Over years of learning about real estate investing, Ive come up with my own formula for buying rental properties that produce real cash flow. Heres what Ive learned.

The following is a true story but names have been changed in case the parties involved read this!

It’s ten o’clock in the morning and John has just gotten another phone call from the property manager who’s currently trying to fill a vacancy in his duplex. He’s told that the existing tenant is breaking the lease because someone has broken in and stolen the tenants toolsfor the second time in 12 months.

This property has been nothing but problems since John bought it a year ago. Here are just a few of the things that have gone on over the past year:

• Johns been unable to secure a tenant for longer than six months.
• John had to replace two broken windows from vandalism while units were vacant.
• John received three midnight phone calls reporting gunshots.
• There is a busted crack house across the street.
• The next-door neighbor (an elderly woman) was kidnapped from her front porch and is still MIA.

You would think that after dealing with these headaches, John would abandon real estate investing all together.

But that’s not the case.

In fact, he’s more passionate than ever about acquiring rental properties.

Why?

Well, for one, John’s learned some very painful and important lessons from the above nightmare. In fact, over the course of the past year, he’s come up with a strict set of criteria that will ensure that many of these problems aren’t repeated. I’ve taken John’s formula, added a few notes, and even threw a couple of my own criteria into the mix.

The result? A near-perfect formula for buying rental properties that provide cash flow.

Before I continue, I just want to emphasize that this strategy is the result of HOURS of reading, multiple conversations with other investors, property managers and real estate agents alike, and an in-depth analysis of our own investments this strategy is a bi-product of our own personal experience and could vary depending on yours.

Here we go…

The first step to ensuring that you don’t end up with a real estate nightmare is:

Before getting into specific techniques, I’d like to re-emphasize that just like any other investment out there, if you don’t know what you’re doing, you will get burned and lose A LOT of money. I always recommend doing your homework and investing FIRST in your education.

Here are a couple of things I do to get educated:

Talk to other investors – make sure you are getting solid advice from people who have accomplished what you are trying to do, not from broke family members! You will be surprised by how many well-meaning people are eager to give you free advice on something they know NOTHING about.

I am a HUGE fan of reading. It’s advisable to read a variety of authors who have different approaches. Your job will be to read enough material to begin seeing patterns and to form your own opinions and strategies.

Consider Buying Courses

There is a TON of quality content out there; however, just like any other industry, there’s also plenty of snake oil salesmen peddling get-rich-quick schemes, so be careful. Usually, a thorough Google search will help sort out the bad apples.

KNOW YOUR MARKET

I recommend buying in an area that you are familiar with, at least for your first few properties as you get your feet wet. If you are not familiar with an area, try spending a few weekends in your target market over a period of months. Drive around in 2-3 zip codes you are interested in and talk to neighbors, local shop owners, property managers, etc. so you can get a feel for the area and the potential clientele you’ll be dealing with.

What type of neighborhood should you be looking in?

Well, each person’s strategy is different, but here is how I analyze properties and scout out neighborhoods:

I evaluate them as one of three categories…

These are in “pride of ownership” neighborhoods occupied predominantly by homeowners. The houses are typically well maintained with green lawns, tree lined streets, etc. These tend to make great homes to impress your friends, but don’t usually pencil out as great investments. I stay clear of these areas.

This typically has the largest range of product between the three classes. These houses usually serve the greatest number of people within the community and have the largest amount of inventory. I usually try to target a neighborhood where there is a large portion of blue-collar workers and where there is a 35/65 percent ratio of renter to homeowner. You can usually tell if you’re in one of these neighborhoods by the number of utility vehicles parked in driveways – cable repair vans, constructions trucks, etc.

These are in “run-down” neighborhoods occupied predominantly by renters. These rental properties typically have a high renter turnover rate. People tend to RUN in these areas at night, NOT jog. There’s high crime, gang and drug activity, substantial cop presence, etc. I am not saying these are poor investments; typically the cash flow on these deals can be high. But the successful investors taking these on are probably running a tight operation and have a specialized property management team in place. For someone looking to acquire one or two investment properties as a way to supplement income, I would recommend against this. I haven’t purchased one and I don’t think John is eager to buy another one either.

THE FOOLPROOF FORMULA FOR BUYING INCOME-PRODUCING RENTALS

a. Buy below market 10-20%.

Think of this not only as a way to grow your net worth, but also as a way to ensure your financial security. If you ever have to sell due to an emergency, that 10-20% is going to allow you to lower your offering price to move it quicker. On a positive note, if you don’t have to sell in an emergency, you’ve just made an instant return on your investment.

b. Property must generate at least a 15% ROI, cash on cash.

That means the rent minus the debt (if mortgaged) and expenses must equal 15% or more. For example, a $20K down payment would have to yield at LEAST a yearly cash flow of $3,000. This is actually fairly low – most of my and John’s deals have been well above the 20% threshold.

c. Buy in a B-class neighborhood, 35/65 percent ratio of renter to homeowner.

d. The rent should be at LEAST 1% of the purchase price.

For example, a $100K home should rent for at LEAST $1000 per month.

e. Due your due diligence regarding repairs before buying.

If the repairs plus your down payment exceeds 15% ROI, move on to the next property.

f. Maintain six months of cash reserves per property to pay the debt service.

This should suffice for any unforeseen repairs or vacancies.

These next few years will probably go down as the best time to purchase income-producing rentals in our lifetime. In many markets, you can acquire property far below the cost to build. Interest rates are at historic lows. Generation Y is three times the size of Generation X and is expected to continue to rent for the foreseeable futurewhile property values have dropped significantly, costs to rent have not.

So what’s John up to now?

Since the acquisition of his nightmare duplex, he’s gone on to purchase three additional B-class properties and is in the process of buying a forth this month. Each house brings in roughly $400 a month in cash flow. And even though he still has to deal with the occasional headache resulting from his duplex, he’s still on track to generate a second income so that his wife can stop working during the first three years of childrearing.

If you’ve ever thought about investing in real estate, what’s holding you back? If you’re already investing, is there anything you might add?