The real estate investment game is lucrative. There are 35 names on the 2017 Forbes 400 list that derived their wealth from successful real estate investment strategies and while you may never become one of the 400 richest Americans, there is much to be learned about a methodical real estate investment plan. It doesn’t need to be written out. It’s the thought and planning process that is the most important.
Where to start?
With goals. I am a strong believer in setting goals to establish a baseline for your investment expectations. These goals should be S.M.A.R.T. goals that are specific, measurable, achievable, relevant, and time bound and they should be combined with your purpose for entering into investment real estate:
- Do you want to do this as a side job? Full-time?
- Do you want to make a quick profit by flipping a house?
- Do you want to reposition a property given your knowledge of the area?
- Do you want to use your construction experience to build a property for sale?
- Do you want to buy and hold a property for capital appreciation and to make passive income each month?
There are many reasons to get started but I think knowing what your motivations are and combining them with S.M.A.R.T. goals will get you started in the right direction. It will drive the type of properties you may look at, the structure and ultimately the complexity of the transactions. For example, as a President/CEO of our Minnesota based bank, I don’t have time to negotiate contracts, remodel a home on a flip project, nor rehabilitate a commercial office building. These projects would not be a good fit, so over the years I have invested in commercial properties leased to the United States Postal Service. These are traditionally triple net leased properties with longer term leases which fits well with my time availability and investment outlook. Everyone has a level of involvement that fits their motivation and their investment outlook and I believe it’s important to vet these ideas prior to starting your journey.
What are the different types of investment real estate?
We put together a great Guide to Investment Real Estate that goes over the different types of investment properties an investor could pursue. It is a large spectrum that can be anything from agricultural land to single family homes to downtown Minneapolis commercial office buildings. The important piece is to find one or two property classes that match your investment goals and personality type. The finances will follow these two key traits.
Where do I want to invest?
Notice how I didn’t say where should I invest? I think often times people hunt deals across a large spectrum of the marketplace in search of the best deal regardless of location. Setting boundaries for where you are most comfortable investing is a key pillar in a well-structured real estate investment plan. Commonly, it is a radius distance from your home or office. This allows for flexibility when a tenant or urgent issue comes up and you need to address a problem with the property. How far is it from your primary location and how long will it take you to get there? Alternatively, do you have a key supplier that can handle these issues timely for you? These are key items to consider as you invest in real estate or expand your real estate operation.
How much will it cost? What’s my liquidity and access to capital?
Focusing in on an area and having a defined set of goals establishes the baseline. Now as you hunt for your first or next deal to accomplish your goals, establishing criteria for your investment will be paramount. Your access to capital and liquidity will build these parameters along with:
- Cash flow requirements
- Max purchase amount
- Max rehab amount
- Investment time horizon
A typical Minnesota real estate investment will require 20-25% down payment and require around 2% for closing costs like mortgage registration tax, title work, and other transaction expenses. Simplified, if you have $100,000 to invest and another $25,000 of additional liquidity, a real estate project up to $450,000 would be an ideal scenario. Why? Because you have enough for the 20% down payment, 2% closing costs, and additional $25,000 for any unforeseen repairs or maintenance expenses.
It’s always important to retain some liquidity for unplanned expenses or vacancies. Sometimes this may be access to a line of credit or other instrument, but it is available when and if you need it.
What’s the anticipated cash flow from my investment project?
Investment property returns can be simply using a spreadsheet to analyze the projected expenses for the project. There is no need to start from scratch. We’ve built a simplified real estate investment worksheet you can fill out to estimate cash flow and returns. We’ve also built one you can use to review historical cash flows, estimate break even interest rates and debt service coverage ratios.
Depending on your property type (commercial or residential) the lease structure, the expenses and the rental process will be different. In assessing your cash flow, it’s important to understand how you plan to market the property and what costs will be involved. In a commercial transaction, there will be broker expenses and potentially tenant improvement expenses to plan for in your project. In a residential transaction, you may use a third party to market your unit for rent either online on sites like apartments.com, craigslist, or one of the many other apartment search sites. In all cases, it’s important to have great pictures and details on the property listing. This will pay off in better tenants, higher rents, and faster unit turnover times.
How will you plan to manage the property?
Depending on your goals, you could be the landlord or you may benefit from hiring a property manager. Hiring a third party to manage your properties will require research. It’s important to reach out to three or more potential managers to get a feeling for how they approach property management. Key questions to ask are:
- How do they handle leasing? Commission on new tenants?
- Property management by property or by unit count?
- Do they do repairs/maintenance internally or hire it out? If hired out, what is the process and timing like?
- How do they handle any tenant turnover in the properties?
Firming up the property management costs will allow you to better model out your projected cash flow and address any potential issues in the process before they happen.
A great resource for any type of property ownership is partnering with a local trade association to capture best practices, comparable expenses and lease rates. As a bank in Minnesota, we know the real estate community and ours is a great one to network within. Three great local resources are the Minnesota Multi Housing Association, NAIOP (Commercial Real Estate Development Association), and the Minnesota Commercial Association of Real Estate /Realtors.
Some common operating questions you will want to pin down:
- How much will you collect for a security deposit? What will you require upon move-in?
- Will you allow pets? Additional pet security deposit?
- What will be your tenant approval process?
- Credit check?
- Will you use a third party tenant check site?
- Do you have the proper legal forms? Do you need an attorney?
- Do you understand what the Fair Housing Act covers?
- Do you understand how to evict a tenant?
Lastly, do you have an exit plan?
Preparing for an exit prior to acquiring a property is good planning. Perhaps your plan is to hold long-term or perhaps it’s a short-term re-positioning investment. I believe having multiple clearly defined exit strategies is one of the most important parts of your plan, particularly for new investors. What are your backup plans?