How to buy your first rental property – Step Six

Posted by neil on February 12, 2010
General

In this article, I will explain to you how you can pick the best rental property to purchase.

We have covered a lot of ground thus far in this article series.

In Step One we discussed the importance of determining WHY you are buying a rental property.

In Step Two we talked about financing the property.

In Step Three we changed gears a bit as we talked about how to pick a location that you will invest in.

Step Four examined how you should examine the economic influences of the area you chose to invest in.

As well, our most recently discussed step, Step Five outlined the importance of picking your property type.

In this article we are going to examine how you filter your potential rental properties.

Filtering potential rental properties

Believe it or not, this step is quite easy. At this stage, you will have picked the location that you are investing in, as well you will be focusing on a particular property type.

At this point you should have established a relationship with a local realtor who is knowledgeable about the local market, and who specializes in buying and selling rental properties.

If you have not formed a relationship with this type of realtor yet, this should be your number one priority before you do anything else. You can refer to Step Three in order to see what types of questions you should ask the realtor. These questions should be asked, so that you can determine the realtor’s level of knowledge and comfort in dealing with real estate investors and with rental properties.

There are other methods that you can use to find potential rental properties, however we are not going to get into these methods at this stage.  At this point, my goal is to make this an easy to follow process for you.  Working with a knowledgeable and quality realtor who specializes in rental properties, will help you tremendously, and make this process easy for you.

The 10% Rule

When your realtor is bringing to you properties of interest that match your property type, you must use the 10% rule when examining the property.

What is the 10% Rule?

  • The 10% Rule is an incredibly important step that you cannot skip.
  • It is a formula that you have to use in order to filter properties.
  • If the property passes the 10% rule test, you put this property on your list of ‘properties of interest’.
  • If the property fails the 10% rule test, then you want nothing to do with the property. Move onto the next property, and start to analyze that one.
  • You must perform the 10% rule test on every single rental property that you review.

The 10% Rule Formula

  • You get from your realtor the monthly current rents of the rental property
  • You multiply this value by 12
  • You take this new value and divide it by the total purchase price of the rental property
  • When you calculate this, if you get a number of 10% or greater, you should put this property on your short list.
  • If you get a number below 10%, please forget about this property and move on.

The 10% Rule in Action

Here is a practical example of the 10% rule in action.

  • I recently purchased a rental property in Hamilton, Ontario, Canada. The rental property was a 3 bedroom townhouse.
  • The current rents on the property are $1250/month.
  • If I take the value of $1250 and multiply by 12 (months of the year), I get a value of:

$1250 * 12 = $15,000

  • I purchased the rental property for $150,000.
  • Therefore, I now divide $15,000 by $150,000…

$15,000 / $150,000 = 10%

As you can see, with this example, I obtained a value of 10% after completing the 10% rule. This is a good thing, and these are the types of properties that you want to research further.

Had the rents on this property been only $950/month.

The 10% Rule Test would have looked like this…

$950 * 12 = $11,400

$11,400 / $150,000 = 7.6%

If this was the case, and I obtained a value of 7.6%, I would not have been interested in this property, and I would have moved on to analyze the next property.

At this stage, do not fret too much about understanding the intricacies of the 10% Rule formula.  Just remember that if a property passes the 10% Rule test, it is a good property that you need to further research.

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7 Comments to How to buy your first rental property – Step Six

  • I am really enjoying your articles, however; I am having a bit of hard time understanding how you can follow this rule hard and fast.

    For example (House 1): If I have a house that has rental income of $2,400 / month it would be $28,800 ($2,400 *12). If I paid $250k for the property than I yield 11.52%. According to your 10% rule, this sounds like a great buy.

    Except you forgot one thing, the taxes on that $250k home are $8,000 / year. Which significantly eats into the property rental income.

    I found other scenarios that the 10% won’t work but the taxes are $2,000 and it seems like a much better buy.

    For example (House 2): If I have a house that has rental income of $2,400 / month it would be $28,800 ($2,400 *12). If I paid $325k for the property than I yield 8.86%. According to your 10% rule, this sounds like a bad buy.

    Except you forgot one thing, the taxes on that $325k home are $2,000 / year. Which significantly helps your bottom line.

    Investment Income:

    House 1: Mortgage is $2,023.54/month (0% down and $1,000 in Homeowners Insurance) which would leave you with $2,400 – $2,023.54 or $376.46 / month in income.

    House 2: Mortgage is $1,881.6/month (0% down and $1,000 in Homeowners Insurance) which would leave you with $2,400 – $1,881.6 or $518.4 / month in income.

    Which one sounds better to you? I think the 10% rule is not accurate. Can you explain this to me?

    Thanks!
    Sean

    • Hi Sean,

      Thanks for your feedback. As you mentioned in your comment, the 10% run doesn’t always work.
      The 10% rule is talked about a lot by some real estate investing groups. It is a simple rule that people can easily understand. However, as per your point, it does not always works in all scenarios.

      Whether one follows the 10% rule or not, the most important thing is to generate positive monthly cash flow each month from your rental property.

  • I’m a 20 year old who is trying to invest into real estate and I knew nothing about real estate. After reading all six of your lessons I learned allot! Thank you so much!

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