The Best Business Model in Real Estate

By Markets Fool.com

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Source: Cincy Project via Flickr

Real Estate can be an excellent way to create wealth and diversify your investment portfolio, but just like everything else in investing, there is a right and wrong way to buy and manage investment properties. One of the best ways to learn how to invest in real estate is to learn lessons from those who have been successful, so let's see what we can learn from some residential REIT heavyweights and the habits of other successful real estate investors.

Location, location, location
One of the most important things you can do is to acquire properties where conditions are favorable for renting. Now, I realize that most of the people reading this aren't going to buy a New York City high-rise or other in-demand trendy apartment building, but you can employ similar principles when choosing properties.

First off, you should focus on buying properties in areas where rental demand is growing faster than supply. This does include many metropolitan markets, but there is likely to be examples of this anywhere in the U.S.

For example, I live close to a major university, and the student population is growing faster than the number of available housing units. So, if I wanted to buy a new investment property, I'd probably start my search there, because not only is the property likely to stay occupied, but basic supply and demand indicate that the rent will rise over the coming years.

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Another thing to look at is the demographics of the neighborhood. According to residential REIT AvalonBay, the 25-34 age group will increase by 1.1 million over the next three years. And since the home-ownership rate among young adults has dropped from 43.6% to 35.3% over the past decade, this is a group that is likely to rent. In other words, areas with high concentrations of this age group are favorable places to own rental properties.

The population of younger Americans, who are more likely to rent, is expected to rise significantly in the years ahead. Source: Equity Residential

Of course, every local market is different, so this will require a little research on your part. And there are other factors to consider, such as the job growth in the area and proximity to favorable landmarks and services like public transportation and shopping/entertainment areas. Just keep in mind that your property's location is the one thing you won't ever be able to change, so it's worth the time and effort to choose wisely.

Be careful who you rent to
Once you've chosen a property, another important step is being selective when it comes to finding a tenant. In addition to a credit check, some important factors to consider (and verify) include:

  • Stable employment -- Has the applicant been at the same job for a reasonable length of time?
  • More than enough income to cover the rent -- A good rule of thumb is a minimum income requirement of three times the rent, so if you're asking $1,000 per month, you want to see monthly income of at least $3,000.
  • A solid rental history -- It's always good idea to call former landlords for a reference. Any prospective tenants who won't allow you to contact former landlords should be a major red flag.

Sure, this involves a bit of legwork, but it's easier than handling a bad tenant or eviction.

Source: Flickr user Mark Moz

Create value through acquisitions and sales
One of the more effective real estate investing strategies is "buy, fix, rent." By purchasing properties with solid structural integrity but some cosmetic issues, you can acquire the property for less than market value, do some rehab work, and rent it out. By doing some minor renovations, you have the potential to greatly improve the property's resale value and create immediate equity. For example, if I could buy a house for $80,000 that needs $5,000 worth of work and would then be worth $100,000, it would produce a quick $15,000 return on my investment -- not including the increased rent I could get as a result of the property's good condition.

On the other side, don't be afraid to sell assets if you feel like you could put that capital to better use. Let's say that you bought a property for $100,000 with 25% ($25,000) down five years ago, and that the property is now worth $150,000, meaning that you could collect a check for $75,000 or more by selling. Instead of continuing to collect a stream of rental income, you could potentially sell that property and take the proceeds to use as a down payment on two or three more properties.

The leading REITs use this as a part of their value-creation strategy, and it has been rather effective. For example, sector leader Equity Residentialsold 10 properties consisting of nearly 3,100 apartment units during 2014, and has another 5,273 under construction where it feels its capital will be put to better use.

Source: 401kcalculator.org via Flickr

Use borrowed money wisely
The most successful REITs have investment-grade credit ratings, and maintaining excellent personal credit is a key to success for individual real estate investors as well.

Upon acquisition, investment properties don't typically cash flow (profit) more than a few hundred dollars per month, if that. Access to the best mortgage rates can literally make the difference between a solid monthly profit and struggling to break even. For example, on a $100,000 mortgage, the difference between a 620 credit score and an 800 is a $95 difference in mortgage payments, based on current rates.

Most lenders want 20% down to finance investment properties, but typically offer the best rates to buyers with 25-30% down. Plus, bear in mind that the less "leverage" you use, the better position you'll be in to absorb fluctuations in the housing market.

The use of borrowed money is essential in producing great long-term results, but it's also important not to overdo it. Just because you could theoretically buy an investment property with 10% down or less doesn't make it a good idea.

Plan for the unexpected
In a perfect world, your investment properties would never sit vacant, you would never have to evict a tenant, and nothing would ever break. Unfortunately, we don't live in a perfect world -- sometimes things don't go as planned.

For this reason, it's important to plan ahead for unexpected expenses like these. As a general rule, plan to set aside 10% of the rent to cover maintenance expenses, and this should be adjusted upward depending on the age of the property. And another 5-10% should be set aside for a vacancy reserve. That way, if the property sits empty for a couple of months between tenants, you can still cover your expenses.

Finally, make sure you have a good landlord's insurance policy (similar to homeowner's), and if you have more than a few properties, an umbrella insurance policy might be a good idea to protect your assets in case a tenant decides to sue you for whatever reason.

To sum it up, as long as you do your research on your local market, screen your tenants properly, manage your assets wisely, borrow responsibly, and prepare yourself for unfortunate situations, real estate can be a lucrative part of your long-term investment plan.

The article The Best Business Model in Real Estate originally appeared on Fool.com.

Matthew Frankel has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.