For those of you who own investment real estate and have been dubbed “Landlord”, I share with you the absolute worst case scenario of Buy & Hold real estate investing if you’ve bought properties with good margins. Note: although I live in Houston Texas and wholesale great Houston investment properties, most of my real estate holdings are in my hometown of Columbus Ohio. If you are interested in more info on either location, I can help you out.
Last year I changed property managers because the previous manager just wasn’t cutting it. The new manager came in, collected some late rents, and kicked out a couple of tenants that needed to go. Out of my 18 investment properties that I am keeping to build long term wealth for myself, 11 of them were occupied, and 2 of those have slow paying tenants. For the first three months after they took over I had $1,000 more in expenses than I did income due to all of those vacant houses. I didn’t have a job (Just Over Broke), and I do like to eat something other than instant noodles.
So, how did I survive? Well, it’s quite simple; I had a cash reserve built up from the previous months and years of investing just in case the “worst case scenario” of a bunch of units being vacant all at once happened. My cash reserve is enough to cover all expenses on all of my units for 3 months, and my own personal living expenses. Without this, I would have been exactly where a lot of other less educated investors were; in foreclosure.
Having a good cash reserve is paramount to your Buy & Hold real estate investing success. Without it, a couple of bad months can wipe you out…and don’t expect the federal government to come in with a $700 billion bailout for you. You will be just another bad real estate investing story.
We’re all in this together!
P.S. Even though my actual cash flow was negative by about a grand per month for 3 months, I still made a small profit since more than a grand of principal was being paid down on my mortgages. My property manager found tenants for 2 of my houses that moved in on the 1st of the following month, and filled a couple more of my properties the month after. Once all the units were filled again, cash flow was around $3,000 per month on the positive side after all expenses.
P.P.S. When bought at the right price with the right terms, even the worst market and economy can’t stop you from succeeding as a Buy & Hold real estate investor.
Are you about to start investing in real estate? Or perhaps you’ve already put your toe in the water but want to learn more. Here is an overview of the factors you need to take a look at in order to project your potential return on an investment.
- Purchase price – obviously, the amount of money you put out for the property is significant in determining your investment outcome.
- The annual appreciation rate at which you expect the property’s value to increase.
- How many years you expect to hold the property. Combined with the 2 figures above, this will enable you to estimate a future selling price.
- Number of rental units, and rent you expect to receive from each unit.
- Annual rate of rent appreciation.
- Expected unoccupancy rate – it’s important to remember that tenants come and go, and will occasionally leave you with empty rental units. It’s best to plan that into your projection.
- Any miscellaneous revenue you anticipate (laundry facilities, etc.), and the rate at which you expect those revenues to grow.
- Property management fees. Even if you expect to manage the property yourself, it’s best to budget in an allowance for professional property management. First, this rewards you for the time and effort you invest. Second, it ensures that you are covered if for some unanticipated reason you need to turn the management over to a pro at some point in the future.
- Last, but not least, you need to know your opportunity cost, something that big investors would call the ‘cost of capital’. For example, if you can earn 5% by keeping your money in the bank, you’re going to want a lot more than 5% for taking on the risk and time investments required by a rental property!
- Annual operating expenses, and the rate at which you expect those expenses to increase over your term of ownership.
- Property taxes and rate of annual increase.
- Insurance and rate of annual increase. It’s critical to insure your substantial investment!
- Any miscellaneous expenses, and rate of annual increase.
- Depreciation expense. To determine this, you’ll need to estimate the building’s assessed value as a percent of the total purchase price.
- Your annual capital investments in the property. You were planning to budget on capital improvements, weren’t you?
- Downpayment – how much cash are you putting in upfront?
- Bank fees – how many points do you expect to pay, and what closing fees do you expect to incur if you will putting a mortgage on the property?
- What mortgage interest rate do you expect? And how long will the payback period be?
Now that you’ve got all the numbers laid out in front of you, you ‘just’ need to build a financial model which will allow you to project cash flow throughout your ownership term, and then use time value of money calculations to create a present value of those flows. Compare the present value of your future cash receipts against the amount of cash you will outlay upfront. If it’s greater, congratulations- you have positive Net Present Value, and this property looks attractive. If the result is negative, it’s a red flag– you need to take another look, because this may not be a good deal for you.
The obvious comment you might have is… “This all sounds awful hard! Aren’t there tools which can help me?”
The good news is that there are! In fact you can use an online investment property calculator which will do all of the heavy calculating for you. You simply plug in the numbers, and review the results. Now THAT’s some smart investing!
Our company gets many calls from reluctant condo investors and preconstruction contract owners that were looking to cash in on what appeared to be easy money. The client wants to know “What should I do?”
While each situation is unique, in general the decision can be crystallized down to the present value of future cash flows. In other words, translate each strategy into a series of inflows and outflows today and in the future and discount each cashflow to the present using an appropriate discount rate to come up with a net present value for each scenario. This combines time value of money and decision tree concepts and it helps convert an emotional decision into a rational financial decision.
Let’s look at the easiest strategy to analyze – Walk Away. You are essentially locking in a loss of your initial investment, not to mention the possibility exists that the mortgage company may come after you anyway if the sale of the property does not cover their mortgage balance. It is an undesirable strategy to put it mildly and the choice of absolute last resort.
Without knowing your personal situation, I can tell you that there are far more effective options that should be explored that will help alleviate your situation. Please contact us for a no obligation free consultation and we’d be glad to explore the best options with you.
2. Sell the Property – You may feel that you have to sell today. The negative media and the overhyped real estate bubble contribute mightily to investor psychology today. Not to mention the hassles of being a landlord. Or getting the unit rented while attending to your million other tasks and your job.
Maybe the property is significantly negative cash flow and the monthly loss is bleeding your finances and savings. You feel you are diving into a money pit and your net worth is plummeting. Here’s how your cashflows line up – if you’re in a hot market, expect to take a significant discount to fair market value in the price you get. In other words, lock in a 10-20% reduction in the price you may get if you decide to ride out this correction.
A word about cycles. At the top of a cycle, things are rosy and projections are that prices will continue to rise indefinitely. We saw that last year. Similarly, today it is difficult to imagine that prices are ever going to rise again and real estate may stay depressed for many years to come. The reality is somewhere in between. Prices will bounce back, it is a matter of when, not if. Given the negative sentiment, we’d venture to say that we’ve already seen the worst of the correction.
The Sell Your Property strategy also has an element of hope. There is no guarantee that you can sell even if you want to desperately. The reality of selling has to do with how low you are willing to bring your price. But also think about this, in the last correction Californians that sold their properties near the bottom lived to rue the day as property values exploded over the past 10 years, rising roughly 2-3 times in that time period.
3. Final Option – Hold & Maximize – When considering a hold strategy, the investor makes the assumption that the market will get better soon. Most experts predict that the current inventory glut will take until Q4 2007 to get to a normal market.
How long you have to hold will depend on how well you bought. The old adage in real estate is that the profit is made on the purchase, not on the sale.
Alongside the hold option, you need to get a financial professional to review your financing for the property. Can you cash out equity, lower your interest rate, defer interest on your mortgage? Each would help lower your monthly outlay. Our company has investor programs that very few other firms can provide. And if we can’t help you, we are tied in to a national network of investor loan consultants that we are certain can.
Secondly, your hold decision depends on demand for real estate in the location you purchased and the inventory situation. Are buyers moving to the area, are incomes rising, is the rental market strong, is there job growth and what is the rational expectation for the market?
If you want a thorough and honest review of your particular situation, contact us. We can help you make a rational decision and help improve your financial situation. If you are in financial dire straits, contact us immediately. We can help you devise a strategy that will not only protect your investment, but also position you for a brighter financial future.
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So… You may ask yourself, why should you buy or invest in real estate in the First Place? Because it’s the IDEAL investment! Let’s take a moment to address the reasons why people should have investment real estate in the first place. The easiest answer is a well-known acronym that addresses the key benefits for all investment real estate. Put simply, Investment Real Estate is an IDEAL investment. The IDEAL stands for:
• I – Income
• D – Depreciation
• E – Expenses
• A – Appreciation
• L – Leverage
Real estate is the IDEAL investment compared to all others. I’ll explain each benefit in depth.
The “I” in IDEAL stands for Income. (a.k.a. positive cash flow) Does it even generate income? Your investment property should be generating income from rents received each month. Of course, there will be months where you may experience a vacancy, but for the most part your investment will be producing an income. Be careful because many times beginning investors exaggerate their assumptions and don’t take into account all potential costs. The investor should know going into the purchase that the property will COST money each month (otherwise known as negative cash flow). This scenario, although not ideal, may be OK, only in specific instances that we will discuss later. It boils down to the risk tolerance and ability for the owner to fund and pay for a negative producing asset. In the boom years of real estate, prices were sky high and the rents didn’t increase proportionately with many residential real estate investment properties. Many naïve investors purchased properties with the assumption that the appreciation in prices would more than compensate for the fact that the high balance mortgage would be a significant negative impact on the funds each month. Be aware of this and do your best to forecast a positive cash flow scenario, so that you can actually realize the INCOME part of the IDEAL equation.
Often times, it may require a higher down payment (therefore lesser amount being mortgaged) so that your cash flow is acceptable each month. Ideally, you eventually pay off the mortgage so there is no question that cash flow will be coming in each month, and substantially so. This ought to be a vital component to one’s retirement plan. Do this a few times and you won’t have to worry about money later on down the road, which is the main goal as well as the reward for taking the risk in purchasing investment property in the first place.
The “D” in IDEAL Stands for Depreciation. With investment real estate, you are able to utilize its depreciation for your own tax benefit. What is depreciation anyway? It’s a non-cost accounting method to take into account the overall financial burden incurred through real estate investment. Look at this another way, when you buy a brand new car, the minute you drive off the lot, that car has depreciated in value. When it comes to your investment real estate property, the IRS allows you to deduct this amount yearly against your taxes. Please note: I am not a tax professional, so this is not meant to be a lesson in taxation policy or to be construed as tax advice.
With that said, the depreciation of a real estate investment property is determined by the overall value of the structure of the property and the length of time (recovery period based on the property type-either residential or commercial). If you have ever gotten a property tax bill, they usually break your property’s assessed value into two categories: one for the value of the land, and the other for the value of the structure. Both of these values added up equals your total “basis” for property taxation. When it comes to depreciation, you can deduct against your taxes on the original base value of the structure only; the IRS doesn’t allow you to depreciate land value (because land is typically only APPRECIATING). Just like your new car driving off the lot, it’s the structure on the property that is getting less and less valuable every year as its effective age gets older and older. And you can use this to your tax advantage.
The best example of the benefit regarding this concept is through depreciation, you can actually turn a property that creates a positive cash flow into one that shows a loss (on paper) when dealing with taxes and the IRS. And by doing so, that (paper) loss is deductible against your income for tax purposes. Therefore, it’s a great benefit for people that are specifically looking for a “tax-shelter” of sorts for their real estate investments.
For example, and without getting too technical, assume that you are able to depreciate $15,000 a year from a $500,000 residential investment property that you own. Let’s say that you are cash-flowing $1,000 a month (meaning that after all expenses, you are net-positive $1000 each month), so you have $12,000 total annual income for the year from this property’s rental income. Although you took in $12,000, you can show through your accountancy with the depreciation of the investment real estate that you actually lost $3,000 on paper, which is used against any income taxes that you may owe. From the standpoint of IRS, this property realized a loss of $3,000 after the “expense” of the $15,000 depreciation amount was taken into account. Not only are there no taxes due on that rental income, you can utilize the paper loss of $3,000 against your other regular taxable income from your day-job. Investment property at higher price points will have proportionally higher tax-shelter qualities. Investors use this to their benefit in being able to deduct as much against their taxable amount owed each year through the benefit of depreciation with their underlying real estate investment.
Although this is a vastly important benefit to owning investment real estate, the subject is not well understood. Because depreciation is a somewhat complicated tax subject, the above explanation was meant to be cursory in nature. When it comes to issues involving taxes and depreciation, make sure you have a tax professional that can advise you appropriately so you know where you stand.
The “E” in IDEAL is for Expenses – Generally, all expenses incurred relating to the property are deductible when it comes to your investment property. The cost for utilities, the cost for insurance, the mortgage, and the interest and property taxes you pay. If you use a property manager or if you’re repairing or improving the property itself, all of this is deductible. Real estate investment comes with a lot of expenses, duties, and responsibilities to ensure the investment property itself performs to its highest capability. Because of this, contemporary tax law generally allows that all of these related expenses are deductible to the benefit of the investment real estate landowner. If you were to ever take a loss, or purposefully took a loss on a business investment or investment property, that loss (expense) can carry over for multiple years against your income taxes. For some people, this is an aggressive and technical strategy. Yet it’s another potential benefit of investment real estate.
The “A” in IDEAL is for Appreciation – Appreciation means the growth of value of the underlying investment. It’s one of the main reasons that we invest in the first place, and it’s a powerful way to grow your net worth. Many homes in the city of San Francisco are several million dollars in today’s market, but back in the 1960s, the same property was worth about the cost of the car you are currently driving (probably even less!). Throughout the years, the area became more popular and the demand that ensued caused the real estate prices in the city to grow exponentially compared to where they were a few decades ago. People that were lucky enough to recognize this, or who were just in the right place at the right time and continued to live in their home have realized an investment return in the 1000’s of percent. Now that’s what appreciation is all about. What other investment can make you this kind of return without drastically increased risk? The best part about investment real estate is that someone is paying you to live in your property, paying off your mortgage, and creating an income (positive cash flow) to you each month along the way throughout your course of ownership.
The “L” in IDEAL stands for Leverage – A lot of people refer to this as “OPM” (other people’s money). This is when you are using a small amount of your money to control a much more expensive asset. You are essentially leveraging your down payment and gaining control of an asset that you would normally not be able to purchase without the loan itself. Leverage is much more acceptable in the real estate world and inherently less risky than leverage in the stock world (where this is done through means of options or buying “on Margin”). Leverage is common in real estate. Otherwise, people would only buy property when they had 100% of the cash to do so. Over a third of all purchase transactions are all-cash transactions as our recovery continues. Still, about 2/3 of all purchases are done with some level of financing, so the majority of buyers in the market enjoy the power that leverage can offer when it comes to investment real estate.
For example, if a real estate investor was to buy a house that costs $100,000 with 10% down payment, they are leveraging the remaining 90% through the use of the associated mortgage. Let’s say the local market improves by 20% over the next year, and therefore the actual property is now worth $120,000. When it comes to leverage, from the standpoint of this property, its value increased by 20%. But compared to the investor’s actual down payment (the “skin in the game”) of $10,000- this increase in property value of 20% really means the investor doubled their return on the investment actually made-also known as the “cash on cash” return. In this case, that is 200%-because the $10,000 is now responsible and entitled to a $20,000 increase in overall value and the overall potential profit.
Although leverage is considered a benefit, like everything else, there can always be too much of a good thing. In 2007, when the real estate market took a turn for the worst, many investors were over-leveraged and fared the worst. They could not weather the storm of a correcting economy. Exercising caution with every investment made will help to ensure that you can purchase, retain, pay-off debt, and grow your wealth from the investment decisions made as opposed to being at the mercy and whim of the overall market fluctuations. Surely there will be future booms and busts as the past would dictate as we continue to move forward. More planning and preparing while building net worth will help prevent getting bruised and battered by the side effects of whatever market we find ourselves in.
Many people think that investment real estate is only about cash flow and appreciation, but it’s so much more than that. As mentioned above, you can realize several benefits through each real estate investment property you purchase. The challenge is to maximize the benefits through every investment.
Furthermore, the IDEAL acronym is not just a reminder of the benefits of investment real estate; it’s also here to serve as a guide for every investment property you will consider purchasing in the future. Any property you purchase should conform to all of the letters that represent the IDEAL acronym. The underlying property should have a good reason for not fitting all the guidelines. And in almost every case, if there is an investment you are considering that doesn’t hit all the guidelines, by most accounts you should probably PASS on it!
Take for example a story of my own, regarding a property that I purchased early on in my real estate career. To this day, it’s the biggest investment mistake that I’ve made, and it’s precisely because I didn’t follow the IDEAL guidelines that you are reading and learning about now. I was naïve and my experience was not yet fully developed. The property I purchased was a vacant lot in a gated community development. The property already had an HOA (a monthly maintenance fee) because of the nice amenity facilities that were built for it, and in anticipation of would-be-built homes. There were high expectations for the future appreciation potential-but then the market turned for the worse as we headed into the great recession that lasted from 2007-2012. Can you see what parts of the IDEAL guidelines I missed on completely?
Let’s start with “I”. The vacant lot made no income! Sometimes this can be acceptable, if the deal is something that cannot be missed. But for the most part this deal was nothing special. In all honesty, I’ve considered selling the trees that are currently on the vacant lot to the local wood mill for some actual income, or putting up a camping spot ad on the local Craigslist; but unfortunately the lumber isn’t worth enough and there are better spots to camp! My expectations and desire for price appreciation blocked the rational and logical questions that needed to be asked. So, when it came to the income aspect of the IDEAL guidelines for a real estate investment, I paid no attention to it. And I paid the price for my hubris. Furthermore, this investment failed to realize the benefit of depreciation as you cannot depreciate land! So, we are zero for two so far, with the IDEAL guideline to real estate investing. All I can do is hope the land appreciates to a point where it can be sold one day. Let’s call it an expensive learning lesson. You too will have these “learning lessons”; just try to have as few of them as possible and you will be better off.
When it comes to making the most of your real estate investments, ALWAYS keep the IDEAL guideline in mind to make certain you are making a good decision and a solid investment.
When considering making an investment in real estate, many new investors struggle with what to offer. Part of the challenge for them is deciding what their exit strategy will be. In other words, will they be purchasing the property and then immediately reselling it? Will they sell the contract before they even close? Will they be buying it to rent and hold long term?
Not knowing what you ultimately want to do with the property makes it extremely difficult to structure an offer to purchase.
This is actually a challenge we had when modeling the how to make purchases of real estate in our Learn To Be Rich investment game. Here’s how I handled it.
To simplify the process, we divided purchasing real estate into two major categories: buying for equity or buying for income.
Buying for equity is purchasing the property at a discount from the current fair market value. This is usually when you are buying a house to fix up and resell.
Buying for income is purchasing the property based on the payments and expenses you will incur when you hold the property as a rental. It also includes assessing the income that the property will produce. This analysis is typically used when you will be holding the property as a long-term investment.
By simplifying the process, investors can now decide whether they are buying for income or equity. It makes it much easier to recognize a good deal with this clear-cut criteria.
For example, if an investor is buying based on equity and he wants to make $10,000 on the deal, he can easily calculate what he can afford to pay for the house in order to net that amount in profit.
On the other hand, if an investor is buying based on income and he wants to make $100 per month, it is just as easy to calculate what his payments and expenses will be. By getting an accurate estimate of what the rental income will be, you can then reverse calculate the price you can afford to pay by using current interest rates in order to have the desired monthly payment amount that makes the property cash flow.