If you read the first part to this series, Creative Financing for Young Real Estate Investment, then you already know how to “get creative,” when it comes to making money appear out of thin air for Real Estate Overhead. In this post I want to talk about valuation, but not Real Estate Valuation – instead I’m going to go into how to evaluate your investment criteria.

I am going to focus strictly on residential real estate  for right now (properties with 4 or less units) since that’s what I assume most of you will be looking into. Before you can even think about prospecting for properties you need to prospect for a geography. The best way, traditionally, to do this is to check out market trends for certain cities. Forbes published a good article in September 2007 about The Best Rental markets in the U.S. The idea of investing in a far off city is not a good one, at least not initially… You need to be around to manage and micro-manage your tenant base, as well as the property(s) .

An ideal market is one where single family homes aren’t too expensive ($100k-$180k), assuming for that price you can pick up at least a mild three bedroom. Conversely, you need to make sure that the current area receiving rents supplement more than just the mortgage! I tend to use a 2 to 1 debt ration when evaluating potential properties for acquisition. This means that the gross monthly rent needs to be twice what the monthly expenses are (mortgage, insurance, taxes) this way you have a nest egg to stick in a capital reserve account. Your capital reserve account will serve as a safety net for your portfolio should a boiler/heating unit or roof decide to need repair. Let me tell you right now roof’s are expensive!

General rule of thumb is DO NOT TOUCH your capital reserve account for 6 months! Should you need something for a property, i.e. light switch, some shingles, etc. reach in your pocket. This is just best practice – if you start deteriorating your capital reserve account prior to 6 months you will simply continue to do so.  Even after 6 months… that’s not profit, that’s not how it works; you now have liquid capital to use for growth.  Leverage your current equity position (it will be small) by taking a lien against your current property and go find another – preferably close by.

When looking for an area make sure it still has some mom and pop shops floating around – the retail saturation of your market has great influence over rents, and not just commercial. If you can get in on an area where the big box retailers (Home Depot, Target, Wal-Mart) are just starting to build – then you’re in the right spot. Actually, you may be too close to the right spot… given the growth rate of the area (population, per capita income) and the annual % rental increase, you may want to step just outside the immediate circle of influence and invest on the fringe – you may get less rent in the beginning – but you will get the property drastically cheaper and build equity faster – not to mention if the swell continues you will realize great appreciation.

*NOTE: you’re pro forma is only as good as your comps!

stay tuned for Part III