The Beginner’s Guide to Purchasing an Investment Property

Many of my clients and friends have asked me how to get started in real estate investing and also how to decide what type of real estate investment they should pursue. Since I have invested in a handful of buy and hold multi-family properties, been a partner on some rehab projects, and have acquired other real estate investments that I have found to make sense, I can sometimes provide helpful advice on this. Being involved in the real estate industry sometimes allows access to and gives me the experience to quickly spot the potential in these opportunities. Good ones are few and far between, especially in a competitive, high-cost market like Los Angeles, but here are some of the most important factors when considering a real estate investment:

• What is your primary goal? Determining your goals and time horizon is the first step in making an investment decision. Is your goal passive cash flow over the long term? Are you looking to add value and re-sell a property for a profit in a short period of time? Is the goal to achieve the highest appreciation with less emphasis on immediate cash flow? Are you willing to manage the property yourself or will you hire property management? Your answers to these questions will take you down a particular path to help you choose or eliminate certain properties or locations. Generally, the more desirable, lower risk locations are the ones that appreciate more over a longer time horizon, but they are also the ones with a lower cash on cash return since their land values and purchase prices are much higher, but rents are not commensurately higher. At the risk of stating the obvious, in a high interest rate environment like we are currently experiencing, it is much more challenging to make the numbers work on cash flow investments, however if rates go down to 4-5% again or if you are putting down a significant amount of cash, they much more easily pencil out.

• How to select a city or location? Some of the factors I look for in determining a strategic investment location are population growth, rental vacancy rate, new construction deliveries, unemployment rate, and how many and which companies are expanding or moving into this area. A lot of this information is available online, so you can research this pretty easily. For Los Angeles, population has been flat to even trending down slightly over the past several years, but the job market is still strong and the vacancy rate is low. If you purchase something locally, you might be able to manage the property yourself and save on 5-10% monthly management fees and leasing fees, which can eat into the cash flow. However, the high cost of housing makes L.A. a very tough market to cash flow regardless of any savings and requires a lot of capital to make a purchase, although historically it has been one of the best markets for appreciation. Selecting a low-cost market such as Cleveland, for example, might allow an investor to be cash flow positive, even with higher interest rates and a lower down payment, although the potential for appreciation might be lower. The population of the city of Cleveland has declined over 25% in the past 30 years, so if this trend continues, questions as to rentability and value arise. Will renting out the property become more challenging? Will rental prices fall and will there be sufficient buyer demand to sell for a profit upon resale? It is hard to imagine a world where rents and values increase when the population decreases by that large of a margin.

In the first quarter of 2022, I was faced with making a personal long-term hold investment decision between Cleveland and Columbus, Ohio. Both located in the same state, I was able to visit both on the same trip. While Cleveland had the edge in terms of immediate cash flow, I saw that the population of Columbus had been growing over time, there were many more stable jobs with a major university, several other major employers, and construction of a major semiconductor facility was being planned in the suburbs. This made it a more desirable, lower risk location with future job growth. Additionally, the neighborhood we were considering in Columbus was more attractive and walkable to upscale amenities, increasing the potential for appreciation, rent growth, and easy rentability. In the end, we chose the lower risk, lower cash flow location, Columbus. With interest rates at that time being much lower than they are today, the property cash flowed slightly from day one, even with property management expenses. With current interest rates, cash flowing would not have been possible with the standard 25% down payment, so we would not have made the same purchase today.

• Current tenant rents, rent control, and vacancy – If you are buying a property for cash flow purposes or to add value, it is important to know whether the property falls under a rent control ordinance and, if so, what that means to your ability to raise rents or remove tenants. There is rent control in Los Angeles and this greatly affects the values of individual properties based on the existing leases of the inherited tenants. If current rents are at market or close to market value, this might not a major detriment to current value, but if they are well below market value, it is going to be difficult to bring them to market value unless and until the tenants move out, which could be many years. While this might give it “up-side potential”, which could lead to an increase in future value, it will be hard to capture this value when tenants cannot be removed from the property, or if doing so is prohibitively expensive. In a rent-controlled market, it would be most desirable if the units are either rented at market value or vacant at the time of the purchase. Keep in mind that rent-controlled locations might also be inherently tenant-friendly, so evictions could be more challenging and there might be restrictions on your or a future owner’s occupancy rights (i.e. in Los Angeles, you cannot ask a tenant to move out of a property if you sell it to someone planning to occupy it without paying a relocation fee). This could cost you money or limit your options when you sell.

• Willingness to/possibility of adding value – If you are open to adding value either through renovations or re-tenanting, it could be possible to quickly maximize the value of your investment through a rehab, also known as a flip. If the property is tenant-occupied, first make sure it is possible to renovate/re-tenant/raise rents (see rent control section).  This might be preferrable to a long-term hold if interest rates are high, however it generally requires more cash for physical improvements and carrying costs than buying an already operating rental property. There is more work involved in this type of investment, as well as the risk of construction delays, cost overruns, or poorly timing the market, but if done right, the sweat equity you create could be the springboard to your next, more lucrative investment.

Investing has been a fun way for me to put my real estate knowledge to work and build long-term wealth. Knowing where to begin is the hardest part, but there are options to fit a variety of goals and budgets. For those who are interested, I am happy to have a conversation about, share my experiences, and I have a network of trusted professionals with whom to connect you in various markets.