If you're thinking about buying your first rental property, there's a good chance you may be considering the purchase of a duplex or small apartment building.
Your idea is a good one: Many small rental buildings can be purchased with a small down payment and they're usually easy to buy and sell. They also help you build equity to eventually make a larger purchase, while teaching you the basics of property management.
But don't make the mistake of thinking that owning and operating a small rental complex is an armchair experience.
"Too many people don't realize that residential property requires a tremendous commitment of time, energy and effort," says Klara Katersky of Katersky Financial, a Woodland Hills-based syndicator who made a fortune by investing in small apartment buildings. "It's not cost-effective to hire a manager for such a small property, so you'll have to do it yourself--and still find time for your spouse, kids and full-time job."
Even before you go out shopping for a duplex or small apartment, it's important to decide exactly what you hope to achieve by purchasing it.
"Determine whether you want the property primarily to diversify your assets or whether you're looking for steady monthly income," says Lawrence A. Krause, president of the San Francisco-based financial planning firm Lawrence A. Krause & Associates Inc.
"If you want monthly income, you'll have to make a pretty big down payment--maybe as much as 45%," Krause adds.
You might be willing to settle for a break-even cash flow or small monthly loss, provided you will be able to write off your losses, or the property's appreciation potential is extremely good, or you plan to live in one of the units to lower your own housing costs.
Once you've decided what you want out of your investment, it's a wise idea to go to a bank and establish a line of credit. "If you find a real good deal that's going to move quickly, it's good to have instant access to $5,000 or $15,000," says Corey M. Patick, chief executive of Stockton-based Gibraltar Community Builders, one of the state's biggest apartment developers and owners.
"You wouldn't want to lose a bargain just because you couldn't make a $5,000 deposit," Patick adds.
Most experts say you should look for a building that's near your current home, primarily because you'll personally have to manage the property and perform most maintenance duties. "Management firms usually want 5% to 10% of your gross monthly income, and that can mean hundreds of dollars a month out of your bottom line," says Patick.
A good real estate agent can be useful, but make sure the broker has sufficient expertise in buying and selling income property in your target area. Patick suggests getting referrals from knowledgeable investors or calling agents who have several "apartment for sale" advertisements in your local newspaper.
Some of the best apartment prospects are often near new commercial developments, says Linda Falcon, a realtor with Century 21/Medallion Realty in West Los Angeles.
"New office buildings and better stores help promote a better living environment and higher prices," Falcon says. Other items to look for are a good transportation system, recent renovation jobs and easy accessibility to parks, entertainment facilities, churches and synagogues.
The condition of the building should reflect its age: Although a run-down duplex or apartment may present a bargain, you must consider how much it will cost to upgrade the building so you can raise rents to market value.
In order to properly evaluate a potential acquisition, the seller will need to provide you with certifiable information about the building's annual rental income and expenses, Falcon says. If any of the tenants have long-term leases, you'll need to consider terms of those leases when estimating future rental income.
Although your realtor should be able to help you determine whether the property is fairly priced, it'll help if you know a little about the factors used in pricing apartment buildings and the terminology you'll hear as you shop for an apartment.
Rental income--what you collect now and what you can collect in the future--is the primary factor in determining the value of any type of income-producing property. Although there are several methods of income analysis, the most popular method is known as the property's capitalization rate.
You calculate your cap rate by taking the building's annual net income figure and dividing it by the proposed purchase price of the property. A building that provides $18,000 in annual net income and is listed for $190,000 has a cap rate of 9 1/2%; an apartment with $25,000 in net income listed for $240,000 has a cap rate of 10.4%.
Is 10.4% a fair return on your investment? It depends on a number of factors, including the riskiness of your investment and the yields of alternative investments.