The following is a guest post on the subject of investing in rental properties.

After the overwhelmingly positive response I received from my previous post, I decided to write another guest post about investing in rental property using a real life example to illustrate my points.

I hope this helps to fill in the gaps left by books or clever clichés.

Arthur’s Formula for Success in Purchasing Rental Property

1. Education: Before describing specific techniques, I would like to emphasize that just like any other investment out there, if you don’t know what you are doing, you will get hurt.  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 are doing what you are trying to accomplish, not from broke family members!  You will be surprised by how many people know someone who owns a rental property (or has lost a rental property L).

* Read, read and read some more – I am a HUGE fan of reading.  I believe it is good to read a variety 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 Paying for materials, courses, etc. – 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 good Google search will help sort out the bad apples.

2. 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.  Drive around in the zip codes you are interested in buying in and talk to neighbors, local shop owners, property managers, etc.

I usually grade neighborhoods with three letter grades, as follows:

A properties – These are in “pride of ownership” neighborhoods occupied predominantly by homeowners.  The houses are typically well maintained with green lawns, tree lined streets, etc.

B properties – These are in “working class” neighborhoods occupied predominantly by blue-collar workers.  These areas usually have a ratio of 70 percent homeowners to 30 percent renters.

C properties – 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, drugs, cops, etc.

The sweet spot for me is right in the B class.  These properties tend to generate a nice cash flow, have a steady renter pool, and will have the broadest appeal long term.

3. Formula for purchasing: I am literally going to give you a formula that I use to decide if I should even drive out to see a property in person.  This will guarantee cash flow, instant return on investment, and long-term security if you ever need to sell.  Here it is – FOR FREE!!!

1. Buy 20-30% BELOW market value, never at market value.

2. Property must generate at least a 20-25% return, cash on cash (not including, tax breaks, depreciation or appreciation).

3. The property should be in a “B” class neighborhood that is 70% homeowner occupied.

4. The property should rent for at least 1% of the purchase price.

5. Do your due diligence regarding repairs – hire a general contractor if        needed to get an accurate quote of repair costs before you buy!

6. Maintain 6 months of cash reserves to pay the debt service (per property).

Case Study: putting the formula to work.

This was a transaction that happened last month:

1.  The rental property I purchased had a fair market value of $105K.  Since the property was a short sale, I was able to offer a below market price of $83K.  After 3 months of negotiations with the bank, I was approved for this price point.   The day I closed escrow, I had $25K of built-in equity.

(Note: market value is based on traditional seller-to-buyer transactions – foreclosures and short sales are NOT included.)

2.  I invested $19K total out-of-pocket (down payment, closing costs, etc.).  The rent in that neighborhood goes for $1050-$1200.  I estimated a modest $1000 per month and accounted for a 20% vacancy, which is really high.   The debt service (mortgage) and taxes is roughly $450 per month at a 5.25% interest rate.

The total return would be roughly  $5280 a year @ $1000 per month.  Not accounting for any repairs, the return on $19K will be roughly 28%.

This does not account for mortgage deductions, return on equity, depreciation, or if the property can get more than $1000 per month in rent.  I estimate that this property will return 35% in total.

3.  The property is in a nice B-class neighborhood in a quality school district near the freeway.  Of the surrounding 25 houses, 6 are rentals.

4. I anticipate getting at least $1100 per month, which is higher than 1 percent of the purchase price.

5.  I lucked out!  The property is in really good shape and total repairs will only be $800 for paint and carpet cleaning.   One of the benefits of purchasing in a neighborhood with a surplus of houses for sale is that you get the pick of the litter.

6.  I have $3K specifically set aside for this unit.

If you stick to this strict criterion, there is very limited risk involved and will ensure that you increase your net worth and enjoy a steady cash flow.

Arthur Garcia is the founder of thebusinessofu.com, a website that focuses on personal finance, business and self-development.  Arthur interviews everyone from real estate investors to precious metals experts and everyday people with extraordinary stories.