Top 4 Things You Should Know When Buying An Investment Property

As a professional in the field, here is a list of things you should look out for if you are new to this line of business. Note that this is not all-inclusive, but these are some of the most crucial decisions you need to make early on:

1. Cash Flows Often Vary

Arguably, the most essential task needed prior to investing in a property is modeling cash flows. Being able to predict with reasonable certainty the profits derived from a project, the expenses, the revenues, the vacancy, the tax rate and credits, the depreciation, and so forth, can save you from being unable to support the debt service in the event a systematic or personal risk materializes. Money now is worth more than money later, and so the cash flows need to be discounted. Growth rates need to be estimated, and your discount rate should be known. That is, you should know what the opportunity cost of this money that you have just sitting can earn you elsewhere. If you can earn more elsewhere on a risk-adjusted basis (often measured by standard deviation), then you shouldn’t invest in this project.

2. Management May Not Be Worth Your Time

Let’s say you save $10 a meal by cooking at home. The hour it takes you to prepare your meal can be used elsewhere, perhaps at your job, earning more than the $10 you spent. The difference is arbitrage. This is known as opportunity cost. Similarly, managing your property may not be worth your time. Do you want to deal with tenant issues, random fixes, and dealing with the HOA? This can be outsourced to property management companies, and it’s important you know how much your time is worth and what you plan to do prior to purchasing the property.

3. Leveraging Can Make Or Break You

Leveraging is the act of borrowing—hopefully at a lower rate than you are earning—so you can make money off of the bank’s money. There are different types of loans, ranging from low interest rates to hard money. While you are increasing your potential payoff, realize that you are now in first loss position, with equity characteristics. If the property goes down 30%, and that equals your down payment, you have lost all your equity. The bank, meanwhile, still retains its 70% value, which is now virtually 100%. The alternative is you purchase the property cash, which costs a lot more upfront, but if the property goes down 30%, you only lose 30%, not 100% of your money. You will need to make this decision when buying a property. Purchasing now, you can get some of the lowest rates in history, but asset values are also particularly inflated. Keep that in mind.

4. Leave A Cash Cushion For Unpredictables

The one thing I learned from the Great Recession was that my father lost tens of millions by not having adequate cash in hand. Since he was levered, he found the properties worth more than the banks’ loans (virtually underwater), without any cash to support the debt payments. The result is inevitable foreclosure, or selling at the wrong time: when properties values are low. You end up losing all your equity. Make sure to have a cushion prior and after closing on a real estate deal. Putting all your eggs in one basket may be tempting, but realize your unsystematic risk (diversifiable risk) has gone up, and you aren’t getting compensated for this risk.

If you have any questions, feel free to reach out to me—whether for modeling, deal-specific, or other. I’d be happy to help.

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