Is This The Best Business Model In Real...

rent Editor’s Note: Dennis Fassett is a former corporate finance executive turned real estate investing “Cash Flow Mercenary.” Dennis specializes in single-family and multi-family cash flow properties and thoroughly enjoys assisting his fellow investors with their own strategies, including how to buy your first apartment building.

As an ongoing contributor to Mogul’s “Market News Updates,” Mr. Fassett provides us with his own unique, lively, and thought-provoking commentary on the timely industry news and events of today that are impacting our industry. And be sure to check out his other super-helpful Market News Updates. For now, enjoy...

From Dennis Fassett, Cash Flow Mercenary...

I saw a piece on the Motley Fool site recently that piqued my interest. I don’t pay a lot of attention to those guys because of their slavish adoration of stocks, but the article I saw was decent, even though it was a bit oversimplified.

I wanted to pass along their thoughts, though, because I think that it’s good to revisit the "blocking and tackling” aspects of any business that you’re in from time to time to make sure you don’t loose sight of the fundamentals.

The author made the point that if you're thinking of investing in real estate, it pays to know what has worked for other investors. I’m a big fan of not recreating the wheel.

My own personal philosophy on this goes along the lines of what some far smarter and wiser folks like Picasso and Steve Jobs have stated – that good artists copy; great artists steal.

We all know that real estate can be an excellent way to create wealth and diversify your investment portfolio, but just like everything else in investing, there is a right and wrong way to buy and manage investment properties. One of the best ways to learn how to invest in real estate is to learn lessons from those who have been successful.

So let's see what we can learn from the habits of other successful real estate investors…

Location, Location, Location

This seems like it should be beyond a no-brainer…

But I just got yet another call from an out of state “investor” who way overpaid for two abysmal properties in a war zone in Detroit and was looking to sell them. I took a look at the addresses and looked up the property taxes, and gave her the bad news that they weren’t even worth the value of the $4,000 in combined back taxes.

move This is even more significant when you’re buying rental properties. You’re presumably going to own them for a long time, and everyone I know with rental properties want them to be hassle-free.

So, one of the most important things you can do is to acquire properties where conditions are favorable for renting. Now, I realize that most of the people reading this aren't going to buy a New York City high-rise or other in-demand trendy apartment building, but you can employ similar principles when choosing properties.

First off, you should focus on buying properties in areas where rental demand is strong. Another no brainer, I know, but there are countless investors who buy rentals based on price and think they’re going to make it work as a rental no matter where the property is. That’s a prescription for failure, and it’s like trying to cram a square peg in a round hole. It just doesn’t work.

The author says that he lives close to a major university, and the student population there is growing faster than the number of available housing units. So, if he wanted to buy a new investment property, he says he'd probably start his search there, because not only is the property likely to stay occupied, but basic supply and demand indicates that the rent will rise over the coming years.

The author obviously doesn’t own rentals, or else he’d know the downside of doing that. Student housing is on fire right now, and having recently researched the top 100 student housing markets in the U.S. for another project I’m working on, I know that you’re not going to buy anything near any of those universities at a price where you’re going to make money out of the gate, especially if you use financing to buy it.

In fact, in those markets you’d be lucky to get something like a 3-4% ROI, and that's BEFORE financing costs are taken into consideration. So you'll lose money on day 1 with them. It usually takes a few years for appreciation to make those investments worthwhile through refinancing at a higher value.

Another thing to look at is the demographics of the neighborhood. According to one residential REIT, the 25-34 age group will increase by 1.1 million over the next three years. And since the home-ownership rate among young adults has dropped from 43.6% to 35.3% over the past decade, this is a group that is likely to rent.

In other words, areas with high concentrations of this age group are favorable places to own rental properties.

Unfortunately, those locations suffer the same problem as student housing does. Everybody wants to buy them. And that drives the prices way up and the returns way down.

So, instead of following the big boys and girls into an investment niche that initially throws off negative returns, I have another suggestion. It’s an approach that I’ve been using since 2004 and I’ve been teaching people to use since 2008.

I focus on school districts. Exclusively.

Why? Because I want long term tenants who want to live where my houses are; who will stay a good long time; and who take good care of the houses. And so far, I’ve never found any segment of the population that fits that description better than young families with school-age kids.

But whatever niche of strategy that you decide to pursue, remember that you can’t fix location!

Be Careful Who You Rent To

This is another name for tenant screening, and it was the author’s second point, and I agree whole-heartedly with it. In fact, the two absolute critical success factors I teach for rental properties are location and tenant screening.

So once you've chosen a property, the next important step is being selective when it comes to finding a tenant.

The author states some things he thinks are important to screen for, including:

A credit check
Stable employment
More than enough income to cover the rent, and
A solid rental history

This list is a decent start but far from adequate. A good screening process includes a full background check that includes criminal history and any rental related judgments.

Create Value Through Acquisitions and Sales

This is where the author goes off the deep end...

He states that "one of the more effective real estate investing strategies is ‘buy, fix, rent.’" By purchasing properties with solid structural integrity but some cosmetic issues, you can acquire the property for less than market value, do some rehab work, and rent it out. And by doing some minor renovations, you have the potential to greatly improve the property's resale value and create immediate equity.

For example, he says if you could buy a house for $80,000 that needs $5,000 worth of work and would then be worth $100,000, it would produce a quick $15,000 return on investment.

That’s a bunch of crap.

It produces a quick $15k in equity, which adds to your net worth. But guess what? You can’t spend net worth.

It’s always good to buy undervalued properties to get equity, but only when it makes sense. I’ve actually overpaid for rentals in the past because I have an infinite time horizon and really don’t care very much about what they’re worth when I buy them. All I care about is the cash flow they throw off.

Plan For The Unexpected

This was the author’s final point. And it’s an important one.

In a perfect world, your investment properties would never sit vacant, you would never have to evict a tenant, and nothing would ever break. Unfortunately, we don't live in a perfect world - sometimes things don't go as planned.

For this reason, it's important to plan ahead for unexpected expenses like these. As a general rule, plan to set aside 10% of the rent to cover maintenance expenses, and this should be adjusted upward depending on the age of the property. And another 5-10% should be set aside for a vacancy reserve. That way, if the property sits empty for a couple of months between tenants, you can still cover your expenses.

Finally, make sure you have a good landlord's insurance policy, and if you have more than a few properties, an umbrella insurance policy might be a good idea to protect your assets in case a tenant decides to sue you for whatever reason.

Mostly good advice from the Fool.