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Real Estate Investing and Expecting the Unexpected

The following is a guest post by Riley from Young and the Invested. 

Real estate investing often meets unexpected pitfalls, such as acquiring a money pit, handling overly needy tenants, or buying in an area which did not measure up to your expectations. These are all the nature of the business and should be accounted for before you enter the market.

In my case, I am a landlord who encountered two unexpected, yet informative experiences early in my real estate investing career. In a classic cause and effect scenario, one major instance of damage led to the discovery of a safety hazard in need of immediate action.

While both put my tenant at risk, the latter led to a replacement mandate for every owner in the building. This led to a complex-wide special assessment you come to loathe as a condo owner. But like all things in life, unexpected expenses crop up and hopefully you have been smart enough to budget accordingly.

The subject of this post will be the trying time I had the pleasure of experiencing early in my real estate investing career. It is fitting the story takes place at my condo, the investment property I felt most certain would present the fewest problems.

Clearly, there was an expectations gap and reality had other things in store.

My Real Estate Investment – A Condo in a 14-Story High Rise

When I started my real estate investing adventure, bright-eyed and bushy tailed, I knew being a property owner would present its challenges. This did not dissuade me from venturing out, but rather served as a caution I needed to observe for myself and fully recognize.

When I bought my condo in New Orleans, I lived there for almost 3 years. The unit presented a great location near my job, offered me my own space, and most importantly, represented a great value in a rapidly improving area of town.

During my stay, I was fortunate only to encounter one clogged drainage pipe from my air-conditioner compressor. Otherwise, the unit never gave me a problem and led me to believe the maintenance and upkeep would not be a hassle. Expectations can be a dangerous thing.

When I moved out, I decided to lease the unit and thereby enhance my return on the real estate investment. Initially, I thought I would use any free cash flow to pay off my mortgage faster, but first I decided to build up a reserve to guard against unexpected repairs or unit vacancy.

My experience of requiring little maintenance, when combined with a property manager on site, made leasing the unit a foolproof decision in my mind.

In many ways, the arrangement paid off and was ideal as an investment. However, despite budgeting for repairs, I hadn’t fully prepared myself mentally for them. In my building, those responsibilities fall solely on the unit owners' shoulders and will crop up whether you expect them or not.

And when stuff breaks or requires attention, I've come to learn some repairs can be managed with less urgency while some require immediate attention. This is the story of the latter.

The Emerald City

My trying real estate investing story starts not in New Orleans, where I live and own the condo, but 2,500 miles away in the Emerald City, Seattle, Washington.

In late 2017, my family decided to visit my brother in Seattle for Thanksgiving. He had recently moved there after a lifetime of pining for the Pacific Northwest and found his place amongst his friends who had moved there ahead of him.

We planned to stay for the 4-day weekend and see what the city had to offer. After visiting Gas Works park, the Space Needle, Chihuly’s Glass Museum, and Pike Place Market, our health took a turn.

Seattle, famous for its wonderful fall weather (sarcasm), got my wife and I sick. It’s unfortunate because our health in no way reflected our time spent in the city. I can’t wait to go back.

Little did we know our health was soon to be the least of our problems.

100 Hours of Exhaustion and Desperation

Having trouble sleeping with congestion and all the ailments associated with a cold, the last thing we needed was a 3 AM phone call from my tenant in New Orleans. She called to tell me the bathroom ceiling had collapsed, and the debris had fallen all over the bathroom and hallway floors.

Partly groggy from the cold medication and partly delirious from the time of night, it took me a few moments to assess the situation and what needed to be done remotely.

After talking through the situation with my tenant, I immediately offered to pay for her to stay in a hotel until I could get this repaired. Almost serendipitously, she had other accommodations available through her work, a nice hotel downtown.

She remarked how she had intended to use her free stay benefits but never found the time. When life closes a door, it opens a window. Or, in this case, when life collapses your bathroom ceiling, it books you a free room at a luxury hotel.

Fortunately, we didn’t need to change our plans to leave Seattle early because we were headed home later that day. We would be able to assess the damage that same day and decide how best to proceed.

When we arrived, my tenant had already cleaned most of the debris and managed to secure the suspended light fixture to a wall. My 400 square foot efficiency suddenly had 20% of its ceiling in trash bags.

As it turns out, the cause of the ceiling collapse was a leaking pipe from the unit above mine. Apparently, over the course of 10 years it had slowly dripped onto my bathroom ceiling.

Much like the straw which broke the camel’s back, the final drop tipped the weight of the ceiling and forced it to collapse. The strangest part was the lack of visible water damage prior to the event.

Knowing I could not repair this myself, I was able to hire a contractor through a recommendation of the building manager. Within 36 hours, he was on site and ready to begin his repairs.

He removed the metal grating left behind from the formerly-attached sheetrock ceiling, ran fresh wire to the new lighting fixture, and replaced the new ceiling and walls which had been damaged.

Compounding Problems

In the process, he discovered a major malfunction with my electrical box housed in the bathroom. When the company designed the box in the 1950s, it had a design flaw which could result in a short-circuit and starting a fire.

As you can imagine, this tendency to short-circuit would only increase when exposed to condensation (i.e., from water damage which had accumulated over the previous decade).

My contractor offered to refer me to an electrician, but we soon found out he wouldn’t be available for at least a week. He also quoted me a price I couldn’t believe was accurate.

After speaking with my father, an electrical engineer, he said this would be something we could handle ourselves. However, we would need to replace the circuit breaker box before the contractor could finish the wall replacement around the box.

Otherwise, we'd have to re-replace the wall. That would be more time, more money, and more inconvenience for my tenant. The contractor told us it needed to be replaced within the next 24 hours or he'd have to return to make the wall repairs in 2 weeks, which was unacceptable.

Facing a tight schedule, my dad and I had to size, buy, remove, replace, and rewire the box ourselves.

Working with urgency, we worked all night to install the new box in time for the contractor to replace the wall in the morning.

Exhausted, still sick, and working under the cover of darkness (no power and no daylight), we managed to remedy the entire situation in a little over 100 hours.

We also saw a way to save money by doing the circuit box replacement ourselves. As for the ceiling, the unit owner above me assumed full responsibility and paid the contractor in full.

Later that day, my tenant was able to move back into the unit. I never thought such a small condo could lead to such a big problem.

Lessons Learned from Real Estate Investing

From my story, I hope to convey the following lessons:

• Be prepared for anything as a landlord. Anything can happen. Try to keep a level head because losing your cool in situations like this can lead to poor outcomes. If you can roll up your sleeves and put in the work necessary to maintain your real estate investments, they can make a lot of money and prove to be worthwhile in the long-term.
• Always keep your tenant’s interests in mind. I want to provide my tenants a high-quality living experience in exchange for fair rent. When I think of my tenants, I think about how I would want to be treated by a landlord. Thinking this way guides me not to cut corners and always keep their interests in mind.
• No investment is without risks. Despite this investment providing a good return, it still comes with risks. Much like investing in index funds, there are still ebbs and flows with how your returns accumulate. The importance is to own and maintain the property over the long-term to see true results.

Why Real Estate Crowdfunding May Make Sense for Your Portfolio

The following is a sponsored post from EquityMultiple.

Maybe you’ve heard of “real estate crowdfunding” and associate the term with Kickstarter and GoFundMe (and investments that don’t inspire much confidence). Perhaps you’re unclear on how the concept differs from REITs. Or, perhaps, you haven’t heard of real estate crowdfunding at all.

Real estate crowdfunding - an evolving set of online platforms for direct, private real estate investment - has emerged as a new alternative asset class, and viable means for individual investors to access private real estate on a level that was unavailable even 5 years ago.

Let’s take a step back and review why real estate is an appealing asset class, and worth taking a look at for all individual investors already exposed to the stock market and bonds:

• Strong Historical Returns: In the years between 2000 and 2015, real estate as a whole beat the S&P 500 by 200 basis points, and well-managed assets in burgeoning markets can consistently generate attractive yield.
• Less Volatility: Because real estate values are driven less by investor sentiment and the news cycle, the asset class tends to exhibit fewer dramatic swings than the stock market. Particularly in times when geopolitical factors or other exogenous variables may influence public equities markets, private real estate can provide downside protection and reduce overall exposure to risk
• Uncorrelated Returns: Real estate, like other asset classes, is impacted by macroeconomic factors. However, because real estate markets are driven by demographic trends, and real estate asset performance is driven by inherent value and management quality, real estate returns do not move in lock-step with public equities markets
• Tangibility: Related to the first two points – real estate assets are essential to society in a way that other assets are not: humans will always need places to live, work, and congregate.

Why Real Estate Crowdfunding

Unlike REITs, which have been around since the late ‘60s and are publicly traded, ‘real estate crowdfunding’ offers private-market investments in distinct properties. Because these investments are illiquid, with yield derived from the quality of the underlying asset and management, they tend to correlate far less with the stock market as compared with REITs. It’s been shown that portfolios substantially allocated to private-market alternatives (like real estate crowdfunding) tend to perform better over time.

Ownership of property - the other traditional means of investing in real estate - does offer de-correlation from public markets, and the opportunity to realize sizable yield through shrewd management. However, owning your own rental property is far from passive - indeed, managing real estate can quickly become a full-time job, especially as you consider multi-tenant commercial property.

Real estate crowdfunding, conversely, allows you to passively invest alongside established real estate firms, benefiting from the experience and scale of the firms you co-invest with. And, because investment-level minimums are typically as low as $5k, you can assume less risk and diversify across markets, property types and risk/return profiles.

Put it this way: if you have $100k to invest, you could put it entirely into a downpayment on a rental home, and deal with management of the property and tenants over time. With real estate crowdfunding, you could instead invest passively in 10 different commercial real estate projects across the country, and save yourself a ton of time and many headaches.

Keep in mind, however, that not all real estate crowdfunding platforms are created equal...

What EquityMultiple Offers

As the name implies, EquityMultiple does offer common equity investments, in the realm of ‘equity real estate crowdfunding platforms’. However, EquityMultiple provides a few unique features:

• Commercial Debt & Preferred Equity: In addition to equity investments, EquityMultiple offers senior debt investments (similar to the first model, as described above, but secured by first lien on a commercial property) that target a 7-12% annual rate to investors over a 6-24 month term. Preferred equity offers a hybrid between debt and common equity: pref. equity investors are entitled to repayment before the equity holders and Sponsor are paid, but can participate in the deal’s target upside. EquityMultiple’s preferred equity investments target a 7-12% current and 10-14% total preferred return.
• Institutional Commercial Focus: EquityMultiple enables individual investors to access professionally-managed properties across markets and asset classes, with minimums as low as $5k per deal.
• In-House Diligence: While some platforms operate as laissez-faire posting marketplaces - allowing Sponsors to post deals and attract investors with little in between - EquityMultiple practices rigorous in-house vetting of deals and deal originators, ultimately selecting fewer than 8% of the potential investments we see.
• Transparency & Customer Service: Online platforms create new efficiencies and improve access, but can’t change the fact that investing remains a fundamentally human and trust-centric process. To that end, we provide robust reporting, frequent asset management updates, transparent and thorough offering prospectuses, and we’re always available to pick up the phone. In the long run, the platforms that win high marks from investors won’t be those that hit home runs 100% of the time (over a long enough time frame, no platform will pull that off).

Paint Your House Door Black, Earn $6k

Here's a post that says if you paint your house door black, your home's value will increase by $6k:

Zillow released an analysis Wednesday after examining some 135,000 photos from listings across the U.S. since 2010. Zillow found that on average, houses with black or charcoal gray front doors sold for as much as $6,271 more than expected.

And there's more:

It may sound emo, but painting your front door black is actually a tried-and-true way of increasing home value. According to Realtor.com, a black door gives buyers the impression that your house is a serious, stately and safe choice. It’s so popular that two of Sherwin-Williams’ top 50 paint colors fit the bill: Peppercorn and Tricorn Black.

Before you go all dark on me, I'm not sure this really works.

It's probably true that homes with black doors sell for more, but is it because they magically are worth more or is it simply because homes with black doors are more valuable, in fast-growing areas, or whatever.

I'm betting it's the latter.

Make Thousands by Painting Your Home the Right Color

Here's an interesting piece from MSN Money about paint colors and how they impact home selling prices

A summary:

Homes with blue bathrooms — specifically light shades like powder blue or periwinkle — fetched $5,400 more than expected when sold, according to a paint color analysis from real estate website Zillow. The analysis looked at more than 32,000 sold homes, comparing the sales prices of ones painted certain color versus similar properties that had white walls.

Blue paint isn’t just effective at boosting a home’s selling price when used in a bathroom though. Dining rooms painted in darker blue hues will cause a house sell for $1,926 more than anticipated on average, while homes with light blue kitchens and blue bedrooms will garner a price that is $1,809 higher than expected.

But not all paint colors have this positive effect on sales prices. For instance, a brick red dining room will slash a home’s price down by more than $2,000 versus what was expected. Other ill-advised paint choices — at least where a home’s value is concerned — included yellow, pink and brown.

Where a paint color is used is also important. While blues may wow in kitchens and bathrooms, when used in a living room it decreased home prices by $820 on average.

Those poor color choices all pale in comparison to leaving a bathroom’s walls white though. That decision can reduce a home’s sales price by more than $4,000.

Some thoughts here:

• If I was selling my house I would re-paint using their suggestions in a heartbeat. Paint is not that expensive and if I could get a few more thousand dollars for the right colors, why not???!!!
• Personally, I like white/tan walls. I wonder what that says about me other than I wouldn't get the most out of my home's sale.
• I'm wondering if blue just happens to be "in" now and in a year or two the colors that sell will change. What do you think?

Any other thoughts from the facts above?

Moving in Retirement

Here's an interesting piece from Time about moving in retirement. Here are some of the stats they share:

• 37% have moved in retirement
• 36% do not anticipate moving in retirement
• 27% have not moved but anticipate doing so

And one quite interesting stat:

• 30% of retirees who have moved have gone into a larger home

This topic is a relevant one for us as we transition in life.

As of now we are in a large home in a suburban area of a beautiful city (many people come here for vacation).

We have one child at college and one at home plus we love our location and house. For now we're going to stay put until we see where the kids land, but after that, we have some decisions to make.

Some thoughts we're working through:

• We don't need a 3,500 square foot house for two of us, so unless we think we're going to add residents (my parents could move in with us) or that the kids will form families quickly and come back to visit, we likely will move.
• If we do move, we'd likely stay in the same city and the same area within the city.
• We'd also be more likely to move into an apartment. This would allow us more flexibility to travel.

But who knows what we'll actually do. Time will tell.

Anyone out there who's been through this decision-making process? What did you do and why?

Extra Home Ownership Costs Make Renting Look Good

Here are some interesting facts on home ownership costs from CNBC:

Often-forgotten and underestimated costs of owning a home — from utility bills to yard care — add an average $9,080 per year to homeowners' tabs, according to a new analysis from real estate site Zillow and service site Thumbtack.

The main costs that make up the $9k include:

• Utilities
• Maintenance (including yard care)
• Property taxes
• Insurance

These are some big numbers, especially when you're comparing home ownership versus renting.

These costs alone add up to over $750 per month. Of course you'd still have utilities when renting (though greatly reduced) and renter's insurance (again, greatly reduced).

But you'd also have your equity in the home invested.

For example, if your home was worth $300k and you could earn 3% on your money, that's another $9,000 a year to the favor of renting versus owning. So you could save $750 (or so) by renting plus earn $750 (or so) by renting, so if you could rent for $1,500 or less, it's a "better deal" to do so (assuming you don't consider home appreciation, mortgage costs, and the like -- lots of variables to consider including non-financial ones like space and lifestyle).

That said, I can see us renting one day. Once the kids are out of college and on their own, we'll have no need for a 3,500 square foot home for two people.

Perhaps we'll sell it and move to an apartment. We'd have much less space but also have more freedom to travel without worrying about someone watching the house while we were gone.

Anyone out there downsized from a house to an apartment? If so, I'd appreciate your thoughts on what you liked and didn't like.

Where You Live Can Kill Your Finances

I always find these sorts of pieces entertaining.

Here's a piece from MSN about a couple who finds it difficult to make ends meet even though they earn $125k per year.

The overview:

Sharon Winick, 49, and her husband Michael have three children and own a home in Chevy Chase, Maryland, where Michael is a network administrator. Sharon is a paralegal turned stay-at-home mom. Between his work, her occasional side jobs and their investments, they bring in roughly $125,000 a year. Yet they struggle to make ends meet.

"The amount of money we spend every month is more that we make, it's been that way since we had our first daughter," Winick said.

The main reason they are struggling: they live in a high cost-of-living area.

Here's a list of the highest-cost cities in America.

Number 6 is Washington, D.C., the area where the couple lives.

Here's what the article said about the costs there:

Housing-related expenses including rents and mortgages are by far the most burdensome at more than double the national average.

Imagine how your budget would be impacted if your housing costs, which are generally the highest costs a family has, were DOUBLE what they are now.

That's a budget buster for sure!

In the rest of the U.S. where most of us live, $125k can be quite a large amount.

It is, after all, over twice what the average family in America earns, so somewhere you can certainly make it on $125k.

Yes, where you live has a big impact on your net worth -- for better or for worse.

My recommendation is to earn a high income like this couple does, but do it in a low cost-of-living city.

If you can do that (and yes, it can be done) you can become wealthy.

Top Ten Cities Where You Can Live Comfortably on Less than $60k

CNBC lists the top ten cities where you can live like a king for $60k as follows:

10. Louisville, Ky.
9. Kansas City, Mo.
8. Birmingham, Ala.
7. Cincinnati
6. St. Louis
5. Indianapolis
4. Cleveland
3. Pittsburgh
2. Memphis, Tenn.
1. Detroit

I've actually lived in three of these cities and two others which are close/similar.

Cities I lived in include:

• My work career started in Cincinnati and I lived there a couple years. Young and single (seems like eons ago) while there, I absolutely loved it.
• I worked in Indianapolis for a summer internship. It was a nice city and I wouldn't have minded if I ended up there.
• I spent five years in Pittsburgh which is where I met my wife. I still have relatives who live there. I'm not sure I'd move back (it's pretty cloudy) but I do love the city.

Here are a couple cities I lived in near ones on this list:

• Nashville. AWESOME city!!! It used to be inexpensive to live there but I think that has changed -- too many people want to live there.
• Grand Rapids. Way better than Detroit IMO (my dad lives in Detroit) and much cheaper. Lived there 14 years and my kids still call Michigan "home."

How about you? Have you ever lived in any of these cities?

Buying a House You Can Afford will Save You Tons

Money magazine gives some interesting thoughts on buying a house you can afford and how much it will save you as follows:

The standard rule of thumb for how much house you can afford is 28% of gross monthly income.

But who says you have to spend all 28%? Using this rule, a person making $80,000 could afford a $1,900 mortgage. Based on a 30-year loan at 4.25%, that puts the price at around $375,000. But if you dialed that back to 23% of income, you’d lower your payment to $1,500. Invest the savings at a modest 5%, and you’d have an added $333,000 over the life of the loan.

Also, who says you have to use a 30-year loan? Planner Ron Rogé prefers 15-year mortgages because of the “hundreds of thousands of dollars” in potential savings. Using the 28% example, a 15-year loan at 3.5% would save you $168,000 in interest over a 30-year loan at 4.25%. And once the loan is paid, you’re free to invest $1,900 a month for the next 15 years, netting another $500,000.

Lots of thoughts on this one:

• There are many opinions on how much you should spend on a house but in the end, YOU need to decide what you want to spend. Don't rely on a bank or real estate agent to decide for you.
• It's not only the cost of the house itself, but the associated costs that can really drain your budget. In fact, the house you buy has a great impact on determining your wealth.
• We all know that debt costs a fortune. The above numbers illustrate this completely.
• If you buy a house you can afford (i.e. don't max yourself out to get the largest house possible) and take the right follow-up steps, you can pay off your mortgage in 10 years or less.

Anything to add?

Best Cities to Buy a Home

Go Banking Rates lists the best cities in each state to buy a home.

You can browse the list to see which ones you like, but I want to note that I've lived in three of them:

• Colorado Springs, CO
• Cincinnati, OH
• Pittsburgh, PA

Not only were these great places to live, but they were relatively inexpensive. As we know, where you live can make a big impact on your finances.

So we were able to live in wonderful places, make a large income, and save a ton on expenses. That's a pretty good deal, right?

How about you? Have you lived in any of the "best cities" on this list?

Can You Become Wealthy by Renting?

Here's an interesting piece telling how a single mom and a couple have sworn off home ownership and are better off financially for it (the couple has even gotten "rich"). Some highlights:

• The single mom says, "Having a mortgage is like paying rent on money that you borrowed anyway -- a very high monthly rental fee."
• The philosophy of both the mom and the couple seems to be "save the difference between a mortgage and rent and invest it."
• The mom noted that by renting she can "avoid all the other expenses associated with home ownership."
• A real estate expert in the video is quoted as saying, "A mortgage forces you to save in a way that most of us can't."
• The husband says (paraphrase) that, "Buying a house and locking yourself into 25 years of stress is insane."

So let's go through the rationale here. These people are saying:

• By renting, I can have a lower monthly payment as well as avoid all the expenses associated with home ownership (insurance, taxes, maintenance, etc.).
• I can take that difference and invest it to grow my net worth.

Sounds reasonable, right? Very similar to "buy term and invest the difference".

Of course, as the real estate agent points out, most people won't execute this strategy. Just like with the "buy term and invest the difference", most people have the discipline of a gnat and "buy term and spend the difference." That said, perhaps they do enjoy life more because they are spending money on things they prefer. Same could be said for the renters above.

My take:

• I own a home and own it free and clear. It's probably a break-even financial decision at best versus renting. That said, owning a home has several benefits over renting (space, ability to make the place like you want it, separation from neighbors, etc.) and thus we prefer it.
• We have owned homes that are very nice but are also way less than we could afford. Our home now is about 10% of our net worth.
• I do like what appears to be a general trend from owning a home to renting because I own rental units. :)
• I think the "rent and invest the difference" strategy could work as long as the people executing it actually do invest the difference. My guess is that most people can't execute it well and the difference will end up spent and likely unaccounted for.

So, those are my thoughts on the issue. What's your take on it?

The Big Financial Advantages of a 15-Year Mortgage

Here's an interesting piece from Money magazine that reminds us of the advantages of a 15-year mortgage over a 30-year mortgage -- namely, the cost.

They list four reasons a 15-year mortgage is better but the main reason is point #1 -- it saves a TON of money!

Key quote:

Taking out a 15-year mortgage dramatically cuts your home-loan repayment time. The faster you repay the loan, the less in interest you need to pay. This can save you tens of thousands of dollars over the (shorter) life of your loan. A 15-year mortgage also usually offers better interest rates than other loan products.

Exactly how much money?

I went to Google, typed in "mortgage calculator" and they had an easy on-page calculator that covered the basics.

I then searched for current mortgage interest rates and got to Bankrate's list of mortgage rates. 

So let's assume:

• $300k home
• 20% down, so the buyer is borrowing $240k
• Two loan options: 15-year fixed (2.87% interest) and 30-year fixed (3.56% interest)

The results:

• 15-year mortgage has a monthly payment of $1,642 with total cost of $295,638
• 30-year mortgage has a monthly payment of $1,086 with total cost of $390,874

In other words, you'd save $100k by using a 15-year mortgage versus a 30-year one.

But someone might object that they can't afford the house they want with a $1,642 per month payment.

That's correct -- they can't afford it. They should instead be looking at something they can afford.

There's a tried and true method for buying a house and paying off the mortgage in 10 years. One way to implement this is to get a house you can afford with a 15-year mortgage, put in extra payments, and have it done in a decade.

You'll save yourself $100k which you can then invest over the next 15 years (versus the 30-year mortgage people). This $6,667 per year invested at 8% is equal to $181k! So by choosing a 15-year mortgage over a 30-year mortgage, you're saving yourself/earning almost $200k!

Furthermore, if you let that $181k ride for the next 15 years at 8% it's worth $574k when you retire (if you're wondering, this assumes you buy the house at 25, pay it off at 40, save/invest the $181k by 55, and keep it invested until age 70).

So it seems to me that the 15-year mortgage is a clear winner. Thoughts?

Zillow's Numbers Not What You Think

I was reading a local newspaper (one of those half-page jobs you get for free in the mail) the other night and an article about Zillow caught my attention.

In particular, here's a quote that got my attention:

When questioned about the reliability and accuracy of information available [on the site], the CEO of Zillow made a statement last year that "while Zestimates are a good starting point, nationwide Zestimates have a 'median error rate' of about 8 percent."

Uh, yeah.

First of all, I've noticed this as well. It always seems that any house I own is vastly under-priced on Zillow and when I want to buy and look up the home it's always vastly over-priced. Ugh!

Second, price updates are very sporadic. I remember living in my last house for a year before I saw my purchase reflected in Zillow.

Third, 8 percent!!! Yikes!!! A $500k house could be on Zillow for $540k or $460k -- and that's just the median! It could be worse!!

Finally, the article says the primary purpose for Zillow is a lead generation tool for real estate agents (which I figured, but it was nice it was confirmed).

Ok, I didn't really mean for this post to be a rant against Zillow. The article just confirmed some things I had been wondering about and I thought I'd share them.

Any big Zillow users out there?

Selling Your Home Without a Realtor in 2016: A Guide for the Motivated Property Seller

The following is a guest post from Sacha Ferrandi. He has spent the last 12 years funding real estate investments and building his real estate lending firm. As Founder and Principal of Source Capital Funding Inc., Sacha is an expert in both residential and commercial real estate.

Looking to make a move soon? Recent trends have seen homeowners electing to sell their homes themselves by forgoing the realtor middleman, and for good reason. Selling a home can save homeowners around 6 percent of the price of their home. Let’s put some numbers on this: Say your home is worth $500,000—you can save up to $30,000—definitely not chump change.

With this said, selling your own home isn’t always the right decision. This difficult process is a fulltime job; from paperwork to legal regulations, selling real estate takes a lot of time, patience and effort. This guide gives details on the selling process so you can determine if this route is right for you.

Home Preparation

In order to sell your home, you’ll need to work on getting it buyer-ready:

• Pick a season in which to sell; this can vary based on neighborhood, but generally speaking, homes are sold mostly between spring and summer.
• It’s important to make sure your home is immaculate, from the inside out. Clean as much as possible, plant in the front to improve curb appeal—it can increase your property value by over 10 percent on average—and apply a fresh coat of paint.
• Keep your home décor neutral and inviting; allow any shopping families to imagine their own décor and memories being made in the space.
• Before selling, you may need various certificates, so speak with local county officials and determine exactly what’s required; it could be an occupancy certificate or fire check inspection. The investment of time and money now will definitely pay off down the road when you have an interested buyer.

Before posting your home for sale, you’ll need to do plenty of research on comparable listings and sales in your immediate neighborhood. If you want to be more exact about your home’s value, it’s always a good idea to hire a professional appraiser. On average, an appraiser visit will cost between $300 and $400. We suggest checking certifications and experience when choosing an appraiser, as a false appraisal can impact a sale. A buyer may request an additional appraisal; should a large discrepancy be found, you might find that problems arise with their lending company. Check out this article for more information on appraisals.

Legal Processes

There are many legal ins and outs of the process, so it’s a good idea to hire a lawyer that can help file the proper forms and keep you on the right side of the law. You’ll need to do research on the actual FSBO laws in your town. Regardless of the laws, we suggest you have the following reviewed by a lawyer as FSBO sellers are not often covered by Errors and Omissions Insurance:

• Disclosure forms such as previous fires, floods, lead paint, etc.
• Buyer’s Agents agreements
• Final Purchase Agreement

When it Comes to Listing

You’ll want to list your post online through a site that gets the most traffic—cue the MLS. This is considered to be, by and large, the most comprehensive and detailed list of real estate available in the United States. It’s generally available to realtors, but in some areas, buyers can also access this site. There are certain services that make it possible for individual sellers to post their homes on the site, usually at a fee of a couple hundred dollars. In your listing, be sure to put together a list of updates and improvements you have installed in the home and list by date and cost. This will give buyers the most comprehensive look at the true value of your home.

Market Your Home

Marketing your home is not the same as listing it. Create professional advertisements; if you don’t have graphic design experience, utilize services like Upwork and 99designs that will put you in contact with inexpensive freelance designers. You’ll want to place your advertisements on sites like Zillow and Realtor.com and place physical copies in local neighborhood coffee shops and the like. The more visibility your ad has, the better chance you’ll have at a profitable sale. Before posting your advertisements, prepare important information about the commuting details in your area, the school system, and local amenities. This prepped knowledge will have you ready to field questions when open houses come around.

Hold an Open House

Instead of hosting hundreds of personal home showings, hold an open house once or twice a month. Leverage local newspapers or the popular FSBO sites like Hotpads, Trulia, Realtor.com, etc., to increase turnout. You might be overwhelmed at the aspect of fielding multiple prospective buyers, but remember that competition will make your home more desirable. Channel your inner salesman: highlight the top selling points of your home, such as bedrooms, yards, schools, and privacy factors, but do so without being too over the top. Be polite, use positive words and highlight your home neutrally, and never lie to or argue with a prospective buyer.

Receiving an Offer

Once all goes well with your open home showings, you should get an offer. Do not accept a verbal offer and if a buyer needs a contact, have them ready to send over; you can even print them out and have them available for ease at the open house. When you do receive an offer, you’ll have the option to reject, revise, or accept off the bat. Don’t be surprised if this process requires multiple revisions of the terms between sellers and buyers. Above all, never negotiate without a written offer.

Accepting an Offer

Make sure each offer has a mortgage pre-approval from a lender as well as an earnest deposit check of between 1-2% of the accepted price. Monitor any contingency offers as they can be a headache (contingency of buyer selling their own home, contingency of another property inspection, etc.), and always be sure to include a contingency of attorney approval from your side. Make all 2-3% earnest deposits nonrefundable. There can be exceptions, such as a failed inspection or new information left out of the disclosure, but without a deposit, a buyer can back out at any time and leave you with nothing. Last but definitely not least, always be sure that the buyer has obtained Buyer’s Title insurance.

Buyers Inspection and Bank Appraisal

First time home buyers can be shaky during inspection. Take the lead and talk with them about any issues to help ease their nerves during the buyer’s inspection.

There are considerations to take into account if your buyer is purchasing the home using varied types of loans. If your buyer is taking out a FHA loan, you can’t seek a second appraisal for a period of at least six months, even if you’re later approached by another buyer. If they intend on taking out a conventional loan and putting down 20 percent or less, they will not receive approval for a loan if your home doesn’t appraise for at least as much as they offered. If the bank appraisal is low, you may be forced to lower your selling price.

When you finally depart your home for the last time, make sure it’s in the condition specified in your contract. This might mean having your water meter read one last time, cleaning and wiping down cabinets, running a duster through the blinds, or any other provisions that the buyers might have stipulated.

Finally, make your move and rejoice over your new sale!

Then, if you are looking to buy a new house, do it in a way that allows you to pay off your mortgage in 10 years!

Note: Keep in mind that this article is not meant to represent legal advice. Consider this a jumping off point for making the decision to embark on the arduous journey of selling a home. Make sure you’re ready to sell before taking any additional steps.

Real Estate "Profits" and How I Stack Up

Here's an article from CNN Money that hits a few buttons for me.

• First, it's about real estate investing.
• Second, it lists the "best" markets to become a landlord. I thought I'd compare my results with the best.
• Third, it highlights (again) how little the mainstream media understands financial terms, what they mean, how to use them, and so forth.

Let's begin with the financial terms.

The article talks about "profits" and "average returns" in real estate investing. Both of these terms are "net" amounts -- what you have left over after expenses. For instance, a profit is generated when you earn revenue and then subtract expenses. What's left over is "profit". The same goes for investment returns. You take your net gain (income less expenses) and divide it by the amount invested to get your return percentage.

But in this article the author does not take into account investing costs. He simply takes revenue, divides it by the selling price of a unit (amount invested), and calls that "profit" and calculates "average return."

In the real world, profit and average return are calculated after expenses. Yes, some mutual funds publish their "returns" before expenses (or at least they used to), but we all know those aren't real returns until costs are deducted. The case is the same here. I'm not sure if the author doesn't know the difference or is simply ignoring it. Whatever the case, it makes him look like he doesn't know what he's talking about (at least to an informed reader.)

That said, the chart gets one term correct in calling it "gross rental yield" (GRY). And I admit that there is some value in calculating GRY. But it's certainly not "profit" or "average return." Not even close. You MUST deduct expenses to get those numbers. Believe me, I wish GRY was the same as profit and that's what we all took home to the bank! :)

Ok, with that rant out of the way, let's look at their top markets. The list of cities, gross rental yield, average monthly rent, and average unit selling price are as follows:

• Anderson, S.C. -- 15.3% -- $893 -- $69,900
• Greenville, S.C. -- 13% -- $975 -- $90,000
• Sioux City, Iowa -- 13% -- $914 -- $84,250
• Gainesville, Fla. -- 12% -- $1,161 -- $115,950
• Washington, D.C./Arlington, Va. -- 11.9% -- $1,966 -- $199,000
• Columbia, S.C. -- 11.3% -- $1,046 -- $111,500
• Pittsburgh, Pa. -- 11.3% -- $991 -- $105,700
• Charleston, S.C. -- 10% -- $1,160 -- $139,900
• Columbus, Ohio -- 10% -- $1,039 -- $125,000
• Omaha, Neb. -- 9.9% -- $1,059 -- $128,000

Just so we're all on the same page, here’s how you read the numbers using Anderson, S.C. as an example:

• Anderson's average rental unit sells for $69,900
• The average unit there generates $893 per month in rent (gross, no expenses deducted)
• This means the average rental unit generates $10,716 each year in gross rents ($893 * 12 months)
• The gross rental yield is therefore $10,716/$69,900 or 15.3%

Now, here's how I stack up to that:

• The total costs of my units (includes both purchase price and remodeling costs): $579,342
• Gross monthly rents of these units: $10,890
• Gross annual rents of these units: $130,680
• Gross rental yield: 22.6%

A few comments on this:

• I wish I was earning 22.6% profit on these units. I'm going to be between 8% and 11% when it all shakes out (which should be this fall as my last unit is done with its remodel, it's filled, and I get to a point where I'm through investing big in remodeling).
• I paid for all my units in cash, but my return would be higher if I leveraged my places, as I noted on each property write up I've done on FMF.
• There's no accounting for appreciation in these numbers.
• One thing that helped me out big-time is that I bought my places near the bottom of the market (not at the bottom, but near it, just as they turned up a bit. If I had started two years earlier I'd probably have double the properties now and be looking at HUGE gains.) Unfortunately, those days are mostly over.
• My numbers are against the averages in a market, so it's not really a fair comparison. I'd like it better if I knew what the top 10% or top 25% were earning so I could compare myself with their results.

Well, that's it for now. I will give you a detailed update on my rental units once the smoke clears.

I'd be interested in hearing from those out there who own rental places. What do you think of the article? How do your results compare to those in the cities highlighted?

Six Rookie Landlord Mistakes

Money magazine lists six rookie landlord mistakes as follows:

No. 1: Underestimating costs
No. 2: Breaking the law
No. 3: Skimping on vetting prospective tenants
No. 4: Ignoring renters insurance policies
No. 5: Failing to check out the property regularly
No. 6: Going DIY at tax time

My take on these:

• I always estimate high on costs and low on revenue whenever I look at a property. If it still works then, I try and buy the place. That said, it looks like I've estimated low on both costs and rents overall, so I've done just about what I've expected (I will get a rental real estate update out sometime in the future).
• Having a management firm takes care of #2, #3, and #5 for me.
• I'm not sure about #4 where they recommend requiring tenants to have insurance for their contents. Does anyone do this (or have it required of them as a renter)?
• I do NOT go DIY at tax time. As you know, I use a CPA to do my taxes.

Those are my thoughts on this list. Anyone else have something to add?

What Outdoor Feature Would You Most Like for Your Home?

Money magazine asked its readers what outdoor feature they'd most like for their homes. Their responses:

• Pool -- 30%
• Deck -- 28%
• Screened-in porch -- 26%
• Kitchen -- 16%

It's funny to see this question since we're now debating this ourselves (given we have a new home). What do we want most? Not sure yet, but here are some thoughts:

• We considered a pool but feel like the cost and time (many friends who own one say it needs lots of maintenance) aren't worth it. And our kids will be out of the house soon, so it's not really worth it.
• I think we will get a grill (we left our old one in Michigan -- it had seen better days -- 8 years outside in Michigan winters) soon as we love to cook outside.
• We will probably get some nice landscaping, but it has to be low or no maintenance. For this reason I love...rocks. :)
• None of the four items above sounds good to me. We don't want a pool, have a ranch home with a patio (so a deck and screened-in porch seem useless), and I can't imagine a kitchen outside.

How about you? What outside feature would you want (or do you have that you really enjoy) for your home?

Is Rental Real Estate Really Passive Income?

Fox Business has an interesting post on passive income in general and rental real estate as passive income in specific. After having been a rental real estate investor for two years now, I definitely have some thoughts on this issue.

But let's start with what Fox says. Here's what they list as the definition of passive income:

Investopedia describes passive income as "earnings an individual derives from a rental property, limited partnership or other enterprise in which he or she is not actively involved."

Later the author clarifies his thoughts by saying the following:

Real passive income is earned in your sleep and regardless of the amount of effort you put into it.

Then they give a bit of a reality check:

Becoming a landlord might sound tempting, but -- trust me -- it's not as glamorous as it seems. It's also not nearly as passive as many think it to be, despite what Investopedia or others claim. As someone who has owned and managed two single-family rental properties for almost a decade, I must confess that the income I've earned has been anything but effortless. The truth: It's actually been a lot of work.

Some thoughts from me:

1. The U.S tax code does list rental real estate as passive income. One thing this means is that any losses incurred can only be used to offset passive income -- not active income (like you earn from your job or side business). I found this out in year one when my first property was being renovated and I had expenses, but no income. The losses weren't deductible that year because I had no passive income to offset them. (I was able to deduct them in year 2 as income started to flow in.)

2. While rental real estate may allow you to earn income in your sleep, it is subject to the amount of effort you put in. You don't just buy a place and start earning income, there's a LOT of work that goes into getting it ready, finding a tenant, and so forth. Even after you place a tenant, there are repairs, bills to be paid, etc. that require your time and attention, especially if you manage the properties yourself.

3. And even if you have a property manager, like I do, it's still not completely hands off. I am in communication with my manager at least once a week. Over the past two years I've been in weekly communication with the guy remodeling my units. I still have to manage the insurance, taxes, and finances for the properties. I visit them when needed (I now live in Oklahoma and they are in Michigan, so I'm not sure how often I'll see them). Yes, my manger handles the 3 am toilet plug issues (I still pay for the repairs), but there's still plenty of work to go around.

4. Early on in my real estate investing career, I spent a TON of time learning the business, learning the market, looking at properties, considering bids, and on and on. It required a lot of time and effort.

So I would not classify rental real estate as a passive investment. Even something that's mostly passive (like writing an ebook one time, putting it on a website, and earning sales from it) still requires some effort. You may have to update the book, make sure the site is up, handle returns, and so forth. Yes, it's mostly passive, but not completely.

Rental real estate isn't even most passive. Sure, it's not as much work as 40+ hours at a job each week. But you have to put in a decent amount of time and effort if you want to maximize the income from your investment.

BTW, don't get me wrong. I LOVE rental real estate and am glad I own it. I'm just saying it's not all rainbows and lollipops. It requires work.

That's my take on the issue. What's yours?

Reviewing Rules for Real Estate Investing

I recently stumbled onto the BiggerPockets Ultimate Beginner's Guide to Real Estate Investing, a free PDF on how to get started investing in real estate. It was a decent read, even for someone like me who's been in real estate a bit, but it mostly reinforced what I already knew -- I didn't learn a bunch. It also spent a lot of time on areas of real estate investing I'm not interested in, so I skipped those sections. That said, I thought I'd share it with you because the price was certainly right. It was FREE! :)

The book listed three "rules" of investing in real estate that I thought I'd share with you. Then in a later post, I'll share my "rules" (or at least how I evaluate a property). BTW, I don't use any of their rules. Not to say theirs are wrong and mine are right, just letting you know this upfront. I'll let you decide what you like and don't.

Here's their first rule:

The 2% rule states that your monthly rent should be approximately 2% of the purchase price.

Example, a $100k home should rent for $2,000 a month.

Of course, if monthly rent is more than 2%, I assume that's even better, right? :)

My monthly rents, once I get done remodeling all my units (the last one is almost done!), will be a bit above 1.8% of purchase price plus remodeling costs.

Personally, this rule would eliminate all the properties that I've purchased (which have great returns, by the way). They admit that it's very conservative and it should be used as a guide only. There's also a lot of debate in their forums that it's very unrealistic. I'll let you decide what you think.

Rule #2:

The 50% rule simply states that 50% of your income will be spent on expenses -- not including the mortgage payment.

Personally, I HATE this rule. Why? I don't like to ESTIMATE expenses with a flat percentage. I prefer to do a pro forma for every property before I make an offer on it. Only then can I know if my properties are worth the investment.

That said, once all my properties are completed, it looks like my expenses will be 50% or so (maybe a bit more) of my income. But I don't have mortgages, as most of you know.

Rule #3:

The 70% rule says that you should only pay 70% of what the after repair value is, less the repair costs.

They use this example to explain the rule:

A home which, after being fixed up, should sell for approximately $200,000, needs approximately $35,000 worth of work. Using the 70% rule, a person should multiply $200,000 by 70% to get $140,000 - and then subtract the $35,000 in repairs. The most a person should pay for this property, therefore is $105,000.

Huh?

They note that this rule is used by flippers, so no wonder it seems strange to me. I'm not a flipper. Though who knows, maybe one day I will be. :)

The BiggerPockets people end their rules section by noting that these are just rules of thumb designed to give a potential buyer an idea of whether or not a property is worth looking at a bit deeper. I think that's fair. I have my own rules which I use to give me a sense of whether or not a property is at least in the ballpark of what I'm looking for. Those rules help sort out the vast majority of houses on the market, allowing me to focus on the ones that could be winners.

So, what are your thoughts on the rules above?

How to Sell a House

If you're looking for the details on "how to sell a house", I'll cut to the chase:

Bury a St. Joseph statue upside-down in your yard, facing toward the for-sale house. After the house sells, the seller is supposed to dig up the statue and place it in a spot of honor in their new home.

:)

I stumbled upon this piece from the Wall Street Journal that talks about the inverse relationship between the housing market and sales of St. Joseph statues. When the market is bad, sales of the statues rise (because people are looking for ANYTHING that will help sell their house, even if it doesn't work.) When the market is good, homes sell quickly, so no help is needed from St. Joseph.

I find this piece interesting because:

• It's nonsense, but people do it. And they can't even agree on the rules. Should the statue be upside-down or right-side up? Should it face the house or not? Is it to be placed 6 feet from the house or 6 yards? And on and on.
• When we had our house for sale last fall, I purchased a St. Joseph statue to aggravate my wife (I told her I was going to buy one and she said I was crazy, so I did it.) In fact, the one I purchased is the gray one on the far right in the Journal's piece.
• I has some semblance of being related to personal finance.

Just thought I'd throw the topic out there and let you all comment on it. Has anyone ever heard of this legend? Has anyone ever used it? Did it work?

The Retirement We're All Trying to Avoid

When I read this piece from MSN Money it made me think of one word: yikes!

Here's the part that made me squirm:

At the height of his corporate career, Tom Palome was pulling in a salary in the low six-figures and flying first class on business trips to Europe.

Today, the 77-year-old former vice president of marketing for Oral-B juggles two part-time jobs: one as a $10-an-hour food demonstrator at Sam’s Club, the other flipping burgers and serving drinks at a golf club grill for slightly more than minimum wage.

While Palome worked hard his entire career, paid off his mortgage and put his kids through college, like most Americans he didn’t save enough for retirement. Even many affluent baby boomers who are approaching the end of their careers haven’t come close to saving the 10 to 20 times their annual working income that investment experts say they’ll need to maintain their standard of living in old age.

When the 2008 financial crisis hit, what little Palome had saved -- $90,000 -- took a beating and he suddenly found himself in need of cash to maintain his lifestyle. With years if not decades of life ahead of him, Palome took the jobs he could find.

A few thoughts on this:

• First of all, kudos to him for being willing to work at any job to make ends meet. I know it must be hard but the article shows that he has a great attitude about his situation.
• What a nightmare! This is would be a terrible result IMO and the exact opposite of the retirement I'm planning for.
• The key issue: he simply spent too much. He made six figures for at least part of his working life which means he likely had an above-average salary throughout his career. And yet he managed to save only $90k -- a number BELOW his final annual salary level.

I can't help but both feel sorry for his situation and be reminded that this could be me if I don't stick with my plan (through I'm way past $90k in savings). Hopefully it will encourage you in the same way.

Reasonable Bathroom Renovations with Exceptional Returns

The following is a guest post from Chris Long, a Chicago-area Home Depot sales associate and a regular contributor on plumbing topics for homedepot.com. Chris' advice on bathroom designs for homeowners ranges from fixtures and accessories to DIY remodeling. I asked him to do this article as I just went through this process -- doing little fixes to my house in order to make it sell at a better price.

Are you ready to put your place on the market but worry that you might end up leaving money on the table? If you have minor repairs or updates that need to be done, you may be doing just that.

When potential purchasers visit a property that has visible "deficiencies" (they can be as minor as outdated décor and as major as showerheads swinging from the sheetrock) they automatically assume the worst and the dance of the dollars begins: buyers overestimate costs of repairs and ask for everything including a new kitchen sink while sellers resist making pricey concessions for cosmetic line items.

One way to avoid this struggle altogether is to fix some of those issues before you ever list the property. Even if you have no plans to sell, but want to spruce up your pad, the bathroom is a great place to start because you can add value without investing large amounts of time or money.

Here are a few bathroom updates to consider and some related figures to help you figure out how you can get the biggest return on your investment.

Start with a Plan

Before you dive right in, put an overall plan down on paper to make sure your expectations, your budget and your design scheme are on the same page.

Due to the fact that there are so many elements in play in the bathroom – electrical, plumbing and cosmetic aspects - one of the most direct routes to an updated bathroom is to work within the existing bones of the space and keep your updates superficial.

Simply stated, moving plumbing supply lines and installing new electrical outlets for fixtures can not only increase the cost and extend the timeline of your updates, but your simple bathroom refreshing can turn into a super-sized renovation, especially if you have an older home and cannot safely (or legally) tie into the existing plumbing and wiring.

That said, national averages place a bathroom renovation around the 50-70% return on investment rate. Interestingly, the return does not increase the more you invest so don't fret if you are only able to update minor items and not overhaul the entire room.

And no matter the degree of your remodel, avoid the urge to place your creative stamp on the space. Keeping a neutral palette not only allows a potential buyer to imagine living in the space and incorporating their own style but it also increases the odds that the buyer will not factor redoing the bathroom (to undo all of your taste specific selections) into an offer.

Update the Walls

Don't underestimate the value of a fresh coat of paint – or the impact that comes with stripping away several decades' worth of wallpaper and starting with a clean slate.

Sweat Equity Tip: Few things date a space faster than old (and equally taste specific) wallpaper. Moreover, removing wallpaper is one of the highest ranking remodeling projects that potential purchasers avoid.

If you do the work on the front end yourself you can transform the entire room for little more than the tedious and time-consuming annoyance of the chore and that can equal big returns when you're ready to show the property.

For paint, go with a neutral color that brightens up the room in a matte or washable flat finish (to mask and minimize any imperfections). Pair this with a fresh coat of a clean white semi-gloss paint on the trim to create contrast.

A single gallon of wall paint can cover upwards of 350 square feet and a mid-range brand can cost anywhere from $35-$60 a gallon.

Fix Your Fixtures

New light fixtures and plumbing fixtures like faucets, showerheads and toilets are easy swaps that immediately update an older bathroom.

• Faucets: great options are available in the $50-150 range
• Showerheads: from $30-$300, with many options in the $50-$100 range
• Toilet: can cost upwards of $400 but a new water-saving toilet can be yours for around $150

Tip: Be a forward thinking remodeler and select eco-friendly or water-efficient fixtures that will stay relevant in the near future.

Also, make sure to select finishes that will not become outdated before their time. Brushed nickel and chrome are mid-range options that are neither too taste-specific nor cost-prohibitive.

Finally, make sure your plumbing fixtures and light fixtures are in the same style and finish to create a seamless look overall.

Bang for Your Bigger Bucks

Although it will cost more, one of the smartest bathroom updates you can make is adding another sink because it can really increase the functionality of your bathroom, the desirability of your property and the value of your home on the whole.

Install a Second Sink: A double vanity or dual pedestal sinks are not only a nice touch but they may even be the deciding factor for a family thinking of purchasing your property down the road.

If you have two bathrooms but they each have two sinks, you automatically elevate your property's desirability over area comps that only have a single sink in each of their two bathrooms.

Cost Cutting Tip: If possible, install the two sinks within 30 inches of each other to streamline the plumbing costs: you can avoid installing separate drainage and supply lines when they do not exceed this distance.

What are some of the plumbing updates or bathroom remodeling projects you plan to undertake?

Another Financial Media Mistake (How to Really Measure the Return on Real Estate)

As long-time FMF readers know, I am not a big fan of the mainstream financial media. There are actually several reasons for my feelings, but the main one boils down to this: they don't know what they are talking about.

And since they don't know what they are talking about, they often make mistakes that are misleading at best and dangerous (at least financially) at worst.

Some Mistakes

I highlighted one of these mistakes in my post titled How to Measure and Track Wealth. In it I noted how the mainstream media often incorrectly uses "income" when they mean "net worth." To someone who doesn't know any better (like most of the people writing these sorts of articles), there's really no difference between the two. But as most FMF readers realize, there's a big difference between them.

Recently I ran into a piece from CNN Money titled Top 10 Markets to Buy a Rental Property. As you know, I have rental properties, so I was interested to read the piece when I saw the title.

On the first page of the article they list Wichita Falls, Texas as the top place to buy rental properties, giving this data:

• Median home price: $84,000
• Median rent: $938
• Return on investment*: 13.4%

Ok, let's do the math here so we're all on the same page:

• The price of the average home is $84,000.
• The gross annual rent from this average home is $11,256 ($938 per month * 12 months).
• This gets them a 13.4% "return on investment" by taking $11,256 / $84,000.

Does anyone see the problem yet?

Before I go into detail, you'll notice there's an asterisk after their "return on investment". It leads to the following on the bottom of the page:

*Return on investment is also known as gross rental yield, which is the percentage of profit or loss from an investment that is calculated by dividing the annual gross rental income by the purchase price or market value of the property. Ratings were calculated by comparing gross median rents (the return on investment before accounting for taxes, maintenance fees and other costs) for three-bedroom homes to median home price. All of the markets were relatively strong economically, with unemployment rates below the national average.

No.

No, no, no.

This is so wrong in so many ways.

How They Got It Wrong

How are they wrong? Let us count the ways:

1. Gross annual rents divided by the price of a property (by the way, this includes the purchase price plus any improvements, remodeling, etc. done that are long-term in nature) tells you nothing, really. At best it gives you a very general sense of whether or not a property is a good investment. It is in no way close to the actual return you'd get on a rental property investment.

Actually, the reverse of this calculation is used by most real estate investors. Property value divided by gross annual rents is called the gross rent multiplier (GRM) and is used to get a general feel for the investment potential of one property versus another as well as a property's overall potential return.

The actual numbers vary from market to market, but I can tell you that if a property in Grand Rapids, Michigan has a GRM around 5, it's worth considering as an investment. Why? Because I know that it will be making enough gross income relative to the operating costs to hit my targeted NET return (more on that in a minute.) For the record, the GRMs of my three properties are 4.51, 4.83, and 4.26.

2. The article claims that this false calculation is "the percentage of profit or loss from an investment." Nope. There's absolutely no profit or loss contained in the calculations for one simple reason: it doesn't consider EXPENSES. And how do you know anything about the profit or loss of an investment without looking at expenses? Answer: You don't!!

The piece admits this saying that the numbers are calculated "before accounting for taxes, maintenance fees and other costs". But it simply glosses right over this fact, as if it's not important. Believe me, it's important!

3. So the result using the calculation above is a "return" of 13.4%, which sounds very impressive. The truth is, however, once you deduct all the expenses associated with owning this property, you probably have something like $4,000 left. This gives you a REAL return of 4.8%. This, coupled with an assumed appreciation in the property (not to mention other tax and cash flow benefits) might make this an attractive option for an investor. But let's be very clear. The true, overall return is probably more in the 7% range, not anywhere near 13.4%. It's very deceptive.

Just Plain Wrong

One exception to the above COULD be if they used financing. In many cases you can increase your return percentage by mortgaging properties. Yes, you'll have more expenses (you have to pay the mortgage), but you'll also have less of your own money invested. And if the numbers work correctly, your percentage return will actually increase over paying cash for a place. But since they don't mention or even hint at a mortgage, I don't think they are using one in any way.

Now some may think that I'm nitpicking a bit or am totally wrong about the calculations they've used. But I don't think so. They basically ignore any costs in their equation, suggest gross returns are the same as net returns, and calculate their "return on investment" accordingly. They imply that an investor would be getting a 13.4% return on an average place in Wichita Falls and this is nowhere near the truth.

I'm not sure if this piece is wrong because the person didn't know what in the Sam Perkins they were talking about or if they wanted the "return on investment" to be impressive, so they took a few liberties to make the numbers look good. Either way, they're wrong. And it's yet another financial mistake by media who are supposed to be "experts" on the topic. For goodness' sake, this is CNN Money we're talking about!

How to Really Measure the Return on Real Estate

So, what's the true way to measure your return on a rental property investment? That's a long and complicated answer, or at least can be if you want to get into the details of depreciation, cash flow, tax implications, and so forth, but here are the highlights that matter the most:

• Find the gross annual rents for a property. In the example above, these were $11,256.
• Find the annual expenses for the property. Things like real estate taxes, insurance, maintenance, and so forth. Let's say they are $7,256 just as an example.
• Subtract the expenses from the rents. This leaves you $4,000.
• Take $4,000 and divide it by the amount you have invested in the property. In this case you have $84,000 into it so your return is $4,000 / $84,000 = 4.76%
• If you like, you can add a "plug" number to estimate the value of appreciation. For example, if you think your property will appreciate 3% a year, you could say your investment is returning 7.76% a year. Of course you won't realize this until you sell and the number is highly subjective. For this reason, I don't add in appreciation when I look at my return rates.

For more specifics, see the post Apex did on running the numbers on an investment property.

Ok, I've rambled on for far too long already. Yes, the mistakes of so-called experts tends to get my blood boiling but I'll spare you any more ranting and call it a day on this post. :)

Thoughts on Rental Real Estate

The NY Times recently published a piece on rental real estate that listed the pros and cons of this investment opportunity. I thought I'd share some of their conclusions (in bold below) and offer my take on them.

"If you have a $600,000 portfolio, putting $300,000 into one asset is a highly concentrated bet."

By the time I'm done investing in rental real estate, I want to have my properties diversified by type of home (single family versus multi-unit), area of town (north, south, east, west), and type of renter (larger families, young professionals, etc.) Of course I'll still have real estate in the same city, so that won't be diversified, but I do want to try and spread the risk out as much as possible.

There are the traditional risks that come with being a landlord, like a prolonged vacancy, the possibility that the water heater will die right after you’ve installed a new roof, or that the tenants will lose their jobs or fail to pay for some other reason, which could lead to eviction. But several experts also said not to discount even more remote possibilities. If your property was in an area ravaged by Hurricane Sandy, for instance, could you financially withstand several months of no rental income and the cost of repairs that might not be covered by homeowner’s insurance (and how much insurance is enough, and at what cost)?"

This is a decent point. Just think of all the things you have to consider if you own your own house -- the lawn, the furnace/AC, the appliances, the roof, and on and on and on. The same is true for rental units you own. You have to consider and budget for items like roof replacement (eventually), lawn care, and any other regular or irregular maintenance that may occur. In looking at the financials sellers send to me (when they even have/provide them), almost everyone leaves out expenses for long-term maintenance like roof replacement and the like.

Buying a rental property isn’t solely a financial decision. You need to be prepared to screen tenants, run credit checks and get the water heater repaired at a moment’s notice. That means you’re going to need to establish relationships with a variety of service people, or, if you have the time and ability, do it yourself. So be honest about how big of a commitment owning a house will really be. “I have never had pipes burst at a convenient time — they almost also go out in the middle of the night when you are out of town,” said Alan Moore, a financial planner in Milwaukee who has owned rental properties and counseled clients about the pros and cons of buying investment properties.

So far, I've only used a management company. They have had some emergency calls (tub leaking) and I haven't had to deal with the issues at all (though I have had to pay for them). It's a double-edged sword with both pros (ease of management for me and time) and cons (costs) to the arrangement. For now, I have to use them as I don't have the time to manage the properties. Will I ever? Perhaps. But even using a management company I'm still making a good return on my money and have complete freedom of movement (for instance, if I want to go to the Caribbean for two weeks). So I may always use one. We'll see.

Rental income is taxed at ordinary income rates, but experts say you can often post a tax loss while still generating a profit. That’s because you can deduct the depreciation of the rental — but not the underlying land — to account for wear and tear (the cost of improvements, closing costs and the cost of appliances are all depreciable, too). In most cases, the building is depreciated over 27.5 years. So if the actual structure is worth $200,000, you can deduct about $7,200 a year. Coupled with operating expenses, that is often enough to wipe out any profit on paper.

Yes, there's depreciation which gives you some immediate benefit. But I am not interested in being anywhere near a loss -- even counting it. I intend to earn a good return on my properties just for operating them, then I am hoping for (not counting on) some appreciation in them as well. If I buy them at decent prices and/or make good improvements to them, I think this is reasonable.

You may be tempted to view this sort of investment differently, meaning you may be more likely to continually dip into your personal assets to cover costs.

My investments are currently more than self-sufficient on an operating basis, but I will need to invest more into one of them as tenants move out and I want to upgrade. I have planned on this from the time I bought the place, so the costs all figured into my calculations.

I know there are several rental real estate investors who read FMF. Anything you'd like to add to these thoughts?

Buying Versus Renting

CNN Money recently posted a piece on the costs of buying a house versus renting. An overview:

Figuring out whether it's better to buy or rent rests on three main factors: where you live, how long you plan to stay and how home prices compare to rents in the area.

While markets vary wildly, prices are so reasonable and interest rates so low that buying is the better option in most of major U.S. cities, said Jed Kolko, Trulia's chief economist. Nationwide, home buyers who remain in their homes for three years will save an average of 19% over renting. If they hold onto their homes for 7 years, the savings advantage grows to 44%.

That means all of the initial transaction costs of buying -- the broker's commission, title insurance, legal fees and other closing costs -- will be offset by benefits, like tax write-offs and price appreciation. And those costs will become cheaper than the total costs of renting, which include insurance and agent commissions.

But the math is changing. Home prices rose 7% year-over-year last month while rents went up only 3.2%, according to Trulia. "Buying is still cheaper than renting but the gap is closing," said Kolko.

The piece then shares 10 key markets and whether it's better to buy or rent. Here are two examples -- one where it's best to buy and the other where it's best to rent:

San Francisco
Buy or rent?: Rent
After 3 years: Buyers pay 28% more

Detroit
Buy or rent?: Buy
After 3 years: Buyers save 62%

A few thoughts:

• All real estate is local, so what's happening in your market will be different than every other market in the U.S.
• Of the 10 markets they list, only two are better to rent in. But this may change as housing prices increase. Again, what happens in one market may or may not happen in another.
• Of course it's better to buy in Detroit -- they have a bazillion homes on the market and the value of them has dropped to the cellar. But other markets (Atlanta, Chicago, Houston) still offer significant savings to own versus rent (in the 30% range.)
• As a landlord, you might imagine that the fact that buying is generally a better deal is mixed news to me. :)
• I considered looking at buying places in Detroit because I figured I could pick up places cheap. But I talked to a friend who knows investors in that market and he says the combination of a glut of houses at great prices and the loss of population are resulting in very low rents as well as occupancy rates. Yikes!

What about you? Any renters out there thinking about buying? Or buyers who are thinking of renting?

How to Hire a Contractor

Fox Business has a piece on how to hire a contractor. They list crucial questions to ask before you hire a contractor as follows:

• Can they give you references?
• Are they licensed and insured?
• How long have they been in business?
• Is this an estimate or a fixed price?
• What’s included in the bid?
• Will he handle the job himself or have someone else do it?
• What sort of permits are required?
• How much is required up front?
• Will they sign a lien waiver?

I've hired several people to do work on my various rentals over the past few months, so I have at least a somewhat informed opinion on this issue. Here's what I have to add:

• Get references from friends and/or your network. My real estate agent/mentor, Bob, found me a general contractor who does much of his own work. Bob hadn't worked with him in the past but had heard of him through his network. We hired him when he came in $9,000 cheaper than another option to put windows and siding on place #1 (that's him up on the scaffolding in the pic). And he turned out to be AWESOME!!! We used him subsequently on work needed on property #2.
• Be sure you know what is (and isn't) included in the bid. Some contractors give you one-line bids and others a few paragraphs. Either way, whatever they provide probably needs clarification. I have them itemized as much as possible, then I can bid out portions to others if I want to. For example, the contractor above is great on general work, but he is high on painting. So I have someone else bid on that part of the job and they usually win.
• You have to know who is doing the work. I want the person I know/trust/am working with to do the job. If it's someone else, I want to meet him and see if I like/can work with him. Thankfully, my guy does his own work (with his father).
• I generally pay 50% upfront which gets us the bulk of materials. There's then another 25% for the final wave of materials and then 25% at the end of the project. I have paid as much as 70% upfront, but that was only because I was going on our cruise and I knew he'd need round #2 funding before I got back.
• Most of all, make sure the person you hire is honest, willing to "do the right thing", and is responsible. You will be likely giving them thousands of dollars, so this is certainly not too much to ask in this situation. My contractor went above and beyond what was required -- giving me several fixes for free -- and as such I was very happy with him. To show my appreciation, I sent him a $100 gift card to a nice restaurant to take his wife out to eat.

Anyone else have thoughts on what to do when hiring a contractor? 

Real Estate 101: Summary

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.

Real Estate 101: Questions?

The following is a guest post by FMF reader Apex. As most of you know, he has been writing a series on investing in real estate.

There have been 13 posts in this series covering the topics that I have felt were most important.  However some readers may still have questions.  Before I wrap up the series I wanted to find out if there were any questions that readers felt were not adequately dealt with in any of the posts or if there were any other topics of interest that I did not address.
 
If there is enough content to address I will put together a FAQ post before doing a series wrap up.
 
Please post any questions or suggestions for further content in the comment section of this post.  I will not respond to any comments in this post that I intend to address in a future post.  I will try to address any questions that I feel qualified to comment on but my experience does not cover every aspect of real estate investing.

Real Estate 101: Taxes

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, posting every Friday, 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.

Many people cite the tax advantages of real estate investing as one of the primary benefits.  The tax advantages are real and they are certainly a benefit but I think many people give them more weight than they are worth.
 
The primary tax benefit that people refer to when they talk about the tax advantages of real estate is the depreciation of the property you purchase.  When you purchase real estate for investment purpose you can depreciate any portion of the investment that is not land.  Typical allocation to land is usually around 20-25%.  This means that if you purchased a $100,000 investment property you could expect to be able to depreciate about $75,000 of the investment.  This value is depreciated over 27.5 years for a residential property (39 years for a commercial property).  That would mean each year for the next 27.5 years you would get a tax deduction against your earnings on the property of a little more than $2,700 per year.  If the property had a profit of $5,000 for the year you would only have to pay taxes on $2,300 of that value.
 
To be sure this is a very nice benefit, but it is not exactly free money.  For starters you will be paying $100,000 of cash towards this property either up front or over the course of a loan.  You can deduct all of the interest paid on a loan but the principal payments are not tax deductible.  The depreciation allowance lets you deduct about 75% of those principal payments over time, but not all of it.  That means that over the course of 30 years you will pay $100,000 in real cash to own this property and only get to deduct $75,000 of it against your taxes.  The other $25,000 you will have paid tax on, even though you no longer have that cash.  It is tied up in your property. 
 
Now to be fair if you invest in equities you do not get to deduct any of the cash that you use to purchase stocks, but it is also true that stocks are easily converted back into cash whereas real estate is not.  It’s important to realize that you are not getting a $75,000 dollar tax deduction against profits without putting anything in.  You will actually put in more cash than you get as a deduction.  The deceiving and seductive part of the depreciation deduction is that in the beginning you come out way ahead.  Your mortgage payment is mostly interest which is deductible as an expense so you are paying very little towards principal.  This makes your taxable profit much lower and in addition you still get that $2,700 tax deduction.  This is why your taxable profit is considerably lower than your actual profit or your cash flow in the early years.  But as time goes on, this relationship will invert itself. 
 
Sometime between years 15 and 20, this formula will cause your taxable profit to exceed your actual profit.  By year 27 you will be paying almost all principle on your loan, which means hardly any of those payments will be deductible.  That will make your taxable profit much higher.  You mortgage payment will likely be considerably larger than your $2,700 depreciation allowance and very little of it will be deductible.  The result is that your taxable profit will exceed your actual profit and your cash flow.  What’s worse is on years 28-30 you will have no depreciation left and yet you will still be making those same mortgage payments.  Again there will be hardly any of that mortgage payment that is deductible and without any depreciation left your taxable income will greatly exceed your actual profit and cash flow in years 28-30.  If you blew the money that depreciation benefited you in the beginning, you may find yourself coming up cash short in the end.
 
The second reason this is not quite the benefit it might seem like is because all the deductions you received from the depreciation now become taxable income if you ever sell the property.  You received the deduction while you owned it but the IRS will classify those as recaptured capital gains upon sale.  They will be taxed at a minimum of 25% regardless of which tax bracket you are in.  You may have been in the 15% bracket when you took the depreciation deduction but you will still pay them back at 25% when you sell.
 
This brings us to the second major real estate tax benefit known as a 1031 exchange.  This refers to a section of the tax code that allows you to sell a real estate asset and transfer any taxable gains to a new asset without paying any taxes.  There are a number of requirements that need to be met to do a 1031 exchange, but the key one is that the asset that you exchange into has to be a like kind asset.  That means real estate must be exchanged into real estate and likely the same kind of real estate.  You won’t be exchanging into stocks even if they are REITs and you probably won’t even be exchanging into a golf course even though it could be classified as real estate.  Thus there is no getting out of the real estate business if you want to continue to avoid paying those taxes on capital gains and on past depreciation. 
 
The 1031 exchange allows you to transfer into different real estate assets and even into some kinds of managed partnerships which would allow you to take a hands off approach.  That is a big benefit because it allows you to change the structure of the real estate you invest in and the level of your involvement without incurring taxes.  But regardless of how you do it, if you want to use the 1031 exchange to avoid taxes you will forever remain invested in real estate.
 
The third tax benefit is simply that you can deduct every expense you incur for any reason as long as it is business related.  I already mentioned the deduction for interest paid on your mortgages.  In addition any repairs, maintenance, tenant acquisition costs, professional services fees, vehicle costs, tools, utilities, property taxes, dues of any sort, management costs, employee costs, and office costs are all deductible.  However, this benefit is not unique to real estate, every business can deduct these costs against revenue.
 
In fact every business can depreciate capital assets the same way real estate does too.  The thing that makes real estate depreciation unique is that real estate assets don’t really depreciate the way normal business equipment assets do.  Depreciation is designed to spread the tax deduction of a depreciating asset over a time that approximates its useful lifespan.  When most businesses depreciate a capital asset such as equipment, the asset has very little value left after it has been depreciated.  With real estate assets this is generally not true.  With a little bit of routine maintenance and upkeep the depreciable building asset actually retains or gains value.  This is why there is a special rule about recaptured capital gains for depreciated real estate assets that taxes them differently than other depreciated assets.
 
One topic that always comes up is whether it is worth it to take the depreciation due to some of the recapture issues I mentioned here and if one has to take it.  Let me assure you that the benefits you receive in the beginning will give you more capital for future investment making it very well worth it.  But most importantly the IRS does not allow you to forgo your depreciation deduction.  When you sell a property the IRS will determine what your depreciation schedule should have been for that property and they will require you to pay taxes on the amount that should have been depreciated whether you actually took the depreciation or not.  Not taking the deduction for depreciation will result in you paying taxes twice and that is something you certainly do not want to do.
 
The tax advantages of investing in real estate do provide a nice added benefit to the investment.  Properties that make very low profits will often have no taxable profits for many years, perhaps a decade or more.  Some investors judge their returns by taking into account the benefits of depreciation.  I will warn you to be very careful of using this metric.  It can be used to justify a mediocre or even a poor investment.  I would much sooner have a property that had considerable taxable income left after depreciation. 
 
There is a reason my column on Running the Numbers did not account for any tax benefits from depreciation.  Tax benefits are real but they come after everything else.  If everything else looks good then the tax benefits just make them look a little better.  If everything else looks poor then the tax benefits aren’t enough to make it a good deal.  Success in real estate investing does not come from tax benefits.  It comes from running a profitable business.  Be careful not to over-estimate the value of tax benefits.  No amount of tax benefits can make an unprofitable business, profitable. 

Update: Click here to read the last post in this series.

Real Estate 101: Financing

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, posting every Friday, 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.

The number one roadblock preventing most people from expanding in real estate is access to capital.  Real Estate is a capital intensive business.  Everything in the business revolves around access to capital. 
 
It was one of the 6 reasons I listed in the first column in this series about why you should not invest in real estate.  It was also listed as one of the first steps along the path in the third column on where to start.  Many people want to get started in real estate but do not have enough capital to even get started.  Others can pull together one or two deals but then they hit the capital roadblock as well.  They want to expand into more properties but they are stuck perhaps for years trying to get the capital for their next deal.  Regardless of where you are on the real estate journey, most everyone hits the capital roadblock sooner or later.
 
There are two different sources of money that you will use when investing in real estate, your money, and other people’s money (a.k.a. OPM).  The percentage of each of these sources of money that you use will determine your leverage ratio also know as a debt to equity ratio.  This ratio is determined by dividing the total amount of borrowed funds you have by the total value of all the properties you own.  For example, if you owned 4 properties worth $125,000 each and had $300,000 of borrowed money your debt to equity ratio would be $300,000 / $500,000 or 60%. 
 
Your Money
 
While it is possible to use only your money, it is almost always impossible to use only other people’s money.  In order to get access to other people’s money, you have to have some of your own money to start with.  There are many ways to get your own money.  It usually starts with a decent paying job from which you save a good portion of your money.  It could also involve getting a second job or second source of income.  If you have owned your own house for a number of years you could extract equity from it by doing a cash-out refinance.  It can come from selling things you can live without.  It can include downsizing your car, your house, and your lifestyle.  It can come from virtually anywhere.  You simply have to decide how badly you want it.  If you are driving a new model Lexus but can’t find the cash for a down payment, then you have made lifestyle choices that have prevented you from getting where you want to get. 
 
In my first column I finished the section on capital with this sentence: Unless you are already cash rich, expect to feel somewhat poorer for a while.  If you are unwilling to feel somewhat poorer for a while, then you are the reason you are unable to find the capital to get started in real estate.
 
Other People’s Money
 
Your own capital will only get you so far and for most people that isn’t very far at all. Your money is limited. Other people’s money is vast.  When your money is gone, there is no way to replace it quickly, thus most expanding real estate businesses depend on access to a considerable amount of other people’s money or OPM. 
 
You get OPM by simply borrowing money from whatever sources are available to you.  Getting some OPM might not be too difficult but the more debt you take on, the harder it is to get more.  Those who will be borrowing the money to you will be scrutinizing your debt carrying capacity.  They will be examining your income streams, business model, taxes, and credit ratings in detail.  Eventually many will simply refuse to give you any more money until you can improve your financial standing in their eyes.
 
Because of this there are two primary rules that I consider essential when acquiring financing.

• Rule #1: Get the money for as long as possible.  You know you are going to need more money to purchase future properties so why would you want to be required to pay this money back any sooner than absolutely necessary?  That would just require you to get even more money later.  That may be difficult or impossible to do, and of course borrowing new money always has a cost.  As such you should prefer terms on your loans that are as long as possible.  If you need access to more money in the future, the last thing you want to do is take out a 15 year mortgage on a property you are buying today.  This will require larger payments resulting in significantly reduced cash flow.  If your business is generating less cash that will extend the amount of time it takes to generate enough cash to purchase your next property.  This is why I always prefer 30 year mortgages even if the interest rate is slightly higher.


• Rule #2:  Get as much money as you can get.  Maybe you have enough cash to put 50% down on a property.  Maybe you just feel more comfortable only being leveraged 60% instead of 75%.  There can be any number of reasons why you might choose to borrow less than the maximum.  Don’t do it.  If you are borrowing on a given property, borrow the maximum you can get on it.  If you are more comfortable with lower leverage then buy every third or fourth property with cash, but do not take out 50% or 60% loans on a property.  Always take the maximum they will give you.  It is always more difficult and more expensive to get more money out of a property once you have a mortgage on it.  If you purchase a property with all cash you can go back and borrow against it later.  When you do, you should once again borrow the maximum amount that they will give you.  You can manage your own leverage ratios across all your properties to ensure you do not over leverage yourself but do not put smaller leverage ratios on each property.

Where to Get Financing
 
When seeking financing, the best place to start is with traditional banks using conventional financing and government backed loans.  These are known as agency loans and nearly every person who has ever taken out a house loan on their personal residence has this kind of a loan.  They are backed by agencies such as Fannie Mae, Freddie Mac, or FHA.  These loans typically have better rates than those not backed by a government agency and they also have longer terms.  Many agency loans are amortized over 30 years and not required to be paid in full for 30 years.  It’s almost impossible to find a private non-agency loan with those terms. 
 
Luckily investors are able to qualify for these loans if the property has 4 units or less.  For the first 4 properties these loans can be acquired as easily as they can on your primary residence.  You can get up to 10 agency loans but anything beyond 4 gets considerably more difficult and there are currently very few lending institutions who are willing to offer agency backed loans if you have more than 4.  If you have hit your limit of 4 agency loans you will want to contact as many lending institutions and brokers as you can find until you find one that will continue to do agency loans beyond 4 properties.
 
Other financing options include lines of credit on your personal residence or on any investment properties you may have that have appreciated in value.  Lines of credit offer the advantage of allowing you to take out money when you need it and pay it back when you don’t.  They are a great cash flow management tool.  The next financing option is a private or commercial loan that is not government backed.  The terms and rates on these will be less favorable so you need to make sure it does not put your cash flow in jeopardy.  You can also take out loans using other assets as collateral such as stocks, bonds, jewelry, cars, any assets you have that have value in them that you want to extract for the purposes of securing more financing capacity.  You could also consider borrowing from friends or family if you are in a relationship that supports that and understand the relationship risks that can come from that type of arrangement. 
 
It is worth noting that OPM can be as addictive and seductive as the drug those initials sound like, so it’s important to remain disciplined when borrowing money.  Certainly one can put themselves in a highly over-leveraged state doing things like this.  I am not suggesting you should leverage everything you have to purchase real estate.  I am merely pointing out that there are multiple ways to get access to financing and capital.  As long as you keep your debt to equity ratio at a reasonable level and keep your cash flow margin well within the safety range I would not have much concern about any of the steps I have outlined here.  I would feel comfortable with a debt to equity ratio that did not exceed 80% and a cash flow margin that stays above 10%.  If that debt to equity ratio is higher than some people would feel comfortable with, they should choose a lower number that they feel meets their margin for safety.
 
Lack of access to capital is probably the number one frustration of most beginning real estate investors.  Everyone runs up against the money roadblock.  Sometimes the only path is to wait until you can save enough money to go around the roadblock that is right in front of you.  Of course there is always another roadblock after that one.  However, the more cash flowing properties you can acquire the more cash they will throw off.  Eventually they will be the source of removing the capital roadblocks.  But until that time arrives which can be quite a long time for many real estate investors, you need to consider every option for getting access to capital and always be on the look out for new sources of funds if you want to keep your real estate business growing and expanding.

To read the next post in this series, see Real Estate 101: Taxes.

Real Estate 101: The Lease

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, posting every Friday, 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.

There are entire sections of state statutes dedicated to the landlord tenant relationship in addition to federal laws such as anti-discrimination laws.  The statutes offer protections for both landlords and tenants but they typically offer more protections for tenants.  However, landlords have one major legal advantage on their side.  The tenant will be signing a contract that they likely had no input into. You as the landlord write the entire lease contract and decide what the rules are as long as they don’t violate any of the state statutes of which there are many.
 
As such it is extremely important that you have a solid lease.  This is not something you should just throw together.  You should not go to an office store or the Internet and get a generic lease and simply use that.  This is your one chance to protect your rights.  Doing this carelessly could be a costly mistake.
 
There are 4 things I want my leases to do.
 
Follow Local Statutes
 
They must conform to local statutes.  There are many things you may try to put in your lease that are simply against the law in your state.  It’s not illegal to put them in your lease, but a judge will just throw them out if you end up in court.  If you do not know what the statutes are many sections of your lease that you think are protecting your rights will likely be found invalid in court.  It’s better to find out what is legal and stick to that.  The best way to do that is to find local leases that have been written or approved by your state attorney general or that are being written by local multi-housing associations.
 
Clarify All Money Issues
 
The rent must be clearly spelled out obviously.  In addition all items concerning the security deposit should be clearly spelled out.  This includes how much it is, what it can be used for, how much interest will be paid on it if any, and how and when it will be returned.  Most states have very strict statutes around security deposits so make sure you are in line with what is required by law.  You should also address utilities.  If any are included in the rent list those.  If some are added to the rent as an additional fee that should be listed.  You should state that any utilities not listed in the lease are the responsibility of the tenant lest they get the idea or claim that you told them certain things were included.  Finally all fee related items need to be clearly spelled out.  Late rent fee and returned check fee are the two big ones to address here.  Make it clear what the dollar amount of the late fee is, when it is applied, and how rent needs to be paid if it is late.  Some leases require a cashier’s check once rent is late.  I do not do this but if you do, it needs to be in your lease.
 
Set the Basis for Termination
 
This is an important item that often gets overlooked.  Your lease should make it very clear that a violation of any clause in your lease is reason for you to terminate the lease and to pursue eviction if necessary.  If your lease does not spell out what the consequences of violating parts of your lease are, you should not assume a judge will allow you to evict for it.  There are certain things like not paying rent that are almost always in state statutes as cause for eviction.  However, if you have a no pets clause and your lease doesn’t have a termination and eviction clause for violations, it is unclear that a judge will let you do anything about that violation let alone evict for it.  Ideally you don’t want to go to court at all.  If your lease has a termination and eviction clause you can make it clear to your tenant that you will terminate and evict if they don’t rectify the situation.  Without that clause an informed tenant may very well ignore you and point out that there is no penalty in your lease for violating the no pets clause.  So make sure your lease always spells out that you have the right to terminate and evict for violations of any clauses in your lease.
 
Set Expectations
 
There are some things that are not really a legal issue.  For instance my lease states that the tenants are responsible for changing light bulbs and smoke detector batteries as they quit working.  This isn’t really an eviction issue, but it makes it clear that they are not to call me to deal with these types of issues.  My lease makes it clear they are not to alter the property in any way including painting without prior written approval.  I point out all the sections that have expectations when we sign the lease because not all tenants will read their leases.  There are other expectations in my lease as well.  The point of these is to make it clear what they are expected to do and what they are not allowed to do.  This is an important part of your lease because verbal expressions of what is expected won’t carry the weight of items in the lease that have been pointed out to them.  Some may still violate them but most good tenants will not.
 
Building the Lease
 
In order to do these four things, I start with a lease approved by the Attorney General of my state and then I modify it to meet my needs.  The fact that the Attorney General approves of a lease is not the same as a guarantee that all of it’s clauses will stand up in court, but it is a pretty good bet since they will have written it with very detailed knowledge of the statutes that are necessary.  Some people would argue that it is best to use an approved lease without alteration, but the lease does not do everything I want it to do, and it also has some protections in it for the tenant that I take out.  For instance the lease that my state Attorney General produces states that either side can win legal costs if they win in court.  The statues in my state already make it clear that a tenant can do this if the lease gives the landlord the right to do it.  Whether or not I specifically state this right for the tenant in my lease, they have it.  Stating it just draws their attention to it, and I would prefer not to do that.  In addition there are the things I mentioned above that I want to add to the lease simply to set expectations.
 
It is important that you do not alter the lease in ways that remove the parts that are necessary in your state.  If you don’t know what is necessary then it’s probably best to just add to and not remove from a state approved lease.
 
Your lease protects your rights and tells your tenants what you expect from them.  This is your only chance to do this, so make sure you do not do it carelessly.

To read the next part in this series, see Real Estate 101: Financing.

Real Estate 101: Managing The Property

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, posting every Friday, 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.

Once you find a tenant the only task remaining is to manage the day-to-day operations of the property.  This involves collecting rent, dealing with late or unpaid rent potentially leading to evictions, as well as handling the repairs and maintenance needed for a property.  This area is one that often causes a sense of fear or lack of confidence among prospective investors.  How does one effectively manage the property to deal with these issues? 
 
I am going to answer 4 questions that I hope will relieve some of the anxiety in the area of collecting rent and handling repairs.
 
What do you do when a tenant is late or not paying rent?
 
The first thing I would recommend is that you make immediate contact with the tenant as soon as they are late.  This is absolutely critical.  You must not wait to do this.  The first day after your late fee deadline, you need to call them or email them if they respond to emails.  If you cannot get them to answer their phone or respond to an email within a few days and prior to the 10th of the month, you need to go knock on their door.  I have not had to go to the door knocking step yet but I have come close when I was failing to make contact with them.
 
When you make contact you inform them that the rent is late and ask them when they plan to pay it.  The next step is important.  Listen carefully!  They are now going to be telling you a story.  I have gotten many of them.  Some of them are a little strange, but strange things happen, especially with tenants.  Your task is to determine if this story makes sense or is a delay tactic.  If they do not give you a date certain when they will be paying the rent, you need to ask for one.  If they do not know, that is your answer and you should move to an eviction.  If they give you a date but their story has sounded questionable thus far you need to ask them where the money is going to come from.  If they don’t know that or don’t tell a story that makes much sense to you, you should also consider moving to eviction.  If the date is in the near future it’s probably worth waiting to see what happens.
 
I have found every one of my tenant’s late rent stories to be believable, even some of the strange ones.  I have told them if they do exactly as they have told me there will be no issues.  Every one of them has followed through as they stated.  We will see someday if I can detect a fairytale that has an unpleasant ending since I haven’t been told one yet.  It is worth noting that almost all of my tenant’s stories were as a result of the tenant contacting me proactively prior to the rent being late to inform me that it would be late and why.  This type of story has far more credibility since a deceptive tenant is more likely to try to avoid contact.  When I have had to contact tenants because of late rent, it is usually just them being sloppy, lazy, or dealing with paycheck issues.
 
There are a few typical types of stories you will encounter.  People who are paid bi-weekly get paid on different days of the month each month.  Many months that day will be just before or after your late fee date and they will need that check in order to cover the rent.  Bi-weekly tenants often have beginning of the month cash issues.  You should learn to expect it from certain tenants.  Tenants have unexpected car problems, or other unexpected expenses.  Family, friends and special occasions can cause them to spend money on things leaving them short of enough for rent.  These things happen.  Do not tell your tenants how to manage their lives or their money.  They will not listen to you, they will resent you for it, and it won’t help you get paid.  Your only task is to determine if they can come up with the money to pay you.  Most people can dig themselves out of these issues in a month or two.  It makes sense to stick with these tenants, let them pay a few late fees and dig themselves out.  Evicting tenants who need a little more time, but will eventually have the money is not in your best interest. 
 
If a tenant ever misses a deadline that they gave you, you should contact them immediately and ask for the rent.  If they cannot produce it, you should move immediately to eviction.  You want the tenant to find a way to pay.  But at this point, it is now far too likely that they simply cannot.  You must cut your loses and get them out of your property as soon as possible.  The only thing worse than a vacant property is an occupied property that is not paying rent.
 
How do you do an eviction?
 
Eviction court can be scary.  I have never been there, so it scares me a bit too.  If I needed to do an eviction, the first thing I would do is attempt to get them to leave without having to do an eviction.  I would give the tenant an in person Notice To Quit.  I would tell them that I am beginning eviction proceedings.  I would inform them that this will go on their record making it much more difficult for them to rent in the future.  I would then tell them that if they were to move out voluntarily by a date of our agreement that is not too far into the future that I would have no reason to evict them.  Depending on the circumstances if I could ensure they would be out much quicker than the eviction process I would even consider offering them a financial incentive to leave the property soon.  I would really hate doing this.  I would be paying someone as a result of them refusing to pay me rent.  This would seem to be adding insult to injury.  The truth is this is a business decision.  Evictions cost money.  They take some time, and are an extra hassle.  It may be cheaper and quicker to pay them to leave.
 
If that does not work and you need to do an eviction I would recommend hiring either a service or a real estate attorney who specializes in doing evictions.  They can do this for a reasonable fee in addition to the eviction fees.  Hopefully this is an extremely rare event if you do your tenant screening carefully.  The good thing is that in most states it is fairly straightforward and only takes a few weeks. 
 
How should you handle repairs?
 
You know the level of handy work that you are comfortable with.  If you do not have a mechanical bone in your body, you need a short list of contractors and handymen who do this for hire. My recommendation for finding them is Angie’s List.  I have a multiple year subscription to that service and look up contractors on the service regularly.  I have taken recommendations from friends and other investors.  Their idea of a “good” contractor is often different than mine.  On Angie’s List I can see ratings, other customer’s prices paid, and reviews that describe situations that I can tell I would be comfortable with.  It’s the best tool I have found for finding good contractors.
 
If a wrench doesn’t frighten you too badly, give it a try.  The tenant will be happy to see you quickly responding to their needs and trying to fix their issues.  You might be surprised how many times it is something simple that you can easily fix.  If you cannot fix it you simply inform the tenant that you will need to have a professional come and resolve the issue in a day or two. They will be pleased with either outcome.
 
I also recommend looking up the issue they are having on the Internet before going to the property.  I have looked up countless issues involving fireplaces, washing machines, dishwashers, furnaces, you name it.  If you can accurately describe the problem and the model of the appliance that is causing the issue you would be surprised how many times there are exact descriptions of how to solve it right there on the internet because someone else has asked the same question.  Issues that I would have been going in blind hunting for a problem, I went in, knowing exactly what to look for and exactly how to resolve it because I had researched the problem on the Internet.
 
There are many tasks that I have attempted to fix without having any previous experience dealing with the issue.  I was nervous that I would not be able to fix many of these problems but went to try to address them before bringing in a professional.  I have now fixed leaky plumbing, fixed washing machines, replaced a motor on a furnace, replaced failed smoke detectors and light fixtures, fixed countless electrical outlets, and even replaced failed circuit breakers.  I had never done any of those things prior to having rental properties.  The more you do these things and research on the internet how to deal with them the more you will get comfortable doing them.  I was fixing some plumbing at a property just a few weeks ago and was telling the tenant that I was not exactly a plumbing expert.  He said “not yet anyway.”  I laughed because he had touched on the truth.
 
I also do not recommend trusting the tenant to be able to properly tell you what the issue is or to follow your directions in trouble shooting it.  It is almost always a good idea to go investigate the problem first even if you are going to bring in a professional.  I had one tenant tell me their stove had burned out.  The burners had sparked and the digital control panel went dark.  I asked if they had checked the circuit breakers and they said they had and they were all working.  I was prepared to order a new stove because the same thing happened to my personal stove and it had indeed fried the main circuit board.  My gut told me I better verify it first so I came over with my voltmeter to check it out.  I could not get any voltage so I went to check the circuit breakers.  Sure enough the circuit breaker to the stove was tripped.  I turned it back on and the stove was working again.  The tenant was in a state of shock.  They were confident they had checked the circuit breaker.  I brought them to the box to show them the breaker that was tripped.  I showed them the one that had the word stove written next to it.  They meekly told me that they just checked the breaker that said kitchen because they assumed everything in the kitchen was on that breaker. 
 
If your first call is always to a professional, you will waste money.  For those using a property management company this is worth asking about.  If the property management company’s first call is to a professional, they will waste your money for you as well.  You need to go check these things out yourself first. 
 
What do you do when an appliance fails?
 
All appliances fail.  When they do I recommend having a place you can call that has good inventory and can get you a replacement at a reasonable price.  I have an outlet store that I call.  I tell them what I need, ask them what they have in stock in my price range and ask them to deliver it and replace the faulty unit.  It takes very little time and very little involvement from me. 
 
When you do replace appliances I do not recommend buying used appliances on Craigslist.  I do not recommend buying extremely cheap appliances to save money thinking this is just a rental.  You do not need appliances with lots of extra features, but you want a brand and model that is known to be reliable.  I have even purchased models of certain appliances that are closer to commercial grade.  I pay more for those but it serves two purposes.  First it is projected to last much longer.  In the long run that will likely make it actually cheaper than the cheaper models.  Even more important is an appliance that doesn’t fail nearly as often saves me from having to make services calls to try to fix broken appliances or determine if they need to be replaced.  Paying a couple hundred extra dollars for an appliance that is more reliable and lasts longer is a good investment.
 
Managing the property is an important part of real estate investing, but you do not have to do it all.  You will find out which elements you can do yourself and for those you feel you can’t or simply do not want to there is a professional to help you with every one of them.  If you can manage a home you live in, you can manage a home someone else lives in too.

Click here to read the next post in this series: Real Estate, The Lease

Real Estate 101: Keeping Good Tenants

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, posting every Friday, 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.

It’s very important that you find good tenants, but once you find them you want to keep them.

The most costly thing to your rental business is turnover.  It will cost you time, effort, and money.  The most frustrating thing about turnover is that after all the effort and expense needed to freshen up the unit and find a new tenant, your business will not be improved.  It will merely be returned to the state that it was in before you had a vacancy.   Perhaps you can rent the unit for a slight increase in rent over your previous tenant but it will not be worth the effort and expense it took to turn it over.

The only thing better than a good tenant is a good long-term tenant.  The ideal tenant would stay for 30 years.  If you have a good tenant who is not looking to become a homeowner, you want to do everything you can to encourage them to stay for as long as possible.

These are a few of the things I recommend to retain good tenants.

Be a Good Landlord

Be fair.  Be friendly.  Be responsive.  This is your house but it’s your tenant’s home.  Make them feel comfortable in it.  Be responsive to their needs and repair things quickly.  Do not enter their home unannounced.  In addition to being illegal in most states, it is a frightening invasion of privacy that will scare away good tenants very quickly.  Be willing to be a little bit flexible on things that are not that important.  Many tenants hold a non-flattering view of landlords.  Be different from what they expect.

I have heard from other investors who own properties near mine and from prospective tenants who have talked with some of my tenants.  They tell me that my tenants generally speak well of me.  I have heard phrases such as “I have a good landlord” and “my landlord is a good guy.”  Just because I am running a business does not mean I need to treat people harshly.  I take pride in treating my tenants with respect, but it is also good for my business.  Make no mistake; I am not a push over.  I say no when it matters, but sometimes it doesn’t matter and saying no then doesn’t help you.  Be firm but be fair.  Your tenants will respect that.

Do Not Use Month-to-Month Leases

Month-to-month leases are nearly ubiquitous in the rental business.  I have met very few people who do not use them.  They seem easy.  You can raise the rent at any time with proper notice.  You can simply refuse to renew at anytime with proper notice.  You don’t have to sign lease renewals each time a lease expires.  It just makes everything easier.

However, if you use month-to-month leases you have no stability in your lease terms and have no control over when turnovers are likely to occur.  This means your turnover may occur at inconvenient times for finding new tenants.  It also means your tenants can decide to leave at any time if they happen to see a different rental opportunity they want to take advantage of.  If they are locked into a fixed term lease they can’t pursue opportunities that occur before their lease ends.  This requires them to plan their departure around the lease end date rather than getting a spur of the moment idea.  The planning part doesn’t usually happen unless they truly have a reason to leave.  This keeps them renewing your lease rather than exploring their options.

Have Long Leases

Some people prefer not to have leases longer than a year.  This makes it easier to get rid of a tenant you don’t want and to raise rent more often if the rental rates are going up.  Long leases do lock you into current rental rates but the amount of extra money you could get by raising rent $25 a month after a year is not worth as much as knowing you have a tenant committed to a lease for 2 or 3 years.  It may be wise to keep the first lease to 12 months but once you have determined this tenant is a good tenant, I would encourage them to sign a longer lease.  The tenant can ensure their rent is not going up which in turn will tend to make them want to stay.  It also tends to encourage them to sign another long lease on their next renewal.  I always offer my tenants the opportunity to sign leases longer than a year to lock in the rental rate.  Many of them take me up on it.  I never consider a long lease with fixed rent to be a detriment.  I consider it a large benefit due to having a contractually binding multi-year revenue stream.

Raise Rent Less than the Maximum

When your lease comes due, this is the time to adjust the rent if the market allows you to do so.  However I try to see what comparable properties are renting for and always keep my rent for renewals at or a little below the typical market rates.  I do not want my tenants to feel like I am merely using the opportunity to gouge them and I do not want them to be able to easily find a comparable place for less.  When I am finding new tenants that is when I try to get top market rent if I can.  But after I have a good tenant I don’t want to risk creating turnover with excessive rent increases.

Do Not Rigidly Impose Fees

My lease has a $50 late fee if rent is not paid in full by the 5th of the month. The purpose of the late fee is very simple.  It is to encourage the tenant to pay rent on time so that I do not need to chase after them to get it.  Take note of what purpose the late fee is not intended to serve.  It is not to act as a secondary revenue source.  The late fee does bring in a little extra money every year but that is not why it is there.  If that is actually part of your business model and you intend to squeeze as much extra money out of fees as possible, that is a mistake.  Tenants know when they are being squeezed.  I have a colleague who was renting a place that had a late fee if rent was paid after 4 o’clock on the third of the month.  He paid them at 4:05 on the third of the month and was charged a late fee.  Management had every right to impose that late fee and he knew it.  That did not stop him from thinking they were greedy leeches.  He didn’t stay very long either. 

Depending on circumstances I have waived the late fee on countless occasions.  I have been contacted by tenants letting me know they could not pay until a day or two late.  I have had tenants send me most of the rent with a second small post-dated check asking me to deposit it 10 days later.  I have had checks show up in the mail a day past the late date.  Notice that in each of these cases, I do not have to chase rent.  Unless there is a pattern developing I will typically waive the late fee in these situations.

Once a tenant is a couple days late and I have not heard from them, I start chasing the rent, and at that point I certainly will impose the late fee.  If a tenant tells me they can’t pay rent until the 10th of the month I will impose the late fee then too.  But rigidly imposing the late fee if they are late by 1 day or by $100 does not earn me any trust with the tenant.  Most tenants do not have any emergency fund.  There are going to be months when circumstances leave them unable to come up with the full rent on the 1st of the month.  Letting them know that I am waiving their $50 late fee because they were pro-active earns me considerable appreciation from my tenants.  That is worth far more towards retaining them as tenants than is a meager late fee once or twice a year. 

By combining all of these techniques I am able to keep my tenants for extremely long periods of time.  I have had 4 short-term 6 month tenants.  They were just in transition and not going to stay anyway.  Other than that I have only replaced 1 long-term tenant in over 4 years with 10 properties.  The vast majority of my tenants are going on 3 or 4 years of tenancy.  I expect many of them will continue on for years to come.  This is worth its weight in gold to both my business and my sanity.

To read the next post in this series, see Managing the Property.

Real Estate 101: Finding Good Tenants

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, posting every Friday, 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.

You always want to minimize vacancy time and get a property rented as soon as possible but never at the risk of a poor tenant.  If it is taking a bit longer to rent a property than you had hoped it can be tempting to lower your standards and accept a tenant you might normally refuse.  DO NOT DO THIS!

Vacancy is always preferable to a bad tenant. Nothing will cost your more money, more time, and more frustration.  They are the cause of nearly every real estate horror story you have ever heard. 

Something you need to keep in mind when you are deciding what properties to buy is that your tenant quality will be tied to the quality of your properties.  If you have older dated properties in less desirable neighborhoods, it will be more challenging to find good tenants.  There are still good tenants to be found for most properties, but your overall tenant quality will inevitably suffer if your properties are of poorer quality. 

If you have good properties finding good tenants is not that difficult.  Regardless of what type of property you have, finding good tenants involves a good advertising strategy, carefully crafted policies on who you will reject, and good screening tools.

Advertising

Your advertising must be on the Internet.  Classifieds and print advertising is dead.  There are many places on the Internet to list rental advertising but I have found that the only one that you really need to use is Craigslist and of course it’s free.  I have tried some of the pay services.  I found very few prospects from them and have never found a qualified tenant through any of their services.  The key to good advertising exposure is the place with the most traffic, and right now Craigslist appears to be the dominant place where people search for housing. 

The most important thing about your ad is that it must include pictures of your property.  I would have to be desperate before I would contact a landlord about a property to live in that didn’t show pictures.  Good tenants want to see pictures.  Tenants who don’t need to see a picture don’t care what it looks like when they move in.  They won’t care what it looks like when they move out either.  Never put up an ad without pictures.  By doing so you are reducing the number of tenants who will consider your property and self-selecting from a worse tenant pool.

The pictures should showcase your property well but accurately.  Resist the temptation to make your property appear better than it is.  If your property is older in an older neighborhood and all you show is the updated kitchen and bathroom with granite counters, that is not an accurate representation of what you are renting.  This will result in wasted showings as none of your potential tenants will be interested when the real property falls short of what was advertised.

Your ad does not need to be long with flowing prose.  It merely needs to list the facts that are most relevant in a concise fashion.  If you have any restrictions list those in the ad as well.  You will still get calls about pets even if you say no pets, but it will reduce some of them.  The goal is not to get calls or showings.  It is to get a tenant with the least amount of time and effort on your part, so make your ad as specific and accurate as possible.

From my experience, the best time to find tenants has been 45 to 15 days prior to the unit being available, with the most interest coming on the 1st through the 15th of the month before it is available.  Once you get passed the 15th of the month interest generally slows down.  That’s getting a little close to the end of the month for most people.  Responsible tenants generally do not wait until the week before they are homeless to find their next place.  You should make sure all your tenants meet your qualifications but you should be extra certain for someone who applies on such last minute terms. 

Policies

Make sure you have a list of policies that spell out the reasons you will reject someone.  This is important because it keeps you from taking a risk you know you shouldn’t, and it also helps to protect you against discrimination lawsuits.  Discrimination in housing is not to be taken lightly.  The penalties for doing so can be very costly.  Federal law prohibits housing discrimination on the basis of race, color, national origin, religion, sex, family status, or disability.  Many states have additional restrictions such as sexual orientation, age, etc.  If someone sues you for discrimination you need to have a valid and defendable reason why they were denied.  Having policies that you strictly follow and having the prospective tenant sign a copy of them prior to applying will be very helpful if you need to defend yourself.  Policies themselves can be considered discriminatory so be careful that your policies cannot be construed as discrimination based on how they are written. 

Some of the policies that I consider most important focus on the ability to pay and the history of tenancy.  I require income that is at least 3 times the rent, no previous evictions, no recent criminal record, and only a few delinquent payments on the credit report. 

Screening

There are 4 things that are important to evaluate during the screening process. 

1. Past rental history.  This is the most important item.  If they have been evicted before, you may have to do it again.  If they have had a history of not paying rent they will do it with you as well.  Make sure your credit screening service shows you evictions and always contact any previous landlords.  I deny anyone with previous evictions or previous refusal to pay rent.

2. Ability to pay.  If their income is low or from questionable sources, they will have difficulty finding the rent each month.  They may want to pay you but that doesn’t really make your situation any better if they don’t have the money.  If they cannot pay you will eventually have to take action perhaps including eviction.  Your screening service should either do employment verification or you will need to do it by contacting their employer.  If the applicant does not have sufficient income I will deny their application.

3. Criminal history.  Your screening service must provide criminal background checks.  If an applicant has a history of being involved with drugs or other criminal activity, they are going to bring that to your property and your neighborhood.  Their problem will become your problem.  If it spreads to your neighbors they will make it your problem as well.  You should avoid anyone who has any kind of recent criminal activity.

4. Credit history.  Most screening services include credit history.  Some people will not accept tenants with a credit score below a certain number.  This is a simple and easy way to do a credit assessment, but I prefer to look at recent delinquencies instead of credit score.  Having a bankruptcy or foreclosure will destroy someone’s credit score and there are many people in that situation right now.  But if you look at their credit report you will often find it is just the mortgage they couldn’t pay or perhaps one big medical expense forced them into bankruptcy.  Their inability to pay their $3,000 mortgage doesn’t shed much light on their ability to pay my $1400 rent.  The low score from one big event doesn’t bother me nearly as much as a list of delinquent accounts.  Too many delinquent accounts is an indication that they can’t keep up and eventually that will include rent.  That’s why my policies list too many delinquent accounts as my criteria for denial rather than a particular credit score.  I know that policy is a bit vague.  What qualifies as too many is a judgment call, but the policy has worked well for me.  I have some very good tenants with credit scores that are abysmal but they only have a few minor delinquent accounts.

You can learn a lot about a tenant by talking to them and talking to their past landlords or getting the landlords to fill out a form about their rental history.  They will almost never answer judgment based questions like were they a good tenant.  Most will answer questions like how much was their rent payment; were they ever late and how often; did they ever refuse to pay rent and how was it resolved; Were there any complaints or damage issues that they caused and if so what.

These are all fact based questions that most management companies have a documented history for and do not have a problem sharing if you have a signed form from your candidate allowing them to release these records.  The application that I have tenants fill out for my screening service has them sign a release that gives me and my screening service access to this information.

Your gut often gives you a good initial sense and you should not ignore it, but you should not rely on it exclusively either.  You need to verify it with information.  Both because using your gut could get you into a discrimination lawsuit and your gut can be wrong.  Always make sure you do proper information based screening which includes rental history, income verification, criminal history and credit history.

Finding a good tenant sometimes takes a little patience, but it is time well spent.  Careful selection of good tenants is the most important decision you will make about the day-to-day operations of your real estate business.  Many decisions are important but if you consistently get the tenant decision wrong, none of the other decisions will really matter much.

Update: To read the next post in this series, see Keeping Good Tenants.

Real Estate 101: Getting It Rented

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, posting every Friday, 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.

After you make a purchase there can be a temptation to ease into the property.  You might want to take some time to get more familiar with it.  It can be easy to get distracted by little details and tasks, but this is the time you need a single-minded focus on one major task.  That task is to get the place rented.  This advice is equally applicable to re-renting a property after an existing tenant moves out.  When you have a vacant unit your primary focus must always be getting it rented.

Getting It Ready

If you are purchasing a property that needs rehab, you should start making arrangements as soon as your offer is accepted.  Ideally you would like to get any needed work started the day you close on the property.  Once the rehab is nearly finished you want to start advertising the property so you can have showings lined up as soon as it is finished.  Do not try to show a property before a rehab project is finished.  This is likely to be a waste of time as very few prospective tenants will be able to see past the current state of the property.

If the property just needs freshening up with some paint and carpet you should start taking steps to make those things happen in advance.  If you have a tenant moving out you can get the carpet measured and ordered so it is ready to install right after they move out.  If you are purchasing a property, get permission to get it measured in advanced so you can schedule the carpet for shortly after you close.  Do not however spend any money prior to closing on a property as closings do fall through.

Aggressively Market It

If a new property is in good enough shape to show, get permission to show it prior to close.  I have done this multiple times although not all sellers will allow it.  I had one property that I closed in the morning and moved a tenant in that afternoon.  I had to tell the tenant that the close was still pending and it could fall apart or get pushed back.  They wanted the place enough to take it on that contingency.  That kind of quick turn around is usually not possible, but it does show that you can and should be working on the next steps while you are waiting to close.  If you have a tenant moving out you should start advertising the unit at least 30 days prior to their move out date.  I like to start 45 days in advance to get the people who are looking more than one month ahead.

Time is Money

This is important because time is money, literally in this case.  It is easy to tell yourself that you just have a few minor expenses.  Property taxes and the mortgage payment are probably the big ones.  If you own the property with no mortgage your expenses could be very small.  You may feel like you can take your time to find a tenant because your expenses are low.  That is the wrong mindset.  If you justify that way of thinking you will start using it more often once you convince yourself it is an acceptable way to think. 

Every day that a property sits empty is costing you money.  That money expires each time the sun goes down and it can never be recouped.  The money you lose is not just the expense you incurred while the property was sitting idle.  That makes it easier to justify, but it is not accurate.  The money you lose is the money you could have gotten in rent.  If a property costs you $600 per month in expenses but rents for $1200 per month, you do not lose $600 each month it sits idle, you lose $1200.  This is easy to see when you realize that your bank account balance will be one $1200 check lower than if you had it rented.  Most people would not casually overpay $1200 for a large expense like a furnace just because they didn’t feel like looking for the best price.  Yet a number of owners are complacent about getting a property rented.  It does not make any difference if you spent $1200 you didn’t need to spend or failed to collect $1200 you should have collected.  You are out the same $1200 either way.  We seem to recognize wasteful spending, but it is easier to overlook the same waste when it is caused by a failure to get a property rented.

That is not to say that you should never have a vacancy.  Vacancies do happen and they are a normal part of the business.  The important distinction is that your goal must be to keep vacancies as limited as possible.  An empty property should create a sense of urgency, especially in the beginning when you have fewer properties.  Some investors take this part of the business far too casually.  They do not feel the urgency about it that they should.

I encountered a shocking example of this at a foreclosed duplex I considered buying.  One side was empty and a long-term tenant occupied the other side.  While talking with the existing tenant I discovered that they had lived there for 7 years.  The same owner had owned the property the entire time.  When I asked them about the other half of the unit they said there had been 2 different tenants in there but only for about 2 of the 7 years.  For over 5 of those 7 years that half of the duplex sat idle.  This owner clearly did not feel a sense of urgency about getting his units rented.  It is likely he had a full time job and just didn’t give this business the attention it needed.  He had a reliable tenant whose rent probably covered most of his costs so he may have felt it wasn’t urgent that he rent the second half immediately.  Based on the rent for the occupied half of the duplex he likely failed to collect as much as $70,000 in rent.

This is an extreme example, but it is not an isolated one.  I know of multiple instances of rental properties sitting idle for many months for one reason or another.  This is a not a productive way to run your rental business.  You cannot succeed if you are not generating revenue. 

Will it Rent?

There can also be some anxiety over whether or not you can get a property rented.  Let me assure you that every property will rent.  It’s simply a matter of price.  Market prices are just as important when renting as when purchasing.  It is important that you set your rent at the proper market rate for the type of property you are trying to rent.  If a property is not renting then there is a good chance you have set your rent too high.  This is yet another reason why cash flow margin is so important.  If you have little to no cash flow you will feel pressure to hold to a rent price that keeps your cash flow positive.  However, tenants will not pay more for your property simply because you need more rent to cover your expenses.

You have to be brutally honest with yourself regarding how your property compares to competing units.  If your property has disadvantages to comparable units you will almost surely not be able to get the same rent as those properties command.  Lowering the rent by $25 or $50 per month is far more cost effective than missing out on 1,2 or 3 months of rent holding to a price that is simply higher than the market is willing to pay.  If you cannot find a tenant after looking for 30 days then your rent is likely too high and you should lower it.  I was surprised to hear a story from my agent where he had a property that would not rent at $800 but at $790 he was getting calls.  My properties do not have that kind of hypersensitivity to price but his apparently did.  It’s important that you know your market and know what price people will pay.  Even if you aren’t sure, you can easily find comparable rental rates.  You can then find the market rent for your property by lowering it a little bit every 15-30 days until it rents.  You will find the price that it will rent at.

I now know my market well enough that I don’t typically have to adjust my asking price much.  I set my rent near the top of what I assess the market rent to be for my properties.  If someone tries to negotiate on price and my property has been listed for more than a week, I may tell them I can go down $25 but I can’t go any lower than that.  For the properties I am renting that has worked well.  It might take a little time to get a handle on the right rental rate for your properties.  The more you do this the better you will get at determining what price and process will work best for you and your properties.  The good news is you will get it rented, and if it’s a decent property you will get a good price.  Just be willing to adjust a little bit until you find the true market rent and you will be receiving your first rent check in no time.

Update: For the next post in this series, see Finding Good Tenants.

Real Estate 101: Finding Your Niche

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, posting every Friday, 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.

When you begin your search for properties you have to start somewhere.  After you have seen a few properties you will start to find things you like and things you don’t.  Perhaps homes of a certain age require more work than you want.  Maybe certain neighborhoods are too expensive. 

The more you look the more you will refine the criteria you think makes for a compelling investment.  However, you can only do so much refining in the abstract prior to purchase.  Once you have purchased a property you will now start to find out what is working as expected and what is not; what features make it easier to rent and which ones make it harder; what type of properties and neighborhoods attract the tenants you desire and which ones make it harder to get good tenants. 

Everyone’s process of discovering what works best for them will be different.  Your refinement might happen quickly or it might be more gradual.  It might take some time and a number of properties to be able to identify those things that are important to you and to how you want to run your business.  The most important thing is to identify what your criteria for success is and to work at refining your process to improve your level of success based on that criteria.  I call this process finding your niche. 

I found my niche after I purchased my second property, and it has guided my course for over three years.  Operating my first property for a year had given me some insights that I used to adjust what I was looking for in future properties.  When I found my second property and began operating it, the pieces of the puzzle that I had been trying to define all came together.  Comparing it to my first property made clear the intangibles that I had overlooked.

Operating that property and others like it for over 3 years has only confirmed and strengthened the confidence I have in the niche that I focus on.  This refinement reduces the type of properties I now consider, but that tighter focus has made the entire process of purchasing properties easier and faster.  I now know what I am looking for.  I know when I have found it, and I can pull the trigger quickly because I now have first hand knowledge about how that property will perform.  Having a niche to focus on has proven to be the most effective way to expand my business.  It has freed me from the uncertainty of trying to consider many different types of properties, most of which I will have had no first hand experience with.

Every real estate investor is different.  I cannot tell you what your strategy should be because there are dozens of different ways to be successful investing in real estate.  The best chance for you to succeed is to find a strategy that closely fits who you are.  You cannot merely copy someone else’s model.  You are not them, and the reasons it works for them, may not work for you.  You must be comfortable with your niche. 

If your primary motivation is ROI and none of the other aspects of real estate investing bother you in the least, then you need to focus on the type of properties that produce the best returns for the least amount of cash invested.  If the amount of headaches you have to deal with is a big factor for you then you need to focus on the type of properties that need the least amount of work, rent easily, and attract the best tenants.  You can decide to focus on small apartments with a caretaker who handles most minor tenant issues.  You can focus on high-end properties that have high-class tenants with high rents.  You can focus on cheap properties that cater to government subsidized housing so you know the rent will always be paid. 

The choices available to you are vast.  However it is important that you do not continue too far down this path without attempting to find out what your niche is.  Each of these different options requires a different strategy.  It requires different levels of expertise and effort.  Failing to concentrate on a core strategy will dilute your ability to become skilled and efficient at any one of them.  Your plan can evolve over time and can encompass more than one strategy, but to think that you can take on a myriad of different properties and succeed at running them all is likely to be a costly mistake, especially in the beginning. 

I have narrowed my niche down to the following.  I look for properties that produce good solid returns, not the best returns possible, but very solid.  I combine that with high quality properties, preferably newer with minimal need for repair, in good neighborhoods in the suburbs.  I specifically try to avoid 1 and 2 bedroom properties with single car garages.  Instead I prefer larger properties, 3 and 4 bedrooms, with double car garages.  I have found that these rent very easily and attract reliable, stable, long-term tenants that treat my properties with respect for the most part.  In time this strategy will likely evolve, but that’s what it currently is. 

There are a few things that helped me to define my niche.  I learned that properties that are harder to rent are a big turn off for me.  Showing properties can be a considerable time effort.  If I have to show a property a dozen times that is a big burden.  The properties I own now typically rent with just a few showings, often on the first one.  I have also found that smaller properties with fewer bedrooms tend to turn over faster.  The larger properties attract families with children that care about the school district and do not want to uproot their families as often.  This keeps my turnover and my workload down.  Furthermore the larger units command more rent.  On a pure ROI basis they might not perform quite as well as the smaller units but on a cash flow per unit basis they perform drastically better.  Cash flow per unit is more important to me than cash flow per dollar invested.  While my dollars are limited, my time is even more limited.  Maximizing cash flow per unit is a big part of my strategy.

These are all factors that have gone in to defining my niche.  The factors that will be important in defining your niche might be similar or vastly different.  Only you know what those are.  The quicker you can identify the factors that are important to you the faster you can define what your niche is.  The better defined your niche; the more satisfied you will be with both your investment and with how your business is running.  That personal satisfaction is going to be essential in allowing you to continue operating your business.  Even if the business is profitable, if you are finding it un-enjoyable in a number of ways, you will likely not stick with it.  The problem is probably not with real estate per se.  It’s probably that you have not found a niche that is a good fit for you.  Find that, and you will find success that will last.

Update: To read the next post in this series, see Getting It Rented.

Real Estate 101: Making an Offer

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, posting every Friday, 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.

It’s a long journey to get to the point of making an offer on a property.  You have probably looked at dozens of properties.  You have run numbers on many of them and you have finally found one that you are interested in purchasing.  The only question left is how much to offer. 

Of course you want to pay as little as possible.  To do that you have to know what a property is truly worth.  For all the different valuation metrics that are available there is only one that matters.  This may surprise some people because it isn’t based on a calculation or some measure of actual value.  A property’s worth is simply what other buyers are willing to pay for it.  That’s it.  That’s what a property is worth.  Some may protest.  What about what it cost’s to build it, or what kind of return you can get on it, or what its intrinsic value is?  Those are all different measures of the value of a property, but you don’t get to purchase on those valuations, you purchase on market price.  That is the only valuation that matters when you are a buyer or a seller. 

This can be both good and bad.  Sometimes the market values things at more than they are truly worth.  Sometimes it values them at less.  This means a property may be valued at a price that will not work as an investment, and that’s why you have to know your numbers.  But you have to get passed the idea that your numbers have an influence on what a property is worth, because they simply do not.  If you are buying a pure investment property such as an apartment then investment numbers are going to be a factor but it still comes down to other investors.  If they are willing to pay more than you, then your numbers are irrelevant.  Your first and most important job when determining what to offer is to know your market.  You need to pay close attention to what properties like the ones you want to bid on are selling for.  That gives you a very good idea of what the property you want to buy is worth.  If that price is too high to allow you a good investment return, then you will need to consider other types of properties.

The second thing you need to assess is the competitive demand for a given property.  Certain properties are in higher demand than others.  Good single-family homes for example have many homeowners bidding on them so you are competing with a much larger pool of buyers than if you were buying duplexes for example.  If you want to buy a property that is in higher demand you will have to factor that into your bidding process.  If you are bidding on a property that has multiple other bids submitted, your bid will need to be competitive.  You will need to combine what you know about the market value of properties like the one you are bidding on with how much competition you have.  I have walked away from some properties simply because there were too many offers.  To be competitive I knew I would have to bid more than I wanted to pay so I simply moved on to greener pastures.

A good example of this process is a property I purchased almost three years ago.  I knew from experience that the market for that particular property was $130-$135K.  I had seen a handful of other bank owned properties just like it sell in that price range.  The bank listed the property for sale below market price at $117K.  As a new investor it is important not to let the asking price be an anchor for your valuation of the property.  Asking price is just a starting point and it may have no relation to a property’s actual worth.  Remember, market price is the only valuation that matters, not asking price.  That property was worth close to $135K and I knew it.  Of course the asking price does tend to act as an anchor for many buyers which tends to hold down their offers, so I was eager to put an offer on this property before too many other buyers found it.  I had planned to put in an offer in the mid $120’s.  This offer would be under market but above ask and I was hopeful that if things moved quickly I could pick it up at a discount. 

I was prepared to put my offer in on the second day it was listed but found out it already had 5 other offers in only one day and would likely get more before the bank stopped taking offers.  My agent and I discussed the situation.  We speculated that there were probably a couple buyers who didn’t really understand the market and thought they could purchase it for what was being asked or perhaps even below.  There were probably a couple investors who knew it was below market but were trying to pick it up at a discount like I was.  Then there were probably at least one or two savvy investors or buyers who knew the market well and were willing to bid close to market.  I knew this property made very good money at its true market price and I was convinced it was likely that one of my competitors did too because likely they were bidders on some of the other properties I was comparing with as well.  The difference of a few thousand dollars in the asking price would make almost no difference in the long-term returns or the cash flow of the property.  Given that, and the strong demand for this property I decided to offer just above the known market range at $136K.  Two days later my offer was accepted.

You almost never find out after a deal what any of the competing bids were, but in this case the listing agent told my agent that we barely won the bid, probably because it was so close.  The next closest bidder had offered $135K, exactly what the market price was.  That is no coincidence.  They knew the comparable sales prices and likely made the same calculation I had.  They just calculated $1,000 too low.  That was nice confirmation that we had calculated correctly.  Keep in mind this purchase was in early 2010.  The housing market could not have been in worse shape at that time.  Properties were being purchased below ask all the time.  It would have been very easy to rationalize that you simply don’t pay over asking price in that market.  But asking price is irrelevant.  This price was wrong.  The bank may have purposely chosen the price to attract extra demand and bring in extra bidders, or they may have just mispriced it.  The reason doesn’t really matter.  What matters is I knew what it was really worth, I knew the competition on this property was strong, and I knew the price it made sense at for me.  All those things allowed me to buy a great property at the right price, and at a price that offered a very good return.

I would love to have gotten that property at $125K, or $117K, or $110K.  Likely some of my competing bidders thought they might be able to get it for that, but they were wrong.  That property was not available at those prices.  There were at least two bidders that day at the true market price.  And here is the thing, there usually are.  If your competition is soft on a property or non-existent then you can usually get it for a discount, but if you have limited competition then likely the discount you are getting is the actual market price.

Now there is another strategy that some investors take, which is to attempt to buy properties at well below market prices.  This strategy can work but it tends to not be very easy.  Investors who use this strategy will typically make a lot of offers before they get one accepted.  The properties this works best for tend to be diamonds in the rough. 

Why would a property sell for well below its market value?  Even if a seller is desperate, there are other buyers out there who would bid on a good property.  Typically there are reasons a property would sell at such a low price.  It is in a poor neighborhood.  It has difficult structural issues.  It just simply needs a lot of rehab.  This is the diamond in the rough.  Hopefully you can actually turn it back into a diamond!

This can be a time consuming strategy that involves a lot of failed attempts before success, and this is typically followed by a significant rehab project.  I simply do not have the time for that nor do I seek those types of properties at this time.  However there is another reason I don’t chase these types of deals right now and that is because I simply don’t have to.  There are hundreds of great properties out there in good neighborhoods, that are highly desirable, and that generate very good investment numbers.  They won’t quite generate the kinds of ROI numbers you can get if you are able to purchase a diamond in the rough with a low-ball offer, but that is not my highest criteria for success. 

The last thing I want to mention is the difference between purchasing from an owner and purchasing a foreclosed property directly from a bank.  When purchasing from an owner you are dealing with their emotional attachment to the property but also their need to sell.  There is usually some room for negotiation here but there can also be a stubborn refusal to accept reality.  You cannot make them sell the property at market price if they don’t want to.

A bank is the exact opposite: Unemotional, unattached, and no need to sell the property on a particular schedule.  However, you also cannot make the bank sell at market prices if they don’t want to.  When buying from a bank, if the price is too high, there is only one thing that will change that and that is time.  The property that I used in my column on “Running the Numbers” was one that the bank had originally listed for $20K higher than I purchased it for.  I knew that price was wrong.  The correct price was around $125K but they had listed it for $144,900.  I let it sit on the market for 3 weeks and then I offered at $115K.  My agent told me that was too low for the bank to consider, but I wanted to attempt to meet at the market price.  It turns out he was right.  They countered at $138K, so I raised my price to $122K.  They came back at $137,500.  They were telling me that they were at their bottom price.  Now the truth is I was willing to pay up to $130K for this property and if they had continued to negotiate we could have easily ended up there.  But banks don’t work that way.  They generally have a formula that involves regular reductions in price over time.  One week after they had given me a bottom dollar of $137,500, they dropped the price to $134,900.  I waited another month and they dropped it to $124,900, just like clockwork.  I immediately offered exactly at the asking price and the offer was accepted in a day.  There were two other offers that came in as well.  This shows they had finally gotten to the true market price for the property.  The price that I knew was right because I knew the market.  When they got to the market price they got multiple offers for the property.  When they were over priced they received no offers. 

What I am hoping to get across is that a property will sell for what its market value is.  Even an accepted low-ball offer is usually selling at market value.  There is something about that property that makes it so that no one else wanted it at that price.  Your job is to find properties that have good numbers when they are sold for market prices.  There will likely be a day when that gets tougher to do.  Until it does, there are plenty of good deals to be had.  You simply have to know your numbers, know your market, and know your competition.

Updated: To read the next post in this series, see Finding Your Niche.

Real Estate 101: Running the Numbers

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, posting every Friday, 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.

What if before you purchased a stock, you could get a very close approximation of what kind of return you would get on it in the coming years?  What if before you started a new business, you could make a close estimate of both your overall revenue and expenses to determine what your net profit would look like?  Obviously that would make the decision to invest or start a business much easier to make, but unfortunately there is no crystal ball into that future.

With real estate, however, the future does have a crystal ball and it’s the present.  The near future in real estate looks very much like the present.  This is because rental properties are basically commodities.  Similar properties in similar local neighborhoods will rent for similar prices and have similar expenses.  Furthermore the supply of properties does not change much from year to year and neither does the demand.  This creates a relatively stable environment that makes calculating how a real estate investment can be expected to perform in the coming few years straightforward and remarkably accurate. 

If you research real estate financials you will find there are literally dozens of different numbers and ratios that you can use to measure the performance of the business.  I am going to focus on 4 different ratios, which combine to give a complete financial picture of the investment.  They are cap rate, cash on cash return, return on investment, and cash flow margin.  These are all very straightforward to calculate.

You will notice that I do not account for appreciation in any of these calculations.  Appreciation over long periods of time can improve return on investment significantly.  The problem with appreciation is that it is difficult to project accurately, and it has no immediate cash impact on your business until you either sell a property or borrow against the increased equity to access more cash for future purchases.  All things being equal you should favor a property that is more likely to appreciate, but in the short term your business will thrive much better on high cash flow properties than it will on high appreciation properties with low cash flow.  As such we will focus on cash flow and profit calculations without factoring in appreciation. 

To explore these calculations we will use real numbers from a property I purchased in June of 2011.  This is a 4 bedroom, 3 bath townhouse that was built in 2007. 

There will be two assumptions in these numbers.  First is 1/2 month of vacancy per year, which is about 4.1%.  My vacancy has thus far been much lower than this, because I have long-term tenants with long leases and have had almost no vacancy between renters.  Eventually you will have some vacancy so it is important to make a realistic assessment of what your actual vacancy will be without underestimating it.  Second is an allowance of 5% of revenue for unscheduled costs.  This includes repairs, maintenance, and replacement.  Normally this number would need to be much higher than this but since this is a townhouse most of my large expenses are covered by my association dues.  My actual numbers have been far less than this number as well because of how new the property is, but they will eventually catch up when I have some larger replacement costs.

Here are the numbers.

Purchase Numbers

• Purchase Price: $124,900
• Mortgage Balance: $93,675 (75% loan to value, 30 year mortgage with 5.25% interest)
• Closing Costs: $3,500

Monthly Revenue

• Rent: $1,400 ($1460 – 4.1% vacancy allowance)

Monthly Payments

• Mortgage Payment: $517 (Interest-$410; Principle-$107)
• Association Dues: $210
• Taxes: $133
• Utilities (water): $35  (trash is provided by the association)
• Insurance: $10  (master insurance policy is provided by the association)
• Allowance for other costs (5%): $70
• Total Monthly Payments: $975

From these we will calculate some basic numbers needed by the financial ratios. 

• Cash Invested = Purchase Price + Rehab Costs – Mortgage Balance + Closing Costs

          $124,900 + $0 - $93,675 + $3,500 = $34,725

• Monthly Cash Flow = Revenue – All Payments

          $1400 - $975 = $425

• Monthly Net Income = Cash Flow + Principle Pay down

          $425 + $107 = $532

• Monthly Net Operating Income = Cash Flow + Debt Service (Mortgage Payments)

          $425 + $517 = $942

While these numbers are needed by our calculations, they are valuable on their own as well.  From these numbers we see that this property produces $425 of cash flow each month.  This is real cash that is deposited in your bank account each month.  It also produces $532 of net income or profit.  This would be the amount you would pay taxes on except that you will receive a substantial deduction for depreciation and likely pay taxes on half of this or less.  For instance my depreciation allowance on this property is about $330 per month.  That means I gain $425 per month in cash, I have profit or gain in equity of $532 per month but will only pay taxes on about $200 per month.  The Net operating income of $942 shows how much money this property would make if it were fully paid for.  This is what your cash flow would look like if you purchased it with all cash or after you had paid the mortgage off.

From these numbers we can now calculate the ratios that will tell us how this property will perform as an investment:

• Cap Rate = Annual Net Operating Income / Current Value (Purchase Price)

          $942 * 12 / $124,900 = 9.1%

• Cash on Cash Return = Annual Cash Flow / Cash Invested

          $425 * 12 / $34,725 = 14.7%

• Return on Investment (ROI) = Annual Net Income / Cash Invested

          $532 * 12 / $34,725 = 18.4%

• Cash Flow Margin = Cash Flow / Revenue

          $425 / $1400 = 30.4%

The cap rate is 9.1%, which is a solid number.  This is the return you would get if you purchased the property with all cash.  You will find that if you use more cash and less leverage you will get lower overall returns on your investment but higher amounts of cash flow.  

The next two numbers show us how this property will perform using the financing terms we have chosen.  By using 75% leverage this property’s cash return on the money invested is increased from the 9.1% cap rate to a 14.7% cash on cash return.  This is a 60% increase in cash for every dollar invested.  The Return on Investment (ROI) which accounts for the portion of your mortgage payment that went to equity in your property comes to 18.4%.  This is the more than double return I had mentioned during the benefits column that can be achieved by using leverage over cash.  These two numbers show the actual return you are going to get on this property.  Cash on cash return shows your cash in hand return and ROI shows your total profit return. 

These two ratios are dramatically affected by how much leverage you use.  Because of that the cleanest way to compare one property to another on a pure performance basis is the cap rate.  It’s worth pointing out that if a property is purchased with all cash, then the cash on cash return and the ROI will be the same as the cap rate.

Cash on cash return and ROI work together to tell you how well this investment will perform.  Cash on cash return is important because this tells you what percentage of your investment is being returned to you in cash each year.  This can be used as income or as capital for future investments.  There is one danger with looking only at cash on cash return however.  You can affect this number by changing the financing terms.  Different amortizations and payment terms can make this number look better than it is.  For instance I have some loans that are interest only because they are lines of credit.  They appear to perform vastly better on a cash on cash return basis because the loan payments are only interest.  This is why ROI is also important because when comparing ROI the loan term differences are accounted for and the returns look more similar.  ROI is also your true total return on the property.  You want to be sure you are not convincing yourself something is a better investment than it is by focusing too intently on a single measurement of performance, and you want to avoid making short term financing decisions based solely on numbers that may not be the wisest choice for a long term investment. 

Finally we see the cash flow margin is 30.4%.  This means you are able to keep almost 1/3 of the rent you collect after making all of your payments.  This is an important measurement because you want to make sure there is a margin of safety in your cash flow numbers.  30% is a very safe cash flow margin.

Overall these numbers show that this property performs quite well as a real estate investment.  Since it is a townhouse with association dues involving overhead, a single family house or a duplex can often produce even better numbers depending on the purchase price.

This property turns out to be ideal for the current investment strategy that I have.  It is in a very good neighborhood.  It is almost brand new.  It attracts high quality, stable, long-term tenants and as such my real numbers are actually higher than what I am showing here because the allowances I am using are higher than I am currently experiencing.  Because of the quality of tenants I can attract my tenant issues are minimal.  Since it is a townhouse my maintenance demands are reduced because I only have to deal with inside issues, the association handles everything external.  The intangibles of this property are very high.  Those intangibles are very important to my strategy so I am pleased to get such solid numbers on a high quality property.  It tends to be the case that the higher the quality of property the lower the overall numbers because the sales prices tend to push up on better quality properties and the increased rent usually can’t keep pace with the higher sales prices.

I would like to be able to conclude this column with specific targets for these measurements.  Unfortunately it’s not possible to give universal targets.  Different areas of the country will produce different numbers.  Different eras of real estate investing will drastically affect the kind of numbers one can achieve.  We are in an era where the returns are at the high end of the range.  These numbers won’t always be achievable.  Also different types and qualities of properties will produce different numbers.  Older duplexes will probably produce better numbers than newer single family houses.  But newer single family houses may produce better future appreciation, less maintenance, and depending on location may result in higher quality tenants.  There are far too many variables to say what any of these numbers should look like.

I will, however, offer two pieces of guidance.  The first is around cash flow.  Because of how critical cash flow is, any property you buy should always be able to produce some reasonable cash flow.  If your cash flow margin is in single digits it’s getting uncomfortably low.  Preferably cash flow margin should be in double digits and certainly not below 5%.  This target is easily attainable in this market. 

The other guidance I would offer is to examine your ROI and decide if that number is something you think is worth the effort and worth your investment.  If you get a reasonable cash flow margin by using more cash but at the cost of a low ROI perhaps that is not a sufficient return to justify the investment in real estate.  Personally I would like to see ROI that is in double digits.  You could accept high single digit ROI on an all cash deal but once ROI was down near 5% the return is probably not high enough to justify real estate over alternative investments.  With the use of leverage double digit ROI is also easily attainable in this market.

With these 4 ratios you can effectively compare every property you are considering to determine which ones give you the best returns and which ones do not.  Remember that these numbers do not account for appreciation so over time your return will exceed these numbers.  However, for the purposes of making the initial investment, these 4 ratios will give you all the information you need to make a well-informed decision.

To read the next post in this series, see Real Estate 101: Making an Offer.

Real Estate 101: Where to Start

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, posting every Friday, 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.

Investing in real estate requires a little more planning than simply investing in stocks or bonds.  The transaction is more complicated and the investment has more moving parts to manage.  As such the effort to get started is quite a bit higher than a traditional investment.  These beginning hurdles are one of the reasons so few people ever get passed the exploration phase of real estate investing.  So if you have been thinking about investing in real estate, here’s where you start. 

Step 1:

Start!  Most people never get to this step.  They talk about investing in real estate.  They read books about investing in real estate.  They might even go to real estate seminars.  These are not a start.  These are thinking about starting.  These are getting the courage up to start.  These are debating with yourself if you should start.  You haven’t started until you have taken an action.  I mentioned hurdles in the opening paragraph and this is a big one.  You haven’t started to be a runner because you think about running, or read a book about running, or go to a coaching session about running.  You don’t begin to be a runner until you start running.  This can be a scary hurdle because once you start taking actions you have declared your intent to become a real estate investor.  Other people will be involved.  What if you find out you’re not ready or that it’s not for you?  Don’t worry, starting the process doesn’t mean you have to purchase a property.  You can always decide to stop or delay the process.  Don’t stop before you start.

Step 2:

Find a real estate agent who specializes in investment real estate and is also preferably a real estate investor themselves.  This step is especially critical for someone who doesn’t have previous experience or enough local knowledge to make well informed decisions.  It is very important that your agent is focused on investment properties and not owner occupied housing because the choices you need to make are very different and you will rely on this person for considerable guidance in the beginning.  Because your agent has been helping others purchase investment properties and has purchased and managed their own properties, they will have the information and experience to give you some guidance and advice which will help you to reach informed decisions.  They will also have contacts that can help you arrange financing, legal advice, and perhaps a whole host of connections you could leverage. 

As a new real estate investor you just have too much information that you don’t even know that you need to know.  Furthermore this information is unique to each investor.  Books can help but they are going to be mostly written from a general point of view and they also don’t have the advantage of having firsthand experience in the exact locations that you are looking in.  Your agent has that experience and it is essential.

Step 3:

You need to get access to capital.  That means ready cash of your own for a down payment and access to financing from lending institutions to complete your purchase.  Your agent can likely give you some help with the lending aspect but you will need to come up with enough for a down payment.  Don’t wait until you find a property to do this.  That is too late.  You need to be arranging this very early in the process.

Step 4:

Give some thought to the type of property you want to invest in.  Most people start with a single family house or duplex but even among those there is a wide array of choices.  Townhouses vs stand alone houses; newer and more expensive property vs an older, cheaper property which may be more work; ready to rent vs fixer upper.  You should also consider which neighborhoods you would like to focus on.  Once again your agent can give you some pros and cons of each. 

Step 5:

Start looking, and look a lot.  Get a feel for what is out there and how comfortable you feel about what you are seeing.  If you do not like what you are seeing perhaps you need to consider a different kind of property.  This is one area where you should not let your agent’s experience guide yours.  Do not get caught in the trap of letting your agent convince you that the type of properties that were right for him or her are right for you.   Your agent may place a high priority on ROI and purchase cheap units in low income neighborhoods.  You may have other priorities that are more important to you than just ROI.  Make sure your agent knows what your priorities are so they can take you to properties that meet your criteria, not theirs.

Step 6:

While you are looking you need to be thinking about whether or not you want to manage these properties yourself or hire a management company.  As you see properties you may start to see more work than you planned and a management company might be a good way to mitigate that for you.  Don’t let what you see scare you away from real estate investing.  If the thought of dealing with tenants and repairs scares you or you feel you just don’t have the skills to perform those tasks then hire a management company.  That is what they are for.  Literally tens of thousands of people use third party management for their real estate investments.  If you want to hire a management company it is important to begin searching for and interviewing management companies early in the process.  This will become a critical choice for you so do not take it lightly.  Choosing poorly here will impact all of your rental properties.  Your agent can once again give you some advice on management companies.

Step 7:

You want to be checking on rental rates for comparable properties in areas that you are looking to see what type of rents you can reasonably get.  You then need to run some numbers with typical expenses to ensure the properties you are looking at will make for a good financial investment.  Running numbers is a critical step to narrow down properties.  No matter how much you prefer one property to another if the financial numbers do not work on a property you must not purchase it.  Once again your agent can give you some typical expected rents and some typical expenses.

Step 8:

After you have done all that legwork and have looked long enough to find some properties that make for a good investment comes the last and often most difficult step of all.  Buy something!

When I first started looking at properties my agent introduced me to his money guy and I spent about an hour talking to him.  As it turned out he was not able to help me much with financing due to the circumstances of the property I was looking at, but he said something that has stuck with me to this day.  He told me that regardless of what my goals were, one property, a few, or an empire, to not get stuck in a mode of second guessing or waiting for the perfect deal.  He had talked to hundreds of people who were thinking about investing in real estate but very few ever actually became investors because they simply couldn’t get to the point of pulling the trigger on a deal.

I have seen the evidence of his words in people I have personally talked with and I even had to fight it a little bit in myself.  Many never start as I already mentioned.  Once you do start, cold feet come quickly.  As you are looking at properties you may not like some of what you are seeing.  You can always find something wrong with a property or some reason not to proceed.  You should of course never do a bad deal or a deal that you know won’t work well for you but if you have looked long enough at enough different properties there are deals out there that are right for you.  The problem is that one of those beginning hurdles I mentioned in the opening paragraph is the “perfect deal” hurdle.  The perfect deal could be a mindset that says you have to get a steal on the price.  It could be that you feel you need just the right property that is in the right location or the right condition or whatever it may be. 

To clear the “perfect deal” hurdle you have to accept one very important thing.  You will make mistakes on your first deal and that is ok.  You will probably make a number of mistakes on your first deal.  As long as you have done your homework and your finances make sense these mistakes are not only not a problem, they are essential to your development as a real estate investor.  Success is a process of incremental improvement and improvement only comes by learning from mistakes.  Most of us don’t tell our kids to expect perfection the first time they attempt something, yet it’s easy to fall into the trap of thinking we cannot make a mistake on something this important.  A mistake is not going to kill your business unless it is a fatal one.  If you have an experienced agent helping you along the path and do your homework on the number, you are not going to make a fatal mistake.

My first property had multiple mistakes from my point of view.  There was nothing drastically wrong with that deal and I still have the property, but I would not purchase another one like it today for a number of reasons.  In spite of the mistakes, that deal is the most important deal I have ever done.  It’s important for 2 reasons.  First it put me in the game.  With that deal I went from a real estate explorer to a real estate investor.  That change in status comes with a big change in mindset.  Once you have done a deal and went through the steps, you know you can do this and the next one comes much easier.  Secondly, most of the things I now know about how I want to do real estate and how I don’t want to do it, I learned from that deal.  I read a number of books and looked at literally hundreds of properties.  I didn’t learn half as much from all of that as I did by simply buying and managing that one property. 

It took me another year to purchase the next property after that one.  I was enjoying what was working with that property and learning from what wasn’t.  It helped me hone my search and I was able to focus on a narrower slice of the market that would work better for me.  When I found my next deal I closed on 4 properties within 6 months.  Everyone’s experience will be somewhat different, but once you have taken these beginning steps and cleared those initial hurdles, you will begin to know what works for you and what doesn’t because you are doing it.  There is no short cut for just doing it, and it all starts with having the courage to trust yourself, get started, and go do that first deal.

Update: For the next post in this series, see Real Estate 101: Running the Numbers.

Real Estate 101: The Benefits of Investing in Real Estate

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 (click here to begin the series), posting every Friday, based on his experiences.  The series is designed to give prospective investors the basic tools they need to succeed.

There are two concepts that are mentioned regularly in the investing world.  Those concepts are diversification and asset allocation.  Both of these involve spreading your investments around to mitigate risk while trying to get a higher return than might be achieved with safer investments.
 
Real estate is often mentioned as a portion of a well diversified portfolio.  For most people this involves investing in something like a Real Estate Investment Trust known as a REIT which trades just like a stock and is truly a pure real estate investment for the investor.
 
However, actually purchasing income producing property is not the same as investing in a REIT.  When you own property and manage it for income you are actually both an investor and a business owner.  As a managing investor and not a silent partner, you are able to exercise some level of control over the type of returns you get by setting the criteria of the properties you will purchase.  As a business owner you are able to provide some labor and manage the business to control costs and provide stability which increases the safety of the investment.  If you invest in a REIT, you do not control the value of what you are buying, and you cannot run any numbers to ensure the type of return you will get.  This makes the investment inherently less safe.  You are also paying someone else to make investment decisions, to find capital, and to perform all the daily operations of the business.  That cost will remove the higher than average return that real estate can offer.  If you are looking for a pure investment where you put in no labor or management and reap higher than typical returns with low risk, you can keep looking.  If that existed, I assure you, we would all be invested in it and sipping our Pina Coladas on a beach somewhere.  It does not exist.
 
But when you own and operate a real estate investment business you are in a position to do something that almost no other investment offers.  Namely, to reap higher than average returns with lower than average risk.
 
Before I get into the reasons, let me define very specifically what type of real estate investment I mean and what type I do not.  There are three characteristics that must exist to meet my definition of high return/low risk real estate investing.

1. You own property directly or have an ownership interest in specific properties.
2. That property produces a regular income that exceeds your expenses.
3. You provide some level of labor or management necessary to run this as a business rather than as a pure investment. 

There are many valid ways to invest in real estate.  Some examples include REITs, Tenancy in Common investments, and buying property to fix and resell known as flipping.  None of these meet all three of my criteria and so they are not what I will be discussing here.  This series will be focused exclusively on purchasing individual properties, either houses or apartments, renting them out for income and managing that enterprise as a business.
 
Below I will offer a list of what I think are the most significant benefits of investing in income producing real estate.  These benefits come together in a way that allows real estate to offer higher returns than typical investments like stocks, better safety than typical high return investments by being run as a business, and yet requires less labor than a typical business.
 
1. The income stream it produces tends to be extremely stable and predictable.  Rents tend to slowly rise over time but even during tough economic times they tend to be fairly stable, falling only modestly.  You won’t find yourself wondering how much income your properties will produce next year.  They will produce very close to what they produced last year.  If they don’t, they are being poorly managed.
 
2. The income stream is partially passive.  It’s not as passive as a stock dividend but it is far more passive than running a traditional business.  If you hire outside management it will reduce your income stream some, but it can then be even more passive.  It is important to note however that it should never be 100% passive.  If you have no idea what is going on with your business, you have lost the safety buffer the business is designed to provide.
 
3. The underlying property will typically appreciate over time. This is in addition to the income stream.  As the property appreciates rents will tend to rise with it meaning that your income stream will also grow over time.  Both of these act as a hedge against inflation.  Unlike the more typical items offered as inflation hedges such as gold, real estate gives you income while you wait.  Gold just sits there. 
 
4. There are tax benefits to investing in real estate that are not available with most investments.  The most valuable is the tax deduction allowed for depreciation of the property.  As a result of this it is very common for the investment to generate considerable net income while only half or even less is taxable.  It was not uncommon in the past to have a net taxable loss after depreciation, but that was because higher priced properties resulted in lower net profitability.  A properly purchased property today should not be in that situation.  Either way, until a property is fully depreciated, a portion of the income generated each year will not be taxed.
 
Those are all fairly good benefits to investing in real estate.  But I consider those to be the weakest benefits.  The next two are the big ones.
 
5. Rental properties when purchased correctly generate significant cash flow.  If purchased with 100% cash then the cash flow is going to approximate the cap rate and that rate tends to run between 5-10% depending on the type of property and where we are in the real estate cycle.  Currently many properties are able to produce numbers near the high end of that range or even above it.  These are very strong numbers.  Remember that this doesn’t count the appreciation of the property.  This is just cash that you put into your pocket every year; cash that is not all taxable due to deprecation; cash that will be generated reliably year after year with no significant reduction, but slow consistent increases. 
 
The cash flow a property generates is the single most important thing about real estate investing.  If an era of real estate investing offered no properties that could generate good cash flow such as the early 2000’s I would simply not be a buyer of any additional real estate in that environment.  Keep in mind, however, that properties you already own will continue to perform as they always have regardless of the inability of new properties to do so.
 
The reason this is so critically important is because this is the reason why real estate investing can be both stable and low risk.  Refusing to buy properties that do not offer strong cash flow will keep you out of investment trouble.  There is no shortage of people who have lost a lot of money investing in real estate, but not people who had properties that were generating significant cash flow.  I cannot stress this enough.  Successful safe real estate investing revolves around cash flow.  You should never purchase properties with appreciation as your primary objective.  Your business runs on cash and cash flow not on appreciation.  It is so important that it can almost be your only measure of success and safety.  Cash flow is king! 
 
With cap rates of 5-10% and some very modest appreciation such as 2% you are looking at stable repeatable returns of 7-12% per year.  With more typical long term appreciation of 3-4% you are looking at returns of 8-14%.  That’s a pretty high total return considering the level of safety and stability it has.
 
While cash flow is absolutely critical and by far the most important aspect of real estate investing, the last benefit is the most powerful and the most beneficial.
 
6. As good as the returns in real estate are when investing with cash, they can be compounded significantly by using leverage.  The word leverage immediately brings with it the presumption of risk, often high risk.  While gains are increased, losses are as well.  A fractional loss in value can mean a 100% loss of your investment.  Certainly leverage cannot be used in a safe and responsible way, especially with an investment that is being touted as low risk…right?
 
Anyone who has ever had a mortgage on their house has used leverage.  Most people use far higher levels of leverage on their house than is typical in real estate investing.  If you have an FHA loan you can purchase a property with as little as 3.5% down and 50% of that goes to pay a fee to HUD.  That means you have only put 1.75% towards the purchase of your house, which is a leverage ratio of more than 50 to 1.  If the value of your house were to drop by 2% you would be technically insolvent on the property.  You would have lost 100% of your initial investment in your house.  Underwater is the term we hear used today to describe people in this situation.
 
But on an investment property you typically cannot purchase one with less than 20% or 25% down.  In the not too distant past you could get properties with much less down than that but it will be a while before that is possible again.  These are leverage ratios of 3 or 4 to 1.  It would take a 20-25% loss in value for the property to be insolvent or underwater.  That has only happened once in the last 50 years and we just finished going through it.  The odds of it happening again from these levels is remote.
 
But there is a far more important reason that makes this kind of leverage inherently safe and that is the cash flow of the property.  Even if a property you had purchased were to suffer a reduction in value that erased 100% or more of your initial investment, the strong cash flow from the property will render such an event nearly irrelevant to the operation of your business because your business doesn’t operate on the value of its assets but on the power of the income it produces.  That is why cash flow is so critical, and why you should always purchase primarily for cash flow and not appreciation.
 
Furthermore you are paying down principal on your mortgage every month.  Your cash flow is continuing to buy that property regardless of what happens to its value from year to year.  At the end of the mortgage you will own the property free and clear and have made significant profit from it each year as well regardless of what happened to the value of the property in the mean time.  So the risks to this leverage are minimal, but the benefits can be dramatic.
 
The returns mentioned in the cash flow section can currently be more than doubled, perhaps tripled with the use of 3 or 4 to 1 leverage.  And these returns are not just for one year, or two.  They are repeatable every year, year after year.  Now to be fair, if you do not take those gains and purchase more properties with them they will not compound, the same way a dividend on a stock will not compound if you do not reinvest it.  But if you do reinvest it you can continue to create these returns, compounded, year after year, until such time as the real estate cycle no longer allows you to purchase properties with solid cash flow. 

When you put all these reasons together investing in real estate stands apart from nearly every other type of investment.  That’s not to say real estate investing is risk free.  You as the investor are still responsible for making wise choices and running the business in a responsible fashion.  Many investors have failed at this task in spectacular fashion in the past few years.  But if you do it right, it’s one of the best legal investments available.

To read the next post in this series, see Real Estate 101: Where to Start.

Real Estate 101: Why You Should NOT Invest In Real Estate

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, posting every Friday, based on his experiences.  The series is designed to give prospective investors the basic tools they need to succeed.

This might seem like a strange place to start and perhaps a disappointment to some who want to be cheered and encouraged into the wonderful benefits of real estate investing.  After all, usually one leaves it to their detractors to make the opposition’s case.  But the point is not to turn everyone into a real estate investor.  That is a job best left to the late night infomercials.  The point is to help people succeed at investing in real estate.  To do that two things are important.  First is setting proper expectations, and second is targeting the message to those who are up to the task.

And it is a task.  Real estate investing is a bit of a misnomer.  It’s not like stock investing, or buying a CD, or investing as a silent partner in your brother-in-law’s bakery.  Real estate investing is really running a business.  Investing is a part of it, but it shares every aspect of what people more traditionally think of as a business.

Even business owners often take on their ventures with unrealistic expectations.  My wife is a former corporate trainer for an international food company.  She saw many people come through her classes who had recently purchased a franchise as part of an early retirement plan.  They had fanciful notions about managing this business as a part time semi-passive activity in retirement and living the dream of their golden years off the bountiful returns they would reap.  Why did they have such lofty expectations?  Because no one told them differently.  Running a fast food restaurant is a lot of work.  It’s not part time, and you will not be reaping bountiful returns with just a single franchise.  After they had been through my wife’s class they would learn that their notions might have been a bit naive.  But alas, they had already purchased the franchise.  What they really needed was to know why not to purchase a franchise before they decided if they should purchase one.

Before you can be confident that you should invest in real estate, you have to know the reasons why you shouldn’t.  Some people invest in real estate with high hopes only to sell out later with a bitter taste in their mouth.  These people tell a terrifying tale.  They describe what a horrible experience it was, how they lost money doing it, and how they had nothing but one problem tenant after another.  Anyone listening to their experience would reach the conclusion that only a fool would invest in real estate.  But their story is tainted by a mismatch between their expectations and reality.  Often these people have entered real estate investing with the same type of misconceptions as the nostalgic new franchise owners.  Misconceptions that reality quickly disabuses them of once they begin actually running their business.

The truth is that some people are not cut out for investing in real estate just as some people are not cut out for running a franchise.  The best time to find that out is before you start.  Consider the following reasons why you may not want to invest in real estate.

1. It takes work.

The IRS defines income derived from rental property as passive income.  However, this is merely an IRS classification for tax purposes.  There is nothing passive about investing in real estate.  The following is a short list of some of the important tasks you need to be able to do:

(1) Find and determine the right kind of properties to purchase;

(2) Properly prepare your properties to attract the best tenants;

(3) Be able to properly screen candidates to find the best tenants;

(4) Take calls at many different hours and either personally address the issues or coordinate with professionals to fix the problems;

(5) Collect rent and chase late rent;

(6) Evict tenants not paying rent or violating the lease;

(7) Pick-up, clean-up, and fix-up properties when tenants move out.

(8) Identify and perform routine maintenance to retain the value and quality of your properties.

2. It consumes time.

It's one thing to realize you have to do work, but you have to have time for it too.  Many of the tasks that need to be done cannot be simply deferred until your schedule is more accommodating.  When the toilet is not working it needs to be fixed now.  When 3 units have tenants move out at the same time and the units need a fair amount of work to get them ready for a new tenant you either have to work many long nights and weekends immediately after move out or forgo 1 or more months of rent on multiple properties.  Your family time may suffer.  You may find yourself trying to juggle your day job responsibilities with the demands of your rental business because too many things are happening at the same time.  Rental property demands tend to come in bunches.  You can have months with nearly no effort required at all followed by a month of solid work.  You need to think about how this will fit into your life and your schedule.

3. It requires management.

It's not enough to just spend time and do work.  This requires some basic management skills as well.  You need to be able to find a host of reliable professionals and contractors to perform tasks that you are not able to do.  You need to be able to coordinate activities between contractors and tenants often times when you are not going to be there.  If you get that wrong, it will not go well with either the contractor or the tenant.  You need to manage finances and leases and navigate local laws regarding tenant rights. 

The work, time, and management responsibilities can all be mitigated by hiring a professional property management company, but that has some of its own problems.  First it's generally somewhat expensive.  More importantly however, a management company will not be as concerned about your property as you are.  They may not get the type of tenants you want or keep the property in the shape you would.  If they don't you will pay extra for maintenance, repair, and turnover, and you will pay them to manage their mismanagement.  There are plenty of horror stories about management companies just as there are about tenants.  Hiring a management company will not make all of your problems go away.  You still need to manage the management company.  That’s a smaller job than managing tenants but it is complicated by the fact that the management company is running the operations while you generally have little to no interaction with the tenants.  That makes it difficult to know what is actually happening with your business until after it has happened.

4. It demands capital.

There is really no way to get started in real estate with a small buy in like $2,000.  You will need to have enough for a down payment on a property and that down payment is typically 20% at a minimum.  In addition to the down payment you will need cash reserves saved up to deal with the potential of repairs that may require several thousand dollars.  Some large items can cost even more.  If you don't have cash to pay for things that come up your tenants will likely stop paying you rent or perhaps even allow issues to cause excessive damage to your property.  This can spiral from bad to worse.  If you intend to continue investing in real estate you will find yourself trying to scrape up every spare dollar you can find.  New cars and other toys are a detriment to your real estate business.  If you want to grow your business you will need to keep your personal expenses as low as possible for a considerable time while you continue to accumulate property.  Unless you are already cash rich, expect to feel somewhat poorer for a while.

5. It needs debt.

Unless you are sitting on a high 6 figure or low 7 figure pile of cash, you simply can't take this beyond a hobby stage without debt.  If you want to grow it you will need considerable debt.  You will need to spend time exploring multiple financing options.  You will need good credit, and the more debt you take on the more important your financial standing will be.  You will need to be comfortable carrying considerable debt for an extended period of time.

6. It grows slowly.

While the returns on real estate can be good they are not going to be so excessive as to have you swimming in cash.  Furthermore, as already mentioned, any cash your real estate generates needs to be carefully conserved and used to purchase your next property.  The business constantly demands most of the money it generates to feed itself.  Some people find this demoralizing because it seems like you are not getting anywhere.  You are building assets that have value and that can generate considerable cash, but it may take a decade or more to get your business to where you want it.  Any money you extract from it will only delay how long it takes to reach your goal because real estate is a capital constrained business.  It cannot grow any faster than the capital available to grow it.  You cannot merely produce more widgets or hire more sales people.  The only path to growth is increased capital investment which means you cannot afford to enjoy the fruits of your labor if you want the business to continue to grow.

These issues are not insurmountable and are not excuses for not investing in real estate.  However, if you are not aware of them or have assumptions to the contrary they will quickly overwhelm you and likely lead to the demise of your real estate venture.  If this list is overwhelming to you, you are probably not ready to enter the world of real estate investing.  But if you go in with your eyes open, prepared to face the challenges that lie ahead, you will have laid a solid foundation for success.

Click here to read the next post in this series: The Benefits of Investing in Real Estate

Million Dollar Home Foreclosures

CNN Money has a piece on a $2 million home that's going into foreclosure, something they say will be more common in the future (high-priced homes being defaulted on.) A summary:

For years, homeowners at the high end of the housing market were able to postpone the foreclosure process, but now multi-million dollar homes are becoming more commonplace in America's foreclosure pipeline. In fact, America's wealthiest families are now losing their homes to foreclosure at a faster rate than the rest of the country, according to RealtyTrac.

Out of all foreclosure activity, the share of foreclosures on multi-million dollar properties -- or homes valued at more than $2 million -- jumped by 273% since 2007.

In the story above, the reason for the foreclosure was a bad business decision. They put all their money in two high-end restaurants (I'm not sure why they needed two -- what about testing one first?) just as the market toppled and people stopped eating at expensive places. Worst of all, they had taken a buy-out (which I assume was lucrative) from a tech firm to even be able to get to where they were financially, and I'm guessing they lost all of that as well. Now they are back to ground zero financially.

I've seen a bit of this happen personally. Not a foreclosure, but the combination of a bad business situation and an expensive home -- and the financial mess it can make.

I have a friend who lives in a very nice home on a lake (I'm guessing the house is worth $600k -- Zillow lists it as $400k but doesn't even show the right house -- it's off by blocks!). Their neighbor built a huge (6,100 square feet) and expensive log cabin home in 2004. Then the neighbor's company became troubled and there was family in-fighting (much of which was documented in the local press.) In the end, the neighbor's either had to sell or decided to sell the house (no one is sure of the reason.)

They listed the home for $1.8 million in 2008, just as everything went south. It sat there. In September 2009, they dropped the price to just under $1 million. It sat there. They removed it from the market soon thereafter and relisted it a couple months later for $949k. It sat there. In March 2010 they dropped the price to $779k. It sat there. They removed the listing from the market in September 2010, then relisted it for $899k last March. It's still for sale.

I'm not sure why they listed it for $899k when it wouldn't sell at $779k, but that's what has happened. And BTW, all this happened with three different real estate companies acting as the sellers.

These people aren't facing foreclosure (or so it seems), but they are experiencing the problems associated with a hurting/failed business and an expensive home that was probably near the limit of what they could afford. On top of that, they had an economic downturn and a style of home that makes it hard to sell (how many buyers like the log cabin look?) It has "bad situation" written all over it.

What can the rest of us learn from this? A few of my thoughts:

• Don't stretch to buy a huge house if you really can't afford it. Both my friend's neighbors and the couple in the story above would have been much better off buying a home that "only" cost $500k (or some number well below where they purchased.)


• Don't have a huge amount of your net worth in one investment. And it's especially difficult if that large percentage is in your home -- since it's illiquid, you need it to live in, etc.


• Debt kills. Obviously the equation changes (at least a bit) if you own the home free and clear. But if you have a big mortgage (bigger than the home's value at least and/or bigger than your ability to keep making payments), you're playing with fire.


• It pays to have multiple sources of income -- or at least sources that are relatively steady. If one income takes a hit, then you have at least something to help you develop "plan B."


• The riskier your finances (like the ones above), the more you need a big emergency fund to protect you in case things get rough.


• We all need a cushion. Where's the financial cushion in the situations above? It doesn't exist. And hence when things get bad in one area, the whole house of cards comes tumbling down.

In the end, I feel bad when anyone loses their home and I wish all these people well. And I hope the rest of us can learn a lesson from their problems.

How to Pay for Your First House in Cash

Here's a piece from Fox Business that details how one couple purchased their first home with cash. I've selected the key nuggets of what helped them accomplish such an awesome feat and have highlighted them below:

We crunched a bunch of numbers and realized that, if we continued to live simply and frugally and worked hard to bring in extra money through side jobs, we could save enough over the course of five years to pay cash for a starter home.

We knew that we could buy a decent starter home in the area where we were planning to move for around $100,000 to $110,000, so we divided $100,000 by 60 (since there are sixty months in five years) and set a goal to save $1700 every month. Because we didn't have any debt or school loans, and because we lived simply and frugally, we were able to live on significantly less than we were making, thus freeing up a good chunk of money to put towards our house savings each month.

We used coupons, ate a lot of meatless meals, shopped at thrift stores, cooked from scratch, brown bagged it, continued to use our old and worn-down furniture, didn't replace anything that wasn't an absolute necessity, limited our going out to eat, only had one car, stayed home a lot, used gift cards from Swagbucks to buy any non-necessities, bought eye glasses from Zenni optical, learned to be content with what we had, and continued to live on a strict written budget.

Meanwhile, we also looked for ways to increase our income.

As our house savings fund increased, we began to get so excited that we kind of went overboard and worked long, long hours in order to meet our savings goal even faster. I wouldn't recommend putting in such long hours, missing so many social events, or sleeping so little, but the effort paid off because, at the end of two and a half years, we paid 100% down on our first home!

So let's summarize the keys here:

1. They spent less than they earned from the get-go.

2. From here, they tried to cut/limit spending as well as increase income, making their gap as large as possible. A key part of this was that they didn't have any school or other loans to hold them back.

3. They bought a house they could afford. Note that they didn't start out with a $500k house -- they bought a much more reasonably-priced one. This is a key step in my formula for buying a house you can pay off in 7-10 years. 

As most of you know, we paid off our mortgage early as well (just about 15 years ago now). We didn't wait to buy the home until we had all cash, but the methods we used were similar to those the couple above employed. We watched spending, grew income, and put almost every extra penny we had into getting out of debt.

We didn't get as crazy as they did at the end, but I do admit we moved our saving up several notches as we got closer to the goal. Somehow being close enough to see the end in sight motivated us more and more to get the mortgage paid off NOW!

The piece ends with the following:

Not having a mortgage payment has freed us to continue to save aggressively toward other goals, increase our spending in areas that really matter to us, and give generously to needs in our community and around the world.

We've found this to be true in our lives as well. Once you are completely debt free you are really FREE. You can substantially increase your savings AND giving and still have plenty left over to enjoy.

10 Inexpensive Ways to Boost House Value

This Old House lists 10 inexpensive ways to boost your house's value. They do it by getting suggestions from real estate brokers recommending what sellers can do to spruce up their homes (for sale) without spending a ton of money. But really, these tips will work whether you're selling your home or simply want it to look nicer. Here’s their list:

1. Create Space.

2. Prune, Limb, and Landscape.

3. Let in the Light.

4. Don't Put Off Care and Maintenance.

5. Go Green.

6. Home Begins at the Front Door.

7. What's Under Your Feet?

8. Easy Bath Upgrades.

9. Neutral Wall Colors.

10. Remove the Question Marks from Your House.

It's a good list IMO. Here's my take on these ten:

1. We could probably remove a wall or two if we wanted, but I'm not sure we want to -- or that it would be that inexpensive. The #1 candidate for such a change would be to knock down the wall between our dining room (which we now use as a school room) and our kitchen, making our kitchen much larger. We'd also need to change the flooring so the two matched (now one is tile and one is carpet). But I like it separated and while the kids are still in school, we need the area set apart.

2. We had a couple trees and a big bush removed two years ago. They had all been planted 20 years ago and were now too close to the house for the size they were. Two of them were up against the house and were always a battle to keep off the house. One was "the bush that ate the garage" -- it was so big it made it difficult to get into one side of the garage. Cutting them all down made a HUGE, positive difference in how the house looked.

3. One advantage we have lighting-wise is that our home has three skylights -- one in our bedroom, one in the kids' bathroom, and one in the living room. The skylights have their own set of challenges in a climate that gets a good amount of rain and snow, but they let in so much light they are worth the extra effort IMO. We had the opportunity to have them covered over when we had our roof re-done a few years ago and we opted not to -- they are just that valuable to us. That said, the rest of our lighting could use some work as I think our house can be dark in a few areas.

4. We're generally pretty good on maintenance as we want our stuff to last as long as possible (so we take care of it.)

5. The "green" tradeoff is the higher costs of the new system now versus the cost savings later. We've done pretty well since we replaced our furnace and that is to be expected. But investing in something like solar panels would be a whole different story from a cost/benefit standpoint (especially where we live).

6. We got a new door almost two years ago. The house does look better both inside and out, but I wouldn't say the change is gigantic. And the door was expensive, so it's probably not going to give you a quick payback (we got ours for privacy/security as much as we did for looks.) We also had our concrete steps in front sprayed with textured material several years ago. It turned the bland-looking concrete into what looks like a nice bricked set of stairs. Finally, we pulled out a large juniper bush in front (by the door) several years ago and I replaced it with a rose garden. I regularly get compliments throughout the summer on how nice my roses look.

7. I'm not sure putting in new flooring would be a good deal if you were selling quickly. I would think you'd need several years of use and then a sale to make the finances work.

8.  I know we could make our bathrooms look 100% better with a few changes. I think I should get on those now so we can enjoy them.

9. I like neutral wall colors anyway, and our house is all neutral. So we'd simply need a touch up before selling. But before I leave this note, let me say that a little bit of paint can make a TON of difference in how a room looks.

10. I have a list of question marks that I've been working on for years. Seems like I just get one done and two more pop up. Isn't that just the life of a homeowner?

I think many of these things are no brainers if you're selling because they are preferred by the majority of people (things like new/cleaner bathroom fixtures and everything working). But some of the others seem like you could be spending money that makes your house less appealing to a large group of buyers. For instance, let's say you add wood floors. Many people prefer carpeting. Or you knock out a wall. Many people like their rooms divided.

My net takeaway is to do with your house what YOU enjoy, as long as you keep it within reason (no black-light paint, rock yards, etc.). Keep everything working and in good condition and take care of the basics (like the trimming outside.) If you do these things, then all you'll need is a bit of sprucing up (like painting) if/when you decide to sell.

Renting is the Path to Wealth

Remember when the conventional wisdom was that buying a house was a cornerstone in a solid financial plan? Well Yahoo begs to differ and says that renting a house is now the path to wealth. Their thoughts:

Examining 250 properties around the U.S., and going through close to 40 client files to project the financial impact of owning real estate versus liquidating it, Arzaga, an adjunct professor in personal finance at the University of California at Berkeley, found that, "100 percent of the time it was better to rent, rather than own."

But not everyone is on board with the analysis:

"To state that owning a home is or isn't a good investment is too simplistic," says Jeffrey Rogers, president and COO of Integra Realty Resources. "It depends. In times of relatively higher rents, low home values, and low interest rates, it makes sense to own a home. But in a reverse market, it wouldn't be economically feasible. Over time, those who purchase in down or flat markets with low interest rates come out ahead."

Of course. Just like every other financial move people can make, there are some circumstances where it works and some where it doesn't. We're trying to find out what's the "best" option for the majority though.

The piece goes on to say that there is a financial benefit to owning a home:

Greg McBride, a senior analyst at Bankrate.com, agrees with one point of Arzaga's. "Home ownership is not so much a creator of wealth as a store of wealth," he says. "The promise of home ownership is that over the long haul, it can rebate many or perhaps all of your costs, unlike rent, which doesn't rebate a dime."

But when they crunched the numbers, this doesn't really work out either:

McBride crunched the numbers in a pre-bubble era (2004) for a home purchased at $200,000 by a buyer in the 27 percent marginal tax bracket. Factoring in a 30-year mortgage, $1,200 in annual home insurance, closing costs of $5,500 and maintenance costs of $100 a month, along with property taxes, he calculated that it would take a selling price, 10 years later, of $395,404 just to break even. His conclusion gave Arzaga's view credence: "Homeownership may not be the moneymaker you think it is."

Here's my take:

• I'm not sure that home ownership really was ever the path to wealth. People may think it was, but I'm not sure it actually was.


• Sure, some people have made out well with real estate. I have one friend who used to tell me that he had made good money off every home he had sold. That's why he owned a very expensive home now -- he KNEW he could sell it for much more than he paid for it. He was counting on doing so as a major part of his retirement plan. In fact, he used to deride me saying things like, "I know you don't believe in buying expensive homes as investments, but it's always worked for me." Then the recession hit and now it's worth less than he paid. Ooops.


• One thing I think home ownership does do financially is that it forces people to accumulate an asset. Let's face it, left on their own, most people would spend every dime they have and not have anything to show for it 30 years down the road. Buying a house forces them to pay it off and to ultimately accumulate an asset. Sure, it's not the best way to save that money, but it's better than nothing. And which would you rather have at the end of 30 years, a $200,000 asset or memories of a lifetime of useless purchases?


• There are factors other than costs to factor in, of course. These include pros and cons for both owning and renting.


• I haven't rented since I was just out of grad school. Same for my wife. We've always owned -- first condos, then a series of homes. We lost money on our first home since we bought and sold it in less than a year. We made good money on our second home ($30,000 or so even after selling expenses) because it was in a growing and popular area (FYI, we lived there five years.) Our latest house is probably worth $20,000 or so less than we paid for it. So overall, we're at roughly a break-even on the house buying front.


• While I do count our house in our net worth numbers (it is, after all, a paid off asset), it's a small portion of our total net worth. I know many people where their house is a majority or even all of their net worth, and we're nowhere close to this.

How about you? What's your take on this issue?

Good Advice from FMF Readers

There have been several insightful comments lately here at FMF on a variety of topics. Since I know that everyone doesn't read all the comments in every post, I wanted to call these to your attention so you didn't miss them.

The first is from Apex and was left on my post titled Six Steps to Making a Successful Low-Ball House Offer. His thoughts:

The first thing to understand is what a lowball is. Lowballs are only possible if the listing price is too high. You can rarely buy a property for considerably less than market value, only for less than the irrational price the seller wants. If comparable properties are selling for 200k and you think you can convince someone to sell you theirs at 160K or even 180K pray tell what amazing powers of persuasion and hypnotization you have that would convince any sane person to sell to you for that price? Most sellers think their property is worth more than market, not less. Along those lines a better strategy is to try to find properties that are priced closer to market than to try to lowball properties that are considerably overpriced. Paying sticker is a good deal if the sticker is right.

The second thing to understand is that you can't reason with irrational sellers. Very few of the things on this list will do you any good with an irrational seller. Someone asked about tips for dealing with an irrational seller. Here it is, find another seller.

The things on this list are decent but if your goal is to purchase for less than ask then there is really one item that is most important and it's not on this list. That item is time on the market.

Sellers pick a price for a reason. The reason is often entirely invalid but they don't believe that. Only time will show them that their price is wrong. The longer a property has been on the market the more likely it is that the seller will realize it is mis-priced and be willing to accept lower offers. This is of course no guarantee with an irrational seller but it is the number one indicator to determine how much below ask you can offer.

If it is a bank owned foreclosure property time on market is almost the only thing that matters. Banks are basically computerized in this respect. You can watch them drop the price on a schedule until they find the price at which the market will bring in buyers.

There is one other thing that can get a lower priced offer accepted, perhaps even below market. That is if you find a seller who is desperate. Perhaps someone going through divorce, or who needs cash to save a business that is squeezed or some other personal problems that require cash. If someone is desperate they are going to sell quickly because they need to. This is the only situation where someone is going to sell to you drastically below market. Why else should someone sell to you considerably below what other houses are selling for. If you think you can purchase a property far below market value you better be willing to offer on 100 houses to find the one seller who is desperate or get prepared to be regularly disappointed.

Drastically below market deals only happen on late night real estate shark commercials. And none of those are real.

As many here know, Apex knows real estate quite well. His advice is to be especially listened to in this area and I think the above is GREAT counsel for those looking to get a "deal" on real estate.

The next comment was left by Alex on my post titled Another Plug for the Thank-You Note. His comments:

As a hiring manager, I agree with mdb's comment. Thank you notes typically come well after I've made a decision.

The biggest mistakes I see candidates make in an interview?

1. Show up late for the interview (about 50% of all candidates make this mistake).
2. Criticize a previous employer.
3. Fail to bring a "leave behind" such as a resume to share.
4. Appearing disinterested. They either don't listen to/answer the question being asked, talk too long, or speak over the interviewer.
5. Appearing underprepared or on the interview circuit. They don't research the company.
6. Overly nervous or body language that lacks confidence.

If you can avoid these mistakes, you'll have a good shot at the job. After all, to make it to the interview, you've already passed the paper cut for qualifications -- the interview is essentially a manners test.

A couple thoughts:

• He and I disagree on the usefulness of the thank-you note. I think this is highly dependent on the type of job you're looking for. If it's very entry-level, then the hiring decision most likely will be made before a note can get through the mail, so perhaps an email is called for. But at higher levels, the hiring process often drags on a looooong time (believe me, I know) and there's plenty of time to mail a note. In addition, a thank-you at a higher level demonstrates a level of care and follow-through that you'd expect of a manager or executive.


• Everyone should note and avoid the mistakes he lists. Really, this stuff is a lay-up. Be on time, be prepared, and present yourself well and you'll have a great shot at the job.

The next two comments came from my post titled Four Reasons Resumes are Rejected.

The first is from Walden:

I am a recruiter and I review hundreds of resumes each week. I would absolutely agree with all of the above points. If I had to boil it down even further, I would say the top 2 reasons I reject a resume is 1) not telling me right away why you are right for this job, and 2) grammatical/spelling errors.

I'm busy. The hiring managers I work with are busy. If I have to comb through your resume looking for related experience or qualification ABC, forget it. I don't need a long cover letter, but putting a one or two sentence "Professional Summary" at the top of your resume detailing what skills/background you have that are a fit for my job is priceless. Then, spend a little time highlighting applicable experience from your recent positions, do a spelling/grammar check, then do ANOTHER spelling/grammar check, and send it off!

My comments:

• I don't like the cover letter or summary on a resume because it's fluff IMO. I'd prefer that more time and space is spent on work experience. I can tell if you're right for the job based on what you've done and accomplished, I don't need you summarizing your career. Then again, Walden is a recruiter and I am not, so maybe it's better to listen to him. ;-)


• Got to agree that everyone looking at a resume is BUSY. That's why the resume needs to sell, sell, sell (with good accomplishments all over it) from the get-go.


• 100% agree on the spelling. Have a few friends look over your resume before you send it off.

The next is from texashaze -- and it reinforces much of what we've already covered:

We're always interviewing and hiring. Cover letters are never looked at and in fact they aren't even given to us by our screeners/HR. Walden provided a good tip to put 1 or 2 sentences on top of your resume. I always read those and rate them high. Also anything over 2 pages is too much. Finally write your resume to the job. Some resumes I get don't even relate to the position.

I know there have great comments before and since these were made, but I wanted to at least select a few to show you what great and knowledgeable readers we have here at FMF. And why you should always read the comments -- they are often better than the posts! ;-)

Six Steps to Winterizing Your Home

US News lists six steps to winterizing your home as follows:

• Reverse ceiling fan rotation.
• Inspect your furnace.
• Insulate water pipes.
• Seal cracks in windows, doors, and ducts.
• Store summer tools and prep winter ones.
• Stock up on supplies.

Here's how I handle these:

• I know that you can reverse ceiling fans and they supposedly blow warm air down on you, but the breeze they create make them seem cold to our family, so we skip this one.


• We have our furnace checked once a year -- in the spring -- so they can check both the heat and cooling at once (FYI, this is what the company recommended -- doing it at once rather than two separate trips -- when we bought our new furnace a couple years ago.)


• Not sure what our status is on the water pipes...


• I need to get the caulk out sometime soon since I haven't done this in a few years. One thing we did do that eliminated a HUGE draft was we got a new front door last year. It works like a dream in keeping the outside temperatures outside.


• We've put away all the summer tools (like rose clippers, lawn mower, hoses etc.) and now have the winter tools (snowblower, shovels, roof rakes, etc.) ready to go. (And yes, there are such things as roof rakes.)


• We've also stocked up on supplies like windshield wiper fluid (seem to use a lot of this in the winter), salt, and so on.

In addition to these we've gotten the outside of the house ready for winter by covering the roses with dirt/mulch (I have it down to a system and haven't lost a rose bush yet), removed a small (6 inches) fence around the roses so it's easier to blow snow off the driveway, put an insulator on outside faucets, brought in deck furniture, and cleaned out gutters (from the trees shedding leaves.)

I'm not a big fan of winter but the one good thing about it is that there's a lot less yard work! :-)

Have you prepared your home for winter?

Six Steps to Making a Successful Low-Ball House Offer

Smart Money lists six steps to take to make a successful low-ball offer on a home as follows:

1. Understand the market
2. Pick the right real-estate agent
3. Back up your price
4. Know what you're willing to pay
5. Make a clean, easy offer
6. Be smart about a cash deal

I have to say that this is a GREAT list IMO. Much of it came in very handy while we were trying to buy a home in 2008 (we actually had an offer accepted but the inspection ultimately caused us to back out.) That said, I'd offer these comments to supplement what they say:

• Just because you know the market and make a fact-based offer/argument, don't expect the seller to see your side. He will often have reasons why his property is worth more than what comparable homes have sold for (better location, newer construction, etc.) And if he doesn't, he can simply be irrational (which many people are when it comes to selling their home) and just say "no."


• I have to second the real estate agent suggestion. Most agents play the middleman -- they want to get a deal done and thus will work to make you compromise what you really want. Our agent was like this. It's waaaaay better to get an agent that truly is your representative and is willing to work WITH you (rather than against you in some cases) to make sure the purchase is a success.


• There's a huge temptation to fall in love with a place and go over budget when you buy a home. Don't do it or it could cost you a fortune! Paying 10% extra for a candy bar is not so bad, but paying 10% extra for a house is a huge amount of money!!!

I know that several of you who read FMF are regular real estate buyers/sellers. Are there any other tips you have for the rest of us?

Is My House an Investment?

The following is a guest post from Marotta Wealth Management.

Just because something costs a lot doesn't mean it is an investment. An investment is something that pays you money.

For most families the largest purchase they make will be their house. It is crucial to understand how to consider real estate holdings in every aspect of wealth management, from asset allocation to retirement planning.

An investment is something that pays you money. Therefore the house you and your family live in is not an investment. Neither is the vacation home you rent occasionally. Nor that piece of land next to your house you bought to preserve your view. It is human nature to justify a purchase by calling it an "investment," but if it doesn't pay you money, it shouldn't be treated as an investment in financial planning.

Historically, equities appreciate at a rate of about 6.5% above inflation. If inflation has historically been 4.5%, equities average about 11%. Equities include stocks, stock mutual funds and stock exchange-traded funds (ETFs). Your portfolio should be invested mostly in equity investments to appreciate at a rate greater than inflation.

Fixed income is more stable, but averages interest payments of 3% over inflation. If inflation averages 4.5%, fixed-income investments average 7.5%. Fixed income includes bonds, bond mutual funds and bond ETFs.

Real estate as an investment falls somewhere between stocks and bonds. On average commercial real estate produces a real return of about 4.9% over inflation. If inflation averages 4.5%, commercial real estate averages 9.4%.

Commercial real estate as property with no income does not appreciate at the rate of inflation. It actually depreciates against inflation by about 1% a year. Fortunately, it should produce 5.9% in profit to overcome this depreciation and produce a real return of about 4.9% over inflation.

Handling commercial real estate privately requires more work. If your commercial real estate isn't generating a lot more income than it costs to maintain it--including depreciation--it isn't pulling its weight. Only if it can produce significant income and grow at a real return of 4.9% over inflation will a $100,000 investment in real estate grow to $331,000 after 25 years.

Similar equations can be used for residential real estate. On average it produces slightly less income, giving a real return of 4.1% and growing to have a buying power of $273,000. Obviously all real estate is subject to the increasing desirability of the area where it is located. Some excellent school districts have experienced appreciation significantly greater than inflation. But many rural communities have barely kept up.

These historical averages provide benchmarks as a way to judge the investment worthiness of a particular piece of property. If you own a $300,000 rental home, you should expect to average at least $3,000 each year in repairs and upkeep. One year it might be lower only to have major bills the next. Your benchmark is a real return of 4.1%. After repairs and all other expenses, you should have a profit of $12,300, or 4.1% of your investment. That means you have to have a profit of at least $15,300 (5.1%) or more for your investment to pay you the appropriate amount.

Real estate that pays you appropriately can be considered an investment for the purposes of wealth management. But you need to run it like an investment and track your return after all of your expenses.

This analysis helps explain why property that you do not rent is not an investment. Every $100,000 of equity put into property that lies fallow costs you $1,000 in expenses just to keep up with inflation. And although keeping up with inflation is good, without the 4.1% income there is no way your $100,000 investment will grow to have the increased purchasing power of $273,000.

In financial planning, therefore, we consider fallow property as simply keeping up with inflation and holding its purchasing power. In reality it deteriorates about 1% a year, but we assume your costs of upkeep are factored into your standard of living expenses. Whenever you decide to sell fallow property, that money can be invested either in bonds earning 3% more than inflation or stocks earning 6.5% more than inflation.

A family's home, however, is not even worth that much. Some couples sell a large expensive home, purchase a smaller house and invest the difference. Many believe they will, but when the time comes, their downsized house is so much nicer that little is left over to invest.

Additionally, for many couples the value in their home is used as equity toward an assisted living arrangement. The larger their home, the more expensive the retirement community they buy into. For these and other reasons, we usually do not assume that the equity in a family's home will be available during retirement.

To reiterate, just because something costs a lot doesn't mean it is an investment. Investments should appreciate at a rate that grows faster than inflation and gains purchasing power. And spending your money on noninvestments can jeopardize a plan to reach your goals of financial freedom. Investments should work for you, paying you money that you can spend or reinvest elsewhere.

The Best Spending Decision Ever Made

Sound Mind Investing author Matthew Pryor talks about the best spending decision he and his wife ever made. He begins with this story about how banks were dealing with them when they were looking to buy a house:

Lenders were asking, "How much house can you afford?" with the implication being, however much you can afford is what you should buy. This was and still is the WRONG question to ask.

But they didn't borrow the maximum amount lenders were willing to give them. Instead, here's what they did:

We asked not what could we afford, but what could we spend and still be in line with accomplishing our goals. So we turned down bigger and nicer houses in bigger and nicer neighborhoods. Instead, we found a great little house in a great little neighborhood that allowed us to work toward our stated goals. We bought a house that we could afford on just my income because that was the single biggest factor in allowing us to work towards ALL of our stated goals.

This is absolutely the right way to think about buying something so large (and really, buying anything at all.) More on that in a moment..

He then details why this was such a great move for them:

And why was that the best spending decision we've ever made? Because literally two hours before the closing on our house, I lost my job. Two hours and totally out of the blue! Just like that, our income was cut by about 40%. And it would stay that way for the next nine months, until I came back to work for Sound Mind Investing in 2004. But we would be okay on just my wife's salary because we bought the right amount of house.

Why else was it good that we bought what we did? Because it allowed Kim to become a full-time stay at home mom in the summer of 2006.

Why else was it good? Because we were able to get Jordan into the school we wanted.

Why else was it good? Because we eliminated all of our debt (minus the house itself) while in that home.

I'm not sure if it's the case today or not (perhaps the economic meltdown have buyers and lenders thinking more clearly these days), but "back in the day" (aka five years ago or more) it was quite common for buyers to stretch themselves to the point of breaking to borrow as much as they could -- so they could get the "best" house they could -- and lenders were willing to give them the money for it. Then, if everything went perfectly right financially (which it never does) for the next 30 years, they would be able to pay off the home. Guess what happened to those people when they became unemployed, as so many have? Yep, it's not pretty.

Instead, the better way to buy a home is the way Matthew describes above. It's not to have the bank tell you what you can afford to borrow, it's for you to sit down, do a budget, and determine what you can borrow based on what you want to do with your life/money. It's a key part of my formula for buying a house and was a vital part of us being able to pay off our mortgage many, many years ago.

The alternative, especially these days, is borrowing to the max and being on the edge of the financial knife -- not a good way to live IMO.