9 Questions to Ask Before Buying a Rental Property

Most people enter the real estate market with the assumption that all homes will inevitably increase in value. If you hold it for long enough, and as long as the economy remains strong, who knows? Depending on when and where you are buying your rental property, perhaps it may end up being true for you.

But I’ve personally mentored many property investors who didn’t fair so well. For whatever reason, they were unable to hold long term, or they realised that they were accomplishing far less than they could through a different strategy. They ended up regretting their purchase, and experienced more financial pain than financial gain.

The dark side of the perpetual-growth assumption is that investors are inclined to rush out and indiscriminately buy any property that “feels good,” or that is recommended by someone who they perceive to be an authority. Invariably, most of these investors end up with negatively geared properties and in Hyman Minsky’s words are “Ponzi Borrowers.”

We recently ran a poll on PropertyInvesting.com, asking our members to describe their debt situation. Our community is probably more sophisticated than most investors, but even so, 78 percent of them said they own assets that don’t produce enough income to pay down the asset’s principle. Most investors are in a highly speculative position and are therefore dependent upon perpetual capital growth.

In another poll, we asked investors how they would be impacted if the negative gearing tax concession on existing homes was scrapped. Nearly a fourth said, “It would be devastating to my financial goals.” If you can take any lesson from that survey, let it be this: do not put yourself in a position where your financial well being is in the hands of our politicians.

Before you rush out and buy a rental property, I’d encourage you to first ask yourself a series of key questions. In so doing, hopefully you can avoid the most common mistakes and pitfalls of less sophisticated investors.

1. What’s the end goal?

Early in Steve McKnight’s Property Apprenticeship course, we teach investors to be outcome-driven, rather than speculators.

Speculators have the view that it doesn’t really matter what you buy, because in the end, all assets increase in value over time. Believing that the asset generates the profit, speculators are aggressive about getting into the market, but passive about managing what they’ve bought. In fear of getting left out, they rush in and buy, and then “set and forget,” hoping it will all work out well in the end.

Outcome-driven investors take a more proactive approach. Not only do they have a long-term vision for what they hope to achieve, they plan their profit before they buy. They begin with the end in mind, and then tailor their purchase to fit their profit objective.

So first, what’s your long-term goal? How much passive income will you need in five, ten or fifteen years to replace what your job currently pays you? What yield will you expect from your investments? How much capital will you need to produce your desired level of income?

Once you’ve answered those questions, then you can create a shorter-term goal that’s aligned with the long-term vision. How much profit do you need in the next twelve to twenty-four months to put you on track toward financial freedom?

2. Will buying this property bring me closer to, or push me further away from my goal?

Once you know the end goal, both long-term and short-term, then you can create a deal profile, painting the picture of the ideal property to buy. This helps to narrow your search so your not wasting time looking at any property that happens to peak your interest.

With a deal profile, every property that you inspect filters through the profit objective. If it will achieve the short-term goal, it’s a winner. If not, then it’s not a fit.

If you alternatively choose to buy whatever comes along, hoping for the best, you may end up farther from your goal than you are today.

3. Am I making money or just saving tax?

Negative gearing tax concessions have given investors a license for laziness. Without a clear profit objective, even if a property has little merit based on cash flow, as long as there’s a tax benefit and a hope for capital growth, then it appears to be a winner.

You’re not investing in real estate to save tax, but to build wealth. Just because you’re saving tax doesn’t mean you’re making money. If all you’re doing is improving your marginal tax rate, you’re speculating on capital growth, and carrying an enormous amount of risk. Unless your property increases in value, you can’t win.

4. What will the annual cash flow be after deducting operating costs?

What would happen if Labor comes into power and scraps negative gearing, as recently proposed? I can think of at least one thing: investors would need to start itemizing operating costs and learn how to crunch the numbers.

Hey, here’s a novel thought. What if you were to start doing that now?

Before you can make a cash flow projection, you need to know exactly what your fixed operating costs will be, and make allowances for common variable costs.

Here are the most common operating costs to consider:

• Management fees
• Council rates
• Landlord insurance
• Utility costs (if not separately metered)
• Land tax
• Repairs allowance
• Vacancy allowance

Before you buy any rental property, you should quantify these costs and know exactly what your net operating income is likely to be. This is your annual income after operating costs. But bear in mind, you still haven’t factored in your interest expense.

5. Can I afford to make a sustained loss?

Once you deduct all of your operating costs and interest expense from the rental payments, are you in positive or negative territory? If you’re forced to dip into your personal cash flow to keep this property afloat, be sure you’re aware of the implications.

Do you have enough margin in your personal income to cover the loss? If so, what is the opportunity cost of owning this asset. What will you be unable to do from a lifestyle perspective? What about from an investment perspective?

If your rental property is negative by just $50 per week, you’ll end up forking out $2600 by the end of the year. Over ten years, that’s $26,000. If you were to invest that into an income-producing asset earning just 6 percent, and reinvest the profits, you’d actually be foregoing $35,507 in total. If left to continue growing for another ten years, that’s now over $100,000 you’re giving up.

You better be sure that your property increases in value by more than that, or you’ll end up a loser in the deal.

We haven’t even touched on the issue of your newfound slavery to your job. If you’re negatively geared, you now own an asset which depends upon your ability to continue earning an income. What if you were to lose your job?

6. What is my exit strategy if things get tough?

You might be asking, “How could things get tough? It’s not like I’m buying in a mining town like those unfortunate couples interviewed on 60 Minutes a few weeks ago.”

Here in Australia, we haven’t seen tough times for quite a while. Interest rates have been remarkably low, home values have been growing exponentially and we haven’t experienced a recession in 25 years. But there’s no guarantee the future will be like the past. But we have an entire generation that assumes it will be.

John F. Kennedy once said, “The time to repair a roof is when the sun is shining.” Rather than waiting until you’re in the middle of crisis to devise a plan, work out now what your crisis point will be, and how you will respond.

In applying this to a property purchase, carry out a “what-if” analysis. What would your cash flow situation look like if interest rates went up? What if you didn’t get the capital growth you’re expecting? What if the property decreases in value?

You need a spreadsheet that automatically calculates key number crunching formulas, simply by changing these key variables. This will help you make decisions more quickly and efficiently.

7. What must happen to make money on this deal?

Answering this question before purchasing a property will help you to clarify whether you’re in control of the outcome or whether you’re at the mercy of the market. Remember, being an outcome driven investor is all about proactively managing the deal to achieve a predetermined objective.

By now you should have figured out that for negatively geared investors, the only way to make money is for the value of the property to increase. In order to offset cash flow and opportunity losses, that could mean a lot of capital growth. When the only way to win is through generic capital growth, you’re not in control.

8. How many of these properties could I afford to own?

When your property brings a cash flow loss, there’s a limit to the number of properties you can own. Not only must you have funds for future deposits, but you must also be able to service additional loans.

Each negatively geared property that you buy whittles away at your personal income, and therefore your serviceability. Eventually, the bank will tell you that you’re done, probably far before you want to be finished buying. At today’s prices, you’ll likely reach your borrowing limit far before you can gain any traction toward financial freedom.

9. Have I double-checked all the figures and sought independent verification of the data?

Before you buy, check and re-check your numbers and be sure that the information you’re basing your figures on is accurate. As part of your due diligence, here’s some of the most important numbers you need to verify:

• The rental agreement if a tenant is already in the property
• A history of the current tenant’s rent payments
• A copy of the council rates notice
• Management fees
• A landlord insurance quote
• Any possible utility costs
• Repairs allowance
• An allowance for vacancy based on local supply and demand
• Your land tax estimate after purchase
• Stamp duty
• Initial repair or renovation costs
• Due diligence costs
• Borrowing costs
• Data to back up your growth assumption

Conclusion

You can never overestimate the importance of having a thorough due diligence system. In Steve McKnight’s Property Apprenticeship course, we train investors to find, analyse and buy properties with confidence. Through our comprehensive 65-session training program, we’ve helped hundreds of investors avoid costly and even life-shattering mistakes.

Be sure you’re properly equipped before you invest your hard-earned cash.

By Jason Staggers

Jason was a personal mentor working with Steve McKnight's Property Apprentices. He helped hundreds of investors apply Steve's teachings in the real world and achieve greater results on their journey to financial freedom. Jason now lives in Perth, WA where he leads Neuma Church.