Principle of Substitution

December 16, 2019

Introducing the principle of substitution. The principle of substitution states that the upper limit of value tends to be set by the cost of acquiring an equally desirable substitute, assuming no untimely delays. A savvy investor will pay more for an income-producing property than it would cost them to build or purchase a similar property. Likewise, a prudent tenant would not pay more rent than they would pay to rent an equally desirable property.

All properties, regardless of location or price, are substitutable, if the purchase price is the same as an investor you need to look at the income stream. The principle of substitution is closely related to the economic concept of opportunity cost, which holds that the true cost of an economic choice is measured by the opportunity foregone because of the choice.

Costs to Consider when Purchasing Rental Investment Property

The process of searching for investment rental property can be exciting; however, before you get too excited it is important to run some preliminary numbers to make sure you know exactly what you are facing to ensure a successful investment.

First, you need to carefully examine potential rental income.

If the property has already served as a rental property, you need to take the time to find out how much the property has rented for in the past and then do some research to determine whether that amount is on target or not. In some cases, properties may have rented for lower than they should have while in other cases a property may be over-rented. Look at comparables in the area to make sure you know whether the property in question is on target; otherwise you may find that the amount you think you will be receiving in rental income is unrealistic.

Mortgage interest is another area that should be considered carefully.

Make sure you know and understand prevailing interest rates as well as the details of your specific loan because mortgage interest is the biggest cost you will face when purchasing an investment property. First, understand that homes and duplexes tend to have loan structures that are similar to any mortgage loan. With a larger property; however, such as a triplex; rates tend to be higher. If you are looking at commercial property with even more units; the matter of terms and rates is completely different. Typically, the more money you are able to put down on the purchase of the property, the less interest you will have to pay.

Taxes are another issue.

Many people use the taxes from the year in which the property was purchased and assume they can use these figures to estimate expenses. This is not always the case because taxes do not remain the same; they typically change every year. Usually, taxes go up after a property is purchased. This is especially true if the property was previously owner-occupied. So, it is typically a good idea to just assume that the taxes will go up on the property after you purchase it.

One area which many people fail to take into consideration is the cost of the property being vacant.

While you would certainly hope that your property would remain rented all the time, this simply is not realistic. There will probably be times when your property will be vacant. Generally, you should assume that your property will have an average 10% vacancy rate.

The cost of tenant turnover should also be taken into consideration.

This is often a big surprise to many landlords who assume they will rent out their properties and their tenants will remain in the property for some time. Even more of a surprise is how much it costs to prepare the property to rent out again. Just a few of the costs include not only advertising for a new renter but also repainting, cleaning, etc. If the damage was done to the property, the total cost of repair may not be fully covered by the security deposit you charged.

Of course, the cost of insurance should also be taken into consideration.

Keep in mind that the insurance for investment properties is usually higher than an owner-occupied property. Make sure you obtain a quote rather than just using the insurance cost for your own home as an estimating guide. In addition, make sure you take into consideration not only property insurance but also liability insurance as well.

Utility costs are another area that is frequently under-estimated.

If the property has already served as a rental property make sure you find out exactly what the owner pays for and what the renters pay for. You should also make sure to find out whether you will be responsible for other costs such as trash collection.

Finally, take into consideration the costs of property management if you will not be managing the property yourself.

Should I invest near home or long distance? That is the question every investor grapples with.

If your sole consideration is the need or desire to self-manage your investment property. Ask yourself the following questions.

Are you available, and willing, to manage your property on a full-time basis? In other words, can you take on property management as your full-time job?

Are you up-to-date on local landlord laws?

Are you able to manage contractors and ensure that they are doing high-level work?

Are you able to run your tenant's credit and perform background checks?

Do you honestly believe that you are the most qualified person to manage your property?

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