The following is a guest post by FMF reader Apex. He has been investing in rental real estate for more than four years and is authoring a Real Estate 101 series based on his experiences. (To read the series from the beginning, start here.) The series is designed to give prospective investors the basic tools they need to succeed.
This is the last post in the series. I know it has been a lot of work for Apex and I know how much all of us have learned and benefitted from it. So please join me in thanking him for this great effort.
Throughout the Real Estate 101 Series my goal has been to introduce prospective and beginning investors to the world of real estate investing. Specifically I have tried to answer some basic questions, dispel some myths and misconceptions, and give actionable advice that can be used to move towards becoming a successful investor. As I finish the series I hope that the information provided here has mostly met that goal.
This final column will act as a short summary of each of the previous columns with a link back to the original column for the full details. Hopefully this summary column can become a quick reference tool and an overview that helps to pull all the elements together into a comprehensive story line. Below is a summary of each column.
Column 1: Why You Should NOT Invest in Real Estate
Some people might mistakenly believe that anyone can invest in real estate. It’s a much more involved investment than typical investments like stocks or bonds. It’s more like running a business than it is an investment. There are a number of aspects to investing in real estate that you need to be aware of before you decide to enter the business. I listed 6 reasons why you may not want to invest in real estate. They were: (1) It takes work, (2) It consumes time, (3) It requires management, (4) It demands capital, (5) It needs debt, and (6) It grows slowly. Before you invest in real estate, make sure you know what you are signing up for.
Column 2: The Benefits of Investing in Real Estate
Since investing in real estate requires more work than investments like stocks, one would expect there to be some extra benefits. Indeed there are a number of them and in this column I outlined 6 of them. They were: (1) stable income stream, (2) partially passive income stream, (3) property appreciation in addition to income, (4) tax benefits, (5) significant cash flow, (6) returns are significantly compounded by leverage. I spend considerable time in this column on benefits 5 & 6. The first four benefits are valuable but the most important benefit is the significant cash flow and the most powerful benefit is the compounding of returns through the use of leverage.
Column 3: Where to Start
Real estate investing is not something you just decide to do. It requires a little planning and there are a few hurdles that prevent many people from getting any farther than thinking about it. In this column I outline 8 steps to getting started as a real estate investor. They are: (1) Start by taking action, (2) Get a real estate agent who specializes in investment real estate, (3) Get access to capital, (4) Think about the type of property you want to invest in, (5) Start looking at many properties, (6) Determine if you need a management company, (7) Find out what reasonable rental rates are, (8) Buy something! One of the key concepts I try to get across in this column is that you do not have to do this perfectly. You will make some mistakes and that is OK. There are no perfect deals.
Column 4: Running the Numbers
As with any investment it is important to make sure the numbers work. The returns have to be worth the effort and the risks have to be manageable. In this column I go over 4 ratios that I believe will give a good assessment of any real estate investment. They are: (1) cap rate (2) cash on cash return (3) return on investment, and (4) cash flow margin. I show how to easily calculate each of these ratios. I also discuss some other metrics that are used to calculate these ratios but have assessment value in and of themselves. Those metrics are: (1) cash flow (2) net income, and (3) net operating income. Finally I discuss what I consider to be a minimum guideline for two important ratios. Those are cash flow margin of at least 10% and ROI that is also 10% or perhaps very high single digits if the deal was all cash.
Column 5: Making an Offer
Many people think the key to successful real estate investing is getting a steal on the price of a property. Obviously the less you pay for a property the better, but in general properties will sell for what their market price is. You will be competing with other buyers for the same properties. The market price of a property is simply what other buyers are willing to pay. Market prices for some kinds of properties make for much more attractive investments than others. The largest determinant of the price of a property is the type and quality of the property. The most important thing when buying a property is to understand what the true market price for that property is and to know if that property is a good investment at that price.
Column 6: Finding Your Niche
There are many different ways to invest in real estate. You cannot be successful at all of them. As you start investing it will be a learning experience. The most important thing you can do throughout this process is listen to yourself and determine which type of investing fits best with who you are. You will be most successful when you are able to focus on the niche that best fits with your skills and your personality. It may take some time and it’s ok if there are some missteps along the way. Finding your niche will be one of the most important things you do as a real estate investor.
Column 7: Getting It Rented
Tenants pay your bills. If you don’t have tenants you have losses. That’s why vacancy should be the number one thing a landlord tries to minimize. Too many landlords are complacent about getting a property rented when it is vacant. This is a serious financial loss to the business. A vacant property should be aggressively marketed with the intent to rent it as soon as possible. One common mistake is holding to a rent that is higher than the market is willing to pay. It is far better to lower the rent and get it rented than it is to hold out for higher rent leading to months of vacancy. Vacancy will happen, but a diligent landlord will do everything they can to keep their vacancy rates as low as possible.
Column 8: Finding Good Tenants
While a vacant unit is a problem, a bad tenant is a far worse problem. There are many good tenants to be found but it is your responsibility as a landlord to find them. To do this you need to advertise your property appropriately to attract good tenants. More importantly you need to do careful screening on all applicants to find good tenants. This includes background checks, credit checks and most importantly previous rental history and income verification. Good tenants tend to have a history of paying their rent and making sufficient income to do so. If you are not careful about whom you rent to, your tenant quality will likely suffer.
Column 9: Keeping Good Tenants
Once you find a good tenant it’s far easier to keep them than it is to find another one. Turnover costs you time, effort, and money. There are a few basic things that will help you keep good tenants. It starts with treating your tenants fairly and with respect. You want to keep your properties in good condition and respond to your tenants needs. Do not gouge them on rent or fees, and if possible try to use leases that have longer terms to keep both you and them committed to the property on a longer term basis.
Column 10: Managing the Property
One of the biggest concerns for prospective landlords is how to handle the daily management operations of a property. Areas of concern often center around issues of how to deal with tenants that are not paying rent, tenants that are violating the lease, and how to deal with the maintenance issues of the property. Most money issues with tenants can be resolve with a few simple steps. Eviction is rarely required if you have screened your tenants well but even if required there are services that can help you complete it. Repairs can also be handled by management services for anything beyond your comfort level. You can manage the property to whatever level you feel comfortable and simply hire others to manage what you do not.
Column 11: The Lease
Your lease is a contract between you and your tenant. Your ability to set the rules and retain control over what happens in your property depends on the quality of your lease. Your lease should not be something you just throw together or download from a generic lease site on the Internet. It is very important that it follow local statutes so that it is legal in your state. It also needs to state very clearly what will happen when terms are violated and under what terms it can be terminated. In addition you want to use the lease to communicate any rules or expectations with your tenants. A good lease makes your job easier and resolves conflicts before they happen.
Column 12: Financing
Real Estate is a capital intensive business. You will need significant capital if you intend to get very many properties. You will need both your money and other people’s money. You likely cannot get very far with just your money but you also cannot get other people’s money if you don’t have any of your own. There are various means of acquiring financings from conventional financing, to home equity loans, to private and commercial financing. It is important to always be exploring your financing options because the more debt you have financed the harder it becomes to get more.
Column 13: Taxes
Real estate investing provides certain tax benefits that are somewhat unique to real estate. However some people put more emphasis on tax benefits than they deserve. The major benefits include depreciation of the non-land value of a property, 1031 tax exchanges to transfer taxable gains to different real estate entities without incurring taxes, and deduction of all expenses associated with the business. These benefits are actually common to a number of businesses but what makes real estate unique is that you are able to take a depreciation allowance on an asset that actually appreciates in value. Because of that there are special recapture rules that attempt to tax the depreciated value at a future sale date. It is important to understand how these tax benefits work. They have significant benefits in the near term but they also come with future drawbacks. Real estate investing is not about tax benefits, it’s about running a profitable business. Tax benefits alone are never enough to justify an investment.
Conclusion:
Real estate investing like any business is a journey and a process. It takes time to get things started and even more time to begin to get comfortable with your business. With enough time and experience you can settle into a process that works well for you and which you can be successful at. I hope this series has been helpful as a starters guide for some and perhaps as a refresher for others. This series, however, won’t make you a good real estate investor. Only you can do that.
This is the last post in the series. I know it has been a lot of work for Apex and I know how much all of us have learned and benefitted from it. So please join me in thanking him for this great effort.
Throughout the Real Estate 101 Series my goal has been to introduce prospective and beginning investors to the world of real estate investing. Specifically I have tried to answer some basic questions, dispel some myths and misconceptions, and give actionable advice that can be used to move towards becoming a successful investor. As I finish the series I hope that the information provided here has mostly met that goal.
This final column will act as a short summary of each of the previous columns with a link back to the original column for the full details. Hopefully this summary column can become a quick reference tool and an overview that helps to pull all the elements together into a comprehensive story line. Below is a summary of each column.
Column 1: Why You Should NOT Invest in Real Estate
Some people might mistakenly believe that anyone can invest in real estate. It’s a much more involved investment than typical investments like stocks or bonds. It’s more like running a business than it is an investment. There are a number of aspects to investing in real estate that you need to be aware of before you decide to enter the business. I listed 6 reasons why you may not want to invest in real estate. They were: (1) It takes work, (2) It consumes time, (3) It requires management, (4) It demands capital, (5) It needs debt, and (6) It grows slowly. Before you invest in real estate, make sure you know what you are signing up for.
Column 2: The Benefits of Investing in Real Estate
Since investing in real estate requires more work than investments like stocks, one would expect there to be some extra benefits. Indeed there are a number of them and in this column I outlined 6 of them. They were: (1) stable income stream, (2) partially passive income stream, (3) property appreciation in addition to income, (4) tax benefits, (5) significant cash flow, (6) returns are significantly compounded by leverage. I spend considerable time in this column on benefits 5 & 6. The first four benefits are valuable but the most important benefit is the significant cash flow and the most powerful benefit is the compounding of returns through the use of leverage.
Column 3: Where to Start
Real estate investing is not something you just decide to do. It requires a little planning and there are a few hurdles that prevent many people from getting any farther than thinking about it. In this column I outline 8 steps to getting started as a real estate investor. They are: (1) Start by taking action, (2) Get a real estate agent who specializes in investment real estate, (3) Get access to capital, (4) Think about the type of property you want to invest in, (5) Start looking at many properties, (6) Determine if you need a management company, (7) Find out what reasonable rental rates are, (8) Buy something! One of the key concepts I try to get across in this column is that you do not have to do this perfectly. You will make some mistakes and that is OK. There are no perfect deals.
Column 4: Running the Numbers
As with any investment it is important to make sure the numbers work. The returns have to be worth the effort and the risks have to be manageable. In this column I go over 4 ratios that I believe will give a good assessment of any real estate investment. They are: (1) cap rate (2) cash on cash return (3) return on investment, and (4) cash flow margin. I show how to easily calculate each of these ratios. I also discuss some other metrics that are used to calculate these ratios but have assessment value in and of themselves. Those metrics are: (1) cash flow (2) net income, and (3) net operating income. Finally I discuss what I consider to be a minimum guideline for two important ratios. Those are cash flow margin of at least 10% and ROI that is also 10% or perhaps very high single digits if the deal was all cash.
Column 5: Making an Offer
Many people think the key to successful real estate investing is getting a steal on the price of a property. Obviously the less you pay for a property the better, but in general properties will sell for what their market price is. You will be competing with other buyers for the same properties. The market price of a property is simply what other buyers are willing to pay. Market prices for some kinds of properties make for much more attractive investments than others. The largest determinant of the price of a property is the type and quality of the property. The most important thing when buying a property is to understand what the true market price for that property is and to know if that property is a good investment at that price.
Column 6: Finding Your Niche
There are many different ways to invest in real estate. You cannot be successful at all of them. As you start investing it will be a learning experience. The most important thing you can do throughout this process is listen to yourself and determine which type of investing fits best with who you are. You will be most successful when you are able to focus on the niche that best fits with your skills and your personality. It may take some time and it’s ok if there are some missteps along the way. Finding your niche will be one of the most important things you do as a real estate investor.
Column 7: Getting It Rented
Tenants pay your bills. If you don’t have tenants you have losses. That’s why vacancy should be the number one thing a landlord tries to minimize. Too many landlords are complacent about getting a property rented when it is vacant. This is a serious financial loss to the business. A vacant property should be aggressively marketed with the intent to rent it as soon as possible. One common mistake is holding to a rent that is higher than the market is willing to pay. It is far better to lower the rent and get it rented than it is to hold out for higher rent leading to months of vacancy. Vacancy will happen, but a diligent landlord will do everything they can to keep their vacancy rates as low as possible.
Column 8: Finding Good Tenants
While a vacant unit is a problem, a bad tenant is a far worse problem. There are many good tenants to be found but it is your responsibility as a landlord to find them. To do this you need to advertise your property appropriately to attract good tenants. More importantly you need to do careful screening on all applicants to find good tenants. This includes background checks, credit checks and most importantly previous rental history and income verification. Good tenants tend to have a history of paying their rent and making sufficient income to do so. If you are not careful about whom you rent to, your tenant quality will likely suffer.
Column 9: Keeping Good Tenants
Once you find a good tenant it’s far easier to keep them than it is to find another one. Turnover costs you time, effort, and money. There are a few basic things that will help you keep good tenants. It starts with treating your tenants fairly and with respect. You want to keep your properties in good condition and respond to your tenants needs. Do not gouge them on rent or fees, and if possible try to use leases that have longer terms to keep both you and them committed to the property on a longer term basis.
Column 10: Managing the Property
One of the biggest concerns for prospective landlords is how to handle the daily management operations of a property. Areas of concern often center around issues of how to deal with tenants that are not paying rent, tenants that are violating the lease, and how to deal with the maintenance issues of the property. Most money issues with tenants can be resolve with a few simple steps. Eviction is rarely required if you have screened your tenants well but even if required there are services that can help you complete it. Repairs can also be handled by management services for anything beyond your comfort level. You can manage the property to whatever level you feel comfortable and simply hire others to manage what you do not.
Column 11: The Lease
Your lease is a contract between you and your tenant. Your ability to set the rules and retain control over what happens in your property depends on the quality of your lease. Your lease should not be something you just throw together or download from a generic lease site on the Internet. It is very important that it follow local statutes so that it is legal in your state. It also needs to state very clearly what will happen when terms are violated and under what terms it can be terminated. In addition you want to use the lease to communicate any rules or expectations with your tenants. A good lease makes your job easier and resolves conflicts before they happen.
Column 12: Financing
Real Estate is a capital intensive business. You will need significant capital if you intend to get very many properties. You will need both your money and other people’s money. You likely cannot get very far with just your money but you also cannot get other people’s money if you don’t have any of your own. There are various means of acquiring financings from conventional financing, to home equity loans, to private and commercial financing. It is important to always be exploring your financing options because the more debt you have financed the harder it becomes to get more.
Column 13: Taxes
Real estate investing provides certain tax benefits that are somewhat unique to real estate. However some people put more emphasis on tax benefits than they deserve. The major benefits include depreciation of the non-land value of a property, 1031 tax exchanges to transfer taxable gains to different real estate entities without incurring taxes, and deduction of all expenses associated with the business. These benefits are actually common to a number of businesses but what makes real estate unique is that you are able to take a depreciation allowance on an asset that actually appreciates in value. Because of that there are special recapture rules that attempt to tax the depreciated value at a future sale date. It is important to understand how these tax benefits work. They have significant benefits in the near term but they also come with future drawbacks. Real estate investing is not about tax benefits, it’s about running a profitable business. Tax benefits alone are never enough to justify an investment.
Conclusion:
Real estate investing like any business is a journey and a process. It takes time to get things started and even more time to begin to get comfortable with your business. With enough time and experience you can settle into a process that works well for you and which you can be successful at. I hope this series has been helpful as a starters guide for some and perhaps as a refresher for others. This series, however, won’t make you a good real estate investor. Only you can do that.
Thank you, Apex. You have clearly set forth the process of investing in rental real estate. You have avoided overselling an idea that has worked well for you. To teach this effectively demonstrates clear thinking and a willingness to commit the time needed. Good job!
Posted by: Jeffrey | January 11, 2013 at 07:38 AM
I've never commented at FMF before, but feel I need to say thank you as well. What a wonderful series written in a measured, informative manner. We are truly in your debt Apex.
Posted by: Brian | January 11, 2013 at 09:22 AM
Agree, fantastic series. Thanks for that.
Posted by: evilhomer | January 11, 2013 at 10:23 AM
Thanks Apex! I feel much more informed in the process's that go into rental real estate. I found every article brought more than one aspect to mind that I had not thought about.
Posted by: JayB | January 11, 2013 at 11:33 AM
My daughter's ex-husband is a very successful attorney. He has 3 other attorneys working for him as well as an office staff, couriers, and a process server. My other daughter used to be his office manager but now lives in Maui and processes all of his bills for him
He makes over $4,000,000/year. His sole business in the San Francisco Bay Area is evicting tenants from homes, apartments, and office buildings. The last time I talked with him he was processing over 400 evictions/month. Not too many went to court, those that did almost always lost their cases. Often he would evict the same tenants from one rental after another.
I am not a "people" person, plus I am a worrier, so I never considered rentals as a way to build wealth. Rentals are no doubt great for some people but could be a great source of worry and anxiety for others. One man that was in a hiking group that I was part of had about a dozen rentals. The biggest problem he had was that every now again a tenant would move out and leave behind a home that needed a lot of work done on it before he could rent it again. He used to do the repairs himself and as he got older it was wearing him out to the point where when I last met him he was actively selling his rentals and putting the proceeds into the market.
I have what for me is the ideal income source - it is owning passive income investments. Admittedly I only make around 5%/annum from bonds (which is tax deferred or tax exempt) but if you can amass several million dollars even 5% amounts to a lot of income that arrives like clockwork, requires very little of your time to manage, and doesn't require you to have to deal with lots of renters, some of which are good and some bad. I have my bonds laddered out from 2013 to 2042 so every year one or more mature, providing money that I can either reinvest into other bonds, spend, or reinvest into other types of income investments. For 2012 my passive income amounted to over $343,000 and everything is managed right from my desk using Fidelity Investments Active Trader Pro software on my Dell Laptop.
Posted by: Old Limey | January 11, 2013 at 11:55 AM
Great job on this series.
Posted by: jim | January 11, 2013 at 12:19 PM
Old Limey, what yields are you reinvesting at these days? Junk bonds, emerging market debt, and agencies are probably ok? I am getting 20-30% cash on cash return through rentals scooping up foreclosures at 50-75% off with little risk in my opinion. Where else could you find a return like that?
Posted by: Biere | January 11, 2013 at 02:01 PM
I should clarify that is gross %, net is more like 13-20%. Of course this is not including the significant tax benefits.
Posted by: Biere | January 11, 2013 at 02:12 PM
Biere:
Currently I am still able to find muni bonds in the secondary market with 5% coupons. The price of them has gone up a little. A bond that I used to be able to buy for around $986 now costs around $1023. I try to find California bonds whenever I can because they are free of both state and federal taxes. In our IRAs I have been reinvesting interest I earn in the fund PIMIX, Pimco's Institutional class Income fund. For the last 12 months it's annual return has been 22.58% which in an IRA is totally tax deferred. Also in our IRAs I have about $800K of CDs with 5% coupons maturing this year and that money will go straight into PIMIX.
Don't get me wrong I think rentals are great, especially if you are young and don't mind the work that you may get involved in. I do nearly all the maintenance on our home but I wouldn't want to have to run around working on rental properties - I'm too old for that.
Posted by: Old Limey | January 11, 2013 at 09:37 PM
Thanks, Apex for this series. I missed some of them and will go back and read. We bought our first residential rental this year. It has been lots of work, but our tenants seem good, and I think it has been a good decision so far.
Posted by: Kim@Eyesonthedollar | January 11, 2013 at 10:28 PM
This is by far the most helpful, , clear, and thoughtful information on how to launch into real estate & landlording that I've found. Truly, thank you so much Apex, & FMF for hosting this opportunity for readers!
Posted by: SturdyMo | January 12, 2013 at 03:18 AM
To those who commented and felt the material was helpful, thank you for the kind words. It was a fun and educational experience even for me to write this series as it made me put concrete words and action steps to some of the ideas and experiences that I have learned over the years.
Posted by: Apex | January 12, 2013 at 11:21 AM
Thank you for the info. It is an easy to read and understand post.
Posted by: Joan | January 14, 2013 at 06:40 AM
Hi all, I took the plunge in mid 2012 and became a landlord. Now, I am working on taxes, but find mixed information about 1099-Misc forms. Do landlords have to issue them or not? Help.
Posted by: J | March 05, 2013 at 07:58 AM
@J,
IRC section 6041(a) states: "All persons engaged in a trade or business and making payment of rent, salaries, wages, premiums, annuities, compensations, remunerations, emoluments, or other fixed or determinable gains, profits, and income of $600 or more in the course of such trade or business to another service provider who is not incorporated, must report the amount, and the name and address of the recipient of such payment."
There has been some confusion caused by the affordable care act specifically calling out landlords as required to submit 1099s and then that section getting repealed. However 6041(a) still stands and any landlord who is operating rental properties for profit and managing them meets the requirement of 6041(a).
You will also noticed that beginning in 2011 at the top of Schedule E the IRS has added questions A & B. Those questions are:
Question A : “Did you make any payments in 2011 that would require you to file Form(s) 1099?”
Question B : “If ‘yes,’ did you or will you file all required Forms 1099?”
It is clear the IRS still intends for those operating rental real estate for profit to provide 1099's to any individual to whom you have paid more than $600 to provide services who is not incorporated.
When you hire a contractor you should ask them to fill out a W-9. This will give you the information you need to send a 1099 to them and the IRS for the work you pay them to do. If they balk at this then you know that they do not want to get a 1099. The reason is likely because they prefer to take their money under the table and not report it.
For me this is an easy decision. I ask them to fill out the W-9 before I hire them. If they refuse they don't get hired. I pay my taxes and I do not see any reason why I should provide business to others who intend to cheat their way out of paying theirs.
Posted by: Apex | March 10, 2013 at 07:01 PM
Great job! I'm in roughly the same phase you are (acquiring and building a solid cashflow base), and it is really great to see some level-headed discussion about the pros and cons of the business.
Posted by: MidwestLandlord | April 09, 2013 at 09:41 PM