A major difference between purchasing an investment property and personal property is the due diligence process.  Typically, when buying personal property due diligence consists of hiring an appraiser and a home inspector.  Personal home buyers depend upon other general experts to ensure their purchase matches its general description.  An investor’s due diligence process should go much further.

Investors must verify cash flow.  Remember investment properties are valued based on Net Operating Income, which is essentially income available after all property related expenses have been paid, and the Capitalization Rate (cap rate).  The cap rate represents the risk adjusted expected growth rate over time.  Older properties in secondary neighborhood would command higher cap rates because they have more risk and lower expected growth rates.

With that in mind, verification of Net Operating Income will directly affect the price that should be paid for the asset.  In this vein, investors should look to understand and check every line item in detail.

Revenues

Rent receipts should be compared against actually bank deposits.  Any unscrupulous landlord can produce receipts, but it is important to verify that the cash was collected and specifically when the cash was collected.  This should then be compared to the in-place leases to understand if tenants are paying rent on time.  These record should be easy to produce and easy to check.  If you have problems at this stage, be very suspicious of the seller.

Don’t forget to verify ancillary income as well.  Any cash collected from washer/dryers on site or use of specific facilities like a weight room or pool should also be verified against bank deposits.

Expenses

Like revenues, expenses should be verified with bank statements or cancelled checks.  Unlike revenues, there is no rent roll to check expenses against.  The only way to verify that all property expenses have been accounted for is to check against tax filings.  For larger properties, investors will probably incorporate each building, making it easy to verify tax records.  Smaller properties will require looking at the owner’s tax records.  Some make balk at this request, but be firm.  This is the best way to verify the income on the property.

Finding a good real estate market should never be an excuse not to invest.  Almost every market presents a unique opportunity for a creative investor.  Markets with low appreciation and few investors present excellent opportunities to buy cheap, renovate, rent and sell for a profit.  Markets with strong appreciation will require larger capital outlays, but allow the investor to spend less time per dollar invested.

Novice investors should maximize their competitive advantages.  Typically, people know a lot about the neighborhoods in which they live and the surrounding areas.  Little details about what block tends to be worth more than another or new plans for retail development present hyper local investors the opportunity to invest smarter and earlier then outsiders.  Do not give this advantage away by trying to invest in the “next hot market.”

Understanding where the market trends lead should help an investor formulate their investment strategy.  In some areas, renovating and leasing make sense.  In other areas, it might make sense to buy new construction at deep discounts, leases and hold for profits.  Regardless of the area, the more knowledgeable investors can be the better investment decision investors can make. 

Local investors have a valuation advantage as well.  Tracking real estate values in an area for 5+ years provides a good idea of good times to buy and sell.  Additionally, identifying long term trends can often signal market shifts and investment opportunities.  As the new mall becomes the old mall or the north side becomes younger and more desirable, it may be time to cash out of one investment and upgrade to a new area. 

Do not forget that relationship building also takes a tremendous amount of time and effort.  Getting connected to the real estate community is much easier when it’s a 10 minute trip to see an agent, accountant or lawyer. 

Regardless of where you decide to invest, you should be familiar with your local markets.  Investors should never miss opportunities close to home and should be constantly farming their local neighborhoods for like-minded investors.  Maximize your competitive advantage by knowing your neighborhood better than anyone else.

Major and minor developers and investors fill markets like Los Angeles, New York City and Chicago looking to capitalize on the growth associated with these markets.  Novice investors typically take the “me too” approach by trying to enter these markets on a smaller scale or drifting to the outskirts or city limits.  Conversely, smart investors know that by establishing a superior value proposition in an area with little competition yields the biggest return on investment.

Consider my own interesting start in the real estate business.  Living in Detroit, Michigan, I decided to start my real estate practice in the worst real estate city in the United States.  Luckily, I had two things going for me: 1) A tremendous passion for people and real estate and 2) An excellent eye for out of the box investment strategies.  After speaking with real estate agents and mortgage brokers, I discovered that most tenants would pay about $700-$800 to rent a two-bedroom home.  I also discovered that a two-bedroom house sold for $25,000 - $60,000.  The lowest end of the range represented fixer uppers without tenants, while the upper end represented nice structures usually owned by a family or rented to a family.  There would be no natural appreciation because jobs were leaving and the city continued to experience terrible urban decay.

Next, I got on the ground and spoke with the market.  After interviewing tenants, landlords and more agents, I found that most landlords treated tenants poorly and most tenants were only tenants because of their glaring credit score issues.  It turns out that it is very hard to live in Detroit without being laid off at least one time. 

By now I had established a need, an opportunity and a plan.  Everyone in the city needed a decent place to live where they could be treated with respect.  At $25,000 - $40,000, I had the opportunity to provide this at a cost to me of approximately $250-$300/month, while charging a rent of $700 - $800.  Finally, I put together a plan to buy two houses to start the business and test my theory.

My plan ended up being wildly successful.  Not only were both properties providing ~$300/month in cash flow after expenses and debt service, but the properties were appreciating.  They were not appreciating because of the neighborhood, but rather, they were appreciating because I was able to provide any future buyer with tenants, who did not miss a payment in 12 months, and who were locked into a lease at $750/month.  Properties purchased for $30,000 - $40,000 were now worth $50,000 - $60,000. 

This is one example of a unique plan tailored to a local real estate market.  With few investors interested in this market, I had all the investment opportunities I could buy.  Once I established my reputation as one of the best landlords in Detroit, I also had all the tenants I could house.  While this turned out not to be scalable because of its intensive management requirements, I could not have asked for a better first time investment experience.

Appreciation always wins. Novice investors can fall in this trap unknowingly as they search for the perfect first investment. Consider two potential investments: 1) Single family home with a purchase price of $100,000 and a market rent of $1,000. 2) Single family home with a purchase price of $200,000 and a market rent of $1,000. The novice investor will always pick the first investment. It represents a way to stretch investable income and it is intuitively less risky because the rent will more than cover the cost of ownership. So who would ever choose the second investment?

A better question to ask is why the second investment is worth an additional $100,000? There are two ways to answer this question. The simplest way is to say that investors expect the $1,000 generated by the $200,000 property to grow at a much faster rate then the $100,000 property.

Here is an example. The $100,000 property might have rental growth rates of 5%, while the $200,000 might have a rental growth rate of 10%. After 5 years, the $100,000 property will have rents of about $1,275, while the $200,000 property will have rents of about $1,600. What about after 30 years? The $100,000 property will have rents of about $4,300, while the $200,000 will have rents of about $17,500. Over a 30 year period, the owner of the $200,000 will secure about $1.3 million of additional cash based on the higher rental growth rates.

This analysis gets more pronounced when additional renovations that further add to the property are consider because the higher rent also grows at a higher rate. Conversely, it becomes harder to generate appreciation through renovation in lower income, slower growth properties. Typically, the cost of an improvement are fixed (i.e., a washer and dryer costs ~$500 regardless of what neighborhood it is purchased in) but the potential rental increases are highly variable. In some neighborhoods the inclusion of a washer and dryer will bring rents up $10/month, while in other it could be as high as $100. At $10/month, it could take up to 50 months to recover the initial investment, while in the other example, it could take as few as five months. 

Remember the risk/reward trade off in these scenarios. Expected future growth is always riskier than steady consistent cash flow. While the $200,000 property has the ability to appreciate at a much faster rate, it also has the ability to depreciate at a much faster rate. Until 2008 many real estate investors had no concept of deprecation. When expected growth rates adjust downward rapidly, prices follow. Smart investors navigate these ups and downs by buying smart. Great neighborhoods will always be great neighborhoods. Great tenants will always be great tenants. Investors should mitigate the risk they can control, watch the markets diligently and look for potential for area and property specific appreciation. 

 Many first time real estate investors choose single family homes because of their low cost and familiarity. The similarities to purchasing your first home enable the buyer to better understand the risk and offer the buyer an inherent familiarity with the product type. This can be a double edge sword; however, when a buyer becomes so enamored with what he/she wants and forgets about the main focus, the tenant.

Single family investments increase in value based on two factors: asset appreciation and rental increases. Consider two homes in the same neighborhood. One home has a tenant paying $600 per month, while the other has a tenant paying $700 per month. Assuming the market rent is $600 per month and the houses are identical, the $700 per month home will be more valuable because of its higher cash flow. Furthermore, as neighborhoods improve, investors may be willing to pay a higher price for any house in that neighborhood. Perhaps the neighborhood has more jobs, retail, better schools, etc. This increase in value represents appreciation or the thought that the market rent growth rate for a neighborhood should be greater. 

Novice investors have no problem understanding the first concept of rental increases lifting market values; however, the more challenging aspect to understand is appreciation. Appreciation can certainly be property specific.   As an investor installs new kitchens, bathroom, etc. their home increases in value based on these additions. Again, the value increase is because investors expect that they will be able to secure higher rent rates based on the nicer amenities of the property. As in the neighborhood improvement above, investors are willing to pay more today to secure a property where rents will grow at a more rapid pace.

Consider two identical properties today, both rented for $100. An investor buys one of these properties and installs a washer and dryer for $500 and raise the rent $25. Now one property rents for $100 and the other rents for $125. In this example, the fact that one property nets an additional $25 per month in cash flow will add value. Additionally, if market rents increase 10% a year, in the second year the rent for the unit without the washer/dryer will increase by $10, but the unit with the washer and dryer will increase by $12.50.

Based on this simple understanding of appreciation, investors should understand how to create value and how to spot a potentially successful real estate investment. First, look for neighborhoods with strong appreciation. Avoid areas where prices appear to be abnormally high or falling rapidly, even if you think it’s a good deal. Second, look for properties with potential for appreciation. It is rarely a good investment to buy a newly renovated home as a rental because you will have to pay the price for the expected higher rental growth. It is much better to buy a home with no renovation, put in the items that will yield the highest returns and then let the appreciation work for you. It’s always better to buy the worst home in the best neighborhood, than to buy the best home in the worst neighborhood. 

 A great real estate investor always knows the pulse of the markets they invest in. Understanding every aspect of a neighborhood helps investor know the best times to buy and to sell in order to maximize profit and minimize losses. While many companies offer a variety of market data, in my many years of real estate I have found the best way to get to know a market is to simply talk to the locals.

Appraisers, bankers and sophisticated investors guard the most well kept secret in real estate when it comes to market research. Despite the vast amount of resources at the disposal of these sophisticated real estate professionals, they rely on walking the neighborhood, connecting with multiple real estate brokers and attending various community meetings. While many data providers exist to round out this process, any serious real estate investor will be a regular at open houses, local real estate board meetings and have a rolodex of good real estate professionals to periodically check the pulse of the market.

Before considering any investment, an investor must understand the comparable properties. Many novice investors make the mistake of relying on appraisals or one real estate agent to provide them all of their important market data. The only way to understand how much a property can be leased for is to understand the quality and quantity of similar units currently in the market.

Get into the tenants shoes and start shopping. If you are an investor planning to buy a rental property that will charge $600, then you should start you process by first attempting to rent a $600 home or apartment. What do you see? Is there extremely poor service or are the offerings few and of low quality? Why? Often, in landlord friendly markets, tenants will pay a small premium for attentive landlords that provide timely maintenance and repairs.

Comparable shopping provides a road map to maximizing an investment. If no unit in the market comes furnished or with appliances, then its probably a safe bet that most tenants have their own and that it would be a poor spend of investment dollars to provide them. Again, investors should look to be slightly better then the competition, while getting to that point by spending as little capital as possible. 

Market research requires leg work and relationships. Investors that plan on being in a market for an extended period of time serve themselves well by going to a planning meeting, attending open houses, shopping the competition on a monthly basis and getting to know the best local real estate professionals. Not only will those investors make smarter investment decisions and limit their risk, but they will also find this to be a great source of future investment opportunities.