How can one tell which run-down area is best?

Reader Question: How can one tell if one run-down area is best? A friend and I are going to buy an old home and remodel it to rent out. We have a limited budget, so we are looking in areas where prices are lower. Are there any strategies or tips for buying and renovating houses in run-down areas?  James H.

Monty’s Answer: Hello James, and thanks for your questions. When making your first real estate investment everyone starts somewhere, and every “somewhere” has opportunities. The greater risk and work involved often brings the greatest rewards. Here are some observations that may be helpful.

1. Study the neighborhoods being considered for investment. Before buying your first house, become an expert in understanding the submarket and the surrounding area. The following statistics will provide a sense for values and a baseline for future calculations. Here is what to study: Sales rate, time on market, list to sale ratios, average sale price per square foot by style of home, percentage of listings that expire unsold and home value and rental rate trends. Then, look for signs of renovation, parents with young children and new retail outlets. Stop to speak with residents and listen to their impressions.

A good real estate agent will recognize these terms and understand how to search the MLS for these results. It may be possible to search for renovated home sales if the words “remodeled”, “renovated” or “rehab” appear in MLS data sheets. Go back and search the address history to learn the “before rehab” sale price. Some MLS systems have that capability; those sales may be more helpful.

2. Operate under the principal that your money is made when buying the property, not when selling it. This does not mean trying to buy a home for less than market value. It means understanding the best ways to add value to the property when remodeling it. Investors sometimes spend money on “X” but would have been wiser to invest it on “Y.” Invest in improvements to keep tenants in place and happy to live there.

3. Determine the required capital investment by determine what the home will sell or rent for after renovation. Do this before buying it. Work backward by subtracting the renovation costs and soft costs from the future value to reach an offer price. Remember to include rent lost while completing the improvements.

Examine the partnership

Consider a written partnership agreement that contains an exit strategy. What is each contributing to the partnership? As an example, if one is doing the physical work, and the other is putting up the money, consider a pre-established exit plan if the deal goes sour. Ideally, both should be in a similar position financially, plan “comparable worth” assignments and have similar investment goals. Otherwise, as time wears on, one partner may think the other is not carrying an equal share of the load. Get it? Part of this equation depends on your life experiences to date. As an example, are you both in the trades? Have a plan in place where parting friends is incorporated if the deal goes sour.

Picking the right “less desirable” neighborhood

1. Make certain it is a neighborhood that has already started a transition away from being a less desirable neighborhood. Otherwise, it may be throwing good money after bad. If the prices are still deteriorating, it is difficult to predict how long until it begins to recover. Check with the municipality, the state and federal government, as funds often exist dedicated to neighborhood improvement projects that incentivize private investment. Additionally, check out the FHA(203K) rehabilitation mortgage. It wraps the rehab construction costs into the mortgage.

2. Consider calculating a better return. Your plan is renovating to rent and hold, so there will be more work and management attention required in operating the property. Collecting the rent, evictions and added repairs are examples of conditions that may require extra time and effort.

3. A limited budget can be a red flag. Depending on your experience levels, your backgrounds and your resources, rehabbing a building is not the easiest project to jump into on a “limited budget”. Renovation often means unexpected surprises that are expensive to fix. What if you run out of money? Unfortunately, this is often the spot where the first person to abandon ship is your banker. Be careful not to be underfunded.

Finally, consider enrolling in a property management course. Investing the time in understanding the “back room” operations of owning property and dealing with vendors, tenants and regulation can make a big difference in the success of your operations.