How I Select Rental Property Investments -Action Economics

I bought my first home in 2006 when I was 20 years old. Mrs. C. and I started buying investment properties towards the end of 2018 in our local area and we currently own 10 investment properties. One of the most frequent questions I get asked is “How do you select what properties to buy?” Today I will break that process down.

What I Look For In A Rental Property:

These are the main things I look for when evaluating a property to purchase.

Location
Current Ownership (Prefer banks)
Value
Bonuses ( Can I add a bedroom or bathroom?)
Easy “scary” fixes (What will scare off other buyers that I can fix?)
Time on the market

Location:

Here are the main points for location:

Local to my area
Low crime
Low price point / high rent
No city income tax
No wells

Real estate is all about location, and while this is often talked about from a Macro sense, IE Los Angeles Vs. Houston Vs Indianapolis, for us the location is determined within certain boundaries of our small city. I have ZERO interest in owning property that is far away from where I live. I have not scaled to a point where I can make this process fully hands off. Today while working on a property I had to run home 3 times. Sure part of this is poor planning on my part for my tools and supply lists, but still, a 5 minute drive isn’t terrible. A 30 minute, 60 minute, or 4 hour drive is.

If someone pulled up a map of Benton Harbor / Benton Township Michigan with all of the properties we own, no one would likely be able to tell what areas we prioritize. Our houses are spread across several different neighborhoods. Part of this is purposeful diversification, and part of it is selecting specific neighborhoods and avoiding certain neighborhoods. Early on I plotted out violent crime reports on a map and chose to mostly avoid the areas with the most crime. We now own 2 houses that are in the higher crime neighborhoods, and have had no issues.

In general the more time you spend in an area, the more comfortable you become in that surrounding area. For example I can not tell you how much I heard about Pavone St being the most dangerous area in Benton Harbor. In the early 2000s in my mind, this is where you went to get robbed. In 2021 I bought a house on Pavone that needed a ton of work and I practically lived there for 3 months. I had ZERO issues. Every neighbor was kind to me. The back door didn’t properly latch and the house was effectively unsecured at night. I had thousands of dollars of tools and materials in the house and had no property crime.

When looking at crime rates in neighborhoods, you must remember that the vast majority of crime is NOT random. Most assaults aren’t assaults on random people, they are based off of disrespect, someone flashing their money, or other personal matters. This doesn’t make it right, or necessarily somewhere you want to be, just that in general we hear about crimes taking place and assume it could be us.

So now our criteria for location is based more on comfort zone than on actual crime data. There are 2 neighborhoods that we don’t intend to buy in because the values are too high. This is easy enough to spot on a zillow map of recent sales. In general I avoid the city limits because the city has an income tax. Anyone who lives in Benton Harbor city (or works there) must pay this tax. I don’t want my prospective tenants to have to pay this 1% if I can get a similar property outside of the city limits. There are other administrative and government burdens that are more difficult with Benton Harbor city than outside the city limits. Another reason is that in Benton Township short term rentals are allowed, while in the city they are not.

One thing I need to look out for on location when looking outside of the city limits is wells. I have been burned 3 times by wells now and will not be burned again. Many of these homes were built in the 1940s through 1960s and had wells installed at that time, and some houses are still on the original wells. To get the deals I am looking for I often am buying “winterized” properties. This is the process that banks go through to secure properties in the winter to ensure the homes aren’t destroyed. I strongly believe this process damages wells. Replacing a well costs around $7,000 here. To make matters worse we tried to drill a well at one of these properties where we found the well was shot, and WE DIDN’T HIT WATER! Thankfully we could still hookup to city water in this location, which is less expensive. There are some areas of the township where city water is not available and all the properties have wells, so if the well is shot, then you must get a new one. I don’t want to spend $7,000 on a $30,000 to $50,000 house. The only way I’m buying a house with a well in the future is if I take $10,000 off the price tag solely to replace the damn well. There are several neighborhoods that don’t have the ability to be hooked up to municipal water and I tend to avoid these now.

Ownership:

Buying from investors who are exiting the business can be a good strategy to get homes inexpensively, especially if looking for multiple properties. the major downsides that come with this is that often retiring landlords have significant deferred maintenance and have tenants already in place. Those tenants are likely paying far under market rate and treat the property poorly. Our 6 unit had an apartment rented at $350 a month, all utilities included and the exiting landlord remarked “no one ever wants to leave, its great!”

Buying from owner occupants is far worse. Typically these people feel that every personal touch they put into the house is worth 2X what they put into it, and they also “need” to sell for a high price point. In general negotiating with owner occupants is not fun, and I honestly rarely encounter it because their price points are so high.

Buying from the tax auction is another method, whereas the title is now in control by the county. The tax auction process has changed for the worse due to covid, however this is also not a preferable method to buy a house. Mrs. C. and I bought a house at tax auction that was fully boarded up last year. It was full of trash and took 3 months and over $25,000 to rehab it. It is very difficult to know the extent of repairs necessary for a tax auction property.

By far, my favorite seller is a bank. I look up who owns the property and what they paid for it. I then research to find out if it is bank owned or an estate sale. I greatly prefer dealing with banks than home owners. It is much easier to understand the motivation of a bank and to negotiate with them. They are not sentimentally attached to the property and typically negotiate based on real factors and not what they “feel” it is worth. We still have extremely low inventory of bank repos. Banks are also quicker to close and provide a lower amount of hassle in the closing process.

Value:

I ask myself a series of questions on value:

Could I build this property for less than the current price?
Would the rehab price and the purchase price added together be less than the cost to build it?
What will my total “All In” cost be compared to the rents available?
Is This property worth getting a loan for?
What is the projected cash flow?

This is a very important question. Even if this property is a heck of a deal, if it doesn’t make sense to finance then my true cash cost for the property ends up being too high. Here’s an example:

A 1 bedroom house that I can rent out for $600 a month. I can buy this house for $25,000 and will be $30,000 all in on it. IF I were to get a loan my closing costs of $5,000 would be a quarter of the cost of the property. It doesn’t make sense to get a loan when the closing costs are such a high percentage. Alternatively I could use that $25,000 of cash and put it as a down payment on a $100,000 property that will have higher rents.

Cash Flow: I love that I get appreciation with rental real estate. I love that I get great tax benefits. I love that not only do my tenants pay down my mortgage, but that inflation induced debt destruction lowers the real dollars of the debt I pay back. These are all icing on the cake in the grand scheme of things. My real goal is cash flow. The cash flow for the property once it has a loan on it must make sense.

There are countless Youtube experts who will tell you to follow the 1% rule and you will be fine. This is not true. You will lose your ass following the 1% rule. The 1% rule states you should get at least 1% of the value of the property in rent. This did work while interest rates were low, but now this isn’t a safe rule of thumb. Here’s an example of how this would actually work:

Property cost: $100,000
Loan Amount $80,000
Monthly mortgage P+I 15 year 7.25%: -$742
Property Taxes: -$261
Insurance: – $65
Maintenance: -$100
Net Cash Flow: – $168

I don’t want to lose $168 per month. Even before interest rates shot up I wanted to cash flow $400 per month per property. This essentially gives me a clean average of $5,000 per property. In order to do this I need to be in larger properties because the rent on a 2 Bedroom house will typically not be able to cover the cash flow I want. As interest rates have increased I need to get properties at a lower price point than before.

Property cost: $50,000
Loan Amount: $40,000
Rent: $1,100
Monthly mortgage P+I 15 year 7.25% – $365
Property Taxes: -$130
Insurance: – $65
Maintenance – $110
Net Cash Flow: $430

It is important to note that I have never counted my sweat equity into these figures. I put a ton of skilled labor into these projects. There are very few repairs I don’t do. I do electrical, plumbing, framing, drywall, flooring, painting, concrete patching, roofing, etc. If I were to hire out all of this work rather than buying a house for $35,000 and having $15,000 of work into it, I would likely have $35,000 of work into it. As we get more properties I need to start calculating my time into these costs .

Bonuses:

Every property I look at the primary objective I have is to increase the bedroom count. If there are 2 bedrooms I want to make it 3 and if there are 3 bedrooms I want to make it 4. An extra bedroom can add $200 a month in rent easily. This of course tops out, as there are few people looking for a 6 bedroom house. We have added a bedroom to 3 properties so far, have 1 that we can add a bedroom to in the future, and the one we just purchased has the ability to go from a 3 bedroom to a 4 bedroom.

In Mrs. C. and I’s first home we turned the old dining room into a legal bedroom by putting up two doors. In our 3rd rental house we added a basement bedroom into the partially finished basement by adding a legal egress window. In our fourth rental house we added a door to an extra family room. Sometimes it is easy, sometimes not so much.

I just recently started looking for extra bathrooms as well. I have found several properties where there is a shower and toilet in the basement that have been neglected. If I can get the plumbing working and build out a nice clean room around it, I can greatly increase the desirability of the property.

Aside from extra bedrooms and bathrooms, properties with a garage and/or basement are preferred because they give tenants extra storage space. I also like to look for fully fenced in yards, or yards that are almost fully fenced in that I can complete.

Scary Stuff:

At this point I have bought houses with all sorts of scary stuff that will make any rational person run for the hills. It is amazing how many of these scary situations only require a small amount of unskilled labor. Houses full of junk, broken drywall and doors, things like that.

A step further is things that look scary with systems that because I have gained significant skills are no longer scary. Electrical and plumbing are great examples. I just re-ran ALL of the supply plumbing and most of the drain plumbing at my oldest son’s new house for under $500. Electrical fixes are often very inexpensive and just require some troubleshooting. Exposed wires and broken fixtures will scare off a lot of people.

Time on The Market:

Time on the market is a major factor, especially when dealing with bank owned properties. In our current climate we are not seeing any low dollar fixer up houses sitting on the market. The few bank repos that do come through get bidding wars on them. We looked at a house 2 weeks ago that was in terrible condition, had all the scary factors and more, and it had several all cash offers within a day of being listed.

In a normal market, which I do think we will get back to, houses like this that are bank repos that need significant rehabs will start sitting on the market for months. I look for houses that are past 30 days, however anything over 90 days is pure gold. With houses that have sit this long banks are much more likely to take a low ball offer. I remember on my mother in laws house that was a bank repo we offered about 20% less than what they had it listed for and they accepted with no counter offer. Banks do not want to have empty properties on their books for long!

Do you invest in real estate? What do you look for when buying a property?