When considering real estate as an investment for your self-directed IRA LLC or Solo 401(k) plan, proper due diligence is key to achieving solid returns. The concept sounds simple and obvious, but is often overlooked or executed without proper thoroughness. One of the underlying reasons successful investors attain financial reward is by sticking to this principal. Conversely, a primary driver of failed real estate deals is a “ready, fire, aim” approach that does not fully consider the risks that may come with a specific property.
There are many ways one can evaluate a property to try and identify if it will be a successful investment, and the particular approach will vary based on the location, age and initial condition of the property. We’ve outlined a few of the main areas where you should focus your energies as a means of pointing you in the right direction.
Start with the Numbers
Before you even start looking under the hood, so to speak, you need to be sure the numbers on a property work. You do not necessarily have to have every potential cost figured out to the penny, but a rough analysis of purchase costs, potential repairs needed in the immediate and mid-term, taxes and insurance, borrowing costs if a non-recourse loan will be used on the expense side, and the property value and approximate monthly rent on the income side will help you determine if this property is even worth taking a more detailed look. If the numbers look good initially, then a more specific analysis is in order.
If the property has been operated as a rental in the past, audited books or tax returns from the prior owner are the best means of seeing what the operating costs and profit of the property have been. There are also several online tools available to help gauge current rent rates in a neighborhood. Your real estate agent can likely help you in this area.
Evaluating the current condition of a property and the expected costs you can expect to operate and maintain that property is a critical component of your more detailed analysis of a property that looks interesting on the surface. The level of examination required will vary greatly, however, depending on the age and history of the property.
How you acquire a property will also have an impact on your ability to truly evaluate property condition. When purchasing through normal market channels such as a Realtor, you should have the time and contractual space to perform various property inspections. In a foreclosure auction or bank REO acquisition, your ability to have professionals evaluate the property may be limited. As such, you will want to ensure that you only pursue properties with limited ability to inspect if you are very experienced in the market or have someone on your team such as a contractor who is.
When you have time for inspections, consider the various types of systems and whether they need a basic or more thorough evaluation based on age. The requirements for a newer house in a subdivision of similar age homes will be less than those for an older property or a property in a neighborhood where there is a wide variety of ages and conditions. A good whole-home inspection will be sufficient for a more recently built home, or even a 20-year-old home in a large subdivision where an inspector will know the types of issues common to that neighborhood or even a certain builder.
As you work with older or more unique properties, additional inspections such as sewer, radon, lead paint, etc. may become necessary.
While you, of course, will want to obtain adequate insurance coverage for your property, knowing the types of risks common to the location will help you greatly. If a neighborhood is prone to flooding, earthquakes, etc., you will want to know, and be sure to have a policy that provides specialty coverage for these types of events. If you are looking at several houses in an area, and some are at higher risk than others, then leaning towards the lower risk properties will be in your favor.
You can speak with your commercial insurance agent about the history of a neighborhood. You can even have them run a CLUE report on the property to see if there is a history of claims. Not only will such a history affect your insurance rates, but knowing in advance if there are specialty risks can help you to be more prepared. You may want to budget for periodic tree trimming services if there are lots of wind issues, for example. Even if a casualty event is insured, there are certainly headaches and costs associated with damage, including the need to assist a tenant with alternate living arrangements if a property is uninhabitable. Choosing properties that minimize this kind of risk is best when possible.
Location, Demographics & Crime
Many factors impact the desirability of a rental unit and correspondingly the ease of renting to reliable tenants for a competitive rate. Be sure to evaluate the quality of a neighborhood and think in terms of what may be in store in the future. A neighborhood that is in decline is probably not where you want to put your IRA dollars. Conversely, a neighborhood that may have some challenges today, but is being improved as houses turn over to new owners can have potential upside in terms of future rent rates and property appreciation.
There are many resources in most cities to evaluate crime statistics, but it is also helpful to know what the economic circumstances are. What percentages of homes are owner occupied vs rented out? Are people in general moving into or out of the neighborhood? If there are one or more primary employers in the area, do they look to be there long term? Are they expanding or laying workers off?
Knowledge Mitigates Risk
The more you understand a property and neighborhood, the better you will be able to foresee potential issues that may occur over time. Be sure to put in the effort to research any potential investment property you plan to acquire with your self-directed IRA or Solo 401(k) plan. You will be glad you did.