Purchasing  Rental Properties

Determine your objectives

Many people begin the process of looking for such properties with positive cash flow in mind.  While this may be possible with a very large down-payment, a better objective would be to break even or possibly a small negative cash flow.  There are many tax write-offs associated with rental properties and a small negative cash flow can turn positive at tax time. Personally I have never done more than break even on a monthly basis but reap the rewards at tax time.   If you are just starting out in these investments, your goals should be long term appreciation.

Pay close attention to the rental income.  Be realistic and scrutinize the current rent as compared to market.  Often sellers of rental properties will hike up their rents just prior to the sale.  In Washington , purchase and sale agreements for multi-family properties include a books and records review as a contingency.   This is your opportunity as a buyer to review the rental history, investment income portion of the seller’s tax return and other items.  Be sure and ask to see a history of rents.  Be wary of recent rent hikes that may be pushing the envelope for the area.

Crunch the numbers to see if they make sense for you.  Your Realtor can provide some guidance but he or she is not an accountant and should refer you to one for an expert opinion.   Expenses you should consider include a vacancy factor, utilities, repair allowance, taxes and insurance.    Look at both the monthly cost of ownership in terms of cash flow and the tax benefits you can expect to receive.  Can you afford the negative cash flow on a monthly basis and still be able to jump in and spend money on repairs as needed.  Remember that things like hot water heaters, and appliances do break. Heating, Plumbing, and electrical systems can develop problems.  You will need some financial reserves to deal with these problems as they occur.  As a landlord you have a responsibility to fix these problems in a timely fashion.

On the flip side, you can expect healthy tax write-offs.  If you have outside income then these can reduce your tax liability and result in some nice annual tax refunds.  Depreciation, mortgage interest, utilities expenses, property taxes, insurance, mileage to and from the property and property repairs are all tax deductions.   Your tax statement should show a loss on the operation of the property.  Multiply this by your tax rate to arrive at your total tax savings.  Note that there are limits to allowable losses and you should consult with an accountant or other tax expert to determine the exact impact of these expenses on your bottom line.

Evaluate not only the property as-is, but think about required repairs or upgrades.  A property that looks great on paper may not appear that great when you factor in $50K or more in needed repairs and upgrades.  Remember that the overall condition of the property will have an impact on the rent you can expect to receive.  A property in great shape with nice upgrades and amenities will be easier to rent and should collect a higher rent than similarly located properties in poor condition.

Find the right location.  In the local market, neighborhood demographics and demand vary greatly.  Typically less expensive properties are in less desirable locations that command lower rent.  Some of these lower priced properties do provide a better opportunity for positive cash flow but due diligence is required.  Try to determine the availability and quality of available rental properties in the area.  Are the reported rents in-line with the neighborhood?  What kind of tenants can you expect?  Make certain that you feel comfortable managing a property in the area.

Recent trends have shown some of the strongest appreciation has occurred in run down neighborhoods.  As property values continue to climb, the search for affordable housing has driven people to purchase homes in these areas and restore them.  The general affect has been to bring up the value of all the properties in these neighborhoods.  Unfortunately, finding such ‘diamonds in the rough’ has become increasingly difficult as more and more neighborhoods have gone through the‘re-gentrification’ process.

The Purchase and Sale Contract

I want make note about some of the key contractual elements of a contract for the purchase of an investment/rental property.

Contracts for purchase and sale contain a number of contingencies.  These are elements that legally protect the purchaser and allow him or her to walk away from the deal.

Contingencies include:  Books and Records Review, Buyers Walk-thru, Structural Inspection and Financing.   Another common contingency is the Contingent property whereby the deal is contingent upon the successful sale of the buyer’s property.  All of these can cause the deal to fail and allow the buyer to walk away.  They also have timelines and failing to perform within the contractual timelines and provide proper notice means that the contingencies are waived.  For example, assume the purchase and sale agreement calls for a books and records review within 5 days of receipt of such records.  The buyer disapproves of the review but fails to provide notice to the seller within the 5 days.  The condition has been waived by time and is no longer a valid reason to walk away from the contract.

The books and records review is the purchaser’s opportunity to verify that the numbers reported during the marketing of the property are genuine.   If you are purchasing a single family home as an investment property and it is currently a rental you may want to add a books and records review as an addendum. There are typical documents provided for such a review.  The buyer can also request specific documents and disapprove of this contingency if they are not provided.  Rent rolls and rental history, reported income tax information, information on recent repairs and upgrades, and print outs from computer accounting programs are all common information presented to prospective buyers during the books and records review. The sale can be disapproved without any specific excuse.  A simple disapproval form is presented to the seller and the deal is off.  For this reason, it is important that truthful disclosure be given up front during the marketing of the property as actual numbers will surface.

The buyers walk-thru is usually the first opportunity for the prospective purchaser to see the interior of the property.  Sometimes a vacant unit is available for preview prior to entering into the contract, but the walk-thru is usually the first opportunity to see the interior of all the units.  It may be the listing agent’s first opportunity as well!

This is done for good reason as it helps protect the rights of the existing tenants and avoid unnecessary disruptions.  Often times the tenants do not know that the building is for sale but typically will figure it out during the walk thru.  The walk thru must be scheduled in advance with the tenants and they must be provided with proper notice.

The second inspection is the structural inspection.  This is done by a licensed professional to determine if problems exist with the property and the extent of the problems.  A good inspector often has words of advice for the purchaser as how to resolve the problems that he discovers.  Once again, this must also be scheduled in advance with the tenants.  It is nice when a serious purchaser schedules the walk-thru and structural inspection at the same time to minimize tenant disruptions.  Someone who is serious about a purchase will want to minimize the disruptions as the tenants may become his tenants!

The final contingency is the financing contingency.  For small properties of 4 units of less, the rules are similar to single family homes.  The appraisal must meet or exceed the selling price.  The buyer must perform by applying for a loan within a timely fashion.  The seller has the opportunity to review the buyer’s loan process and receive updates on the status of the loan.   The seller can ask that the buyer waive the financing condition or terminate the transaction if it appears that the loan is not proceeding as anticipated.   A good listing agent will insist on seeing some statement of financial qualifications from the buyer’s lender prior to recommending that his client enter into the contract.

For Commercial properties, (5 units and up) the loan process is a bit more stringent.  The building must perform financially and the lender will make a determination of the maximum loan amount.  This is based on the financial performance of the building, estimates of required repairs and repair allowances, estimates of market rents and other factors.  To make the deal close, the purchaser must have the required funds for the down payment based upon the lender’s criteria.  For commercial properties, it is advisable for the listing agent to have several lenders evaluate the property and arrive at the maximum loan amount.  It is then possible to determine the likelihood of the purchaser closing the deal prior to entering into the contract.

I hope that this information has been useful.  You can see that the process of buying or selling such properties can be complex and the services of an experienced Realtor can be invaluable.  If you need help buying or selling, you can call me direct at (206) 412-0466 or toll-free (877) 703-3285.