, probably zero). The current landlord mentioned what was thought the rents should be, and these values are inline with local rents for the same sized units I researched. This increase in rents, would cover all expenses (so MIPT + estimates for repairs, CapEx, etc.) and the cash flow would be much better. However, first year ROI is only 3%.

How much cash flow buffer is enough? I read crazy stories about people only investing in things that have 20%+ ROI but I can't see that happening in such expensive areas.

ANSWER:

This is a great idea.

The factors that you should consider when buying an investment property depend entirely on your strategy and objectives.  If you want a passive investment with yield, the most important number to consider is your Cap Rate (NOI/Purchase Price). Understanding your Pro Forma figures (what you COULD rent for) is very important, as well as the potential appreciation, but these figures can not be guaranteed. A more active investment with a value-add component would require an entirely different analysis that takes into account your cost of improvement and forward-looking ROI.

Also, keep in mind that generally, the more expensive/prime the location, the less yield you will see - as these are the more stable locations with lower risk. If you want high yield, you'll likely be looking at a cheaper unit in a less desirable neighborhood. 

You'll want to keep at least a 6 month buffer on monthly carrying costs to account for a vacancy factor (time the unit sits without a tenant) and any repairs/CapEx/OpEx.

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