As a 16-year active real estate investor, I find that many first-time investors have a bad experience with real estate. Why? I believe it’s because they tend to lead with emotion and start looking at properties too soon.
Picture this: You drive past a blue duplex twice a day with pretty window shutters and pristine landscaping that you’ve long admired. Then one day, you see a “For Sale” sign on the duplex.
You rationalize buying it because the building has great curb appeal; you’re convinced that self-managing won’t be an issue because you always drive past it. Further, real estate seems like a good way to diversify from stocks. You involve an agent. A few months later, it’s yours.
This might work out. Or you might have jumped into a property that produces more monthly expenses than income. To help avoid this, there are factors every real estate investor should consider when they are searching for new property.
Look at the big picture.
- Get clear on what you want real estate to do for you. Do you want income, appreciation, tax advantages or even a lifestyle benefit where you occasionally use the property yourself?
- Find the market that supports what you want. Buying real estate in a city with a declining job market might soon mean that you won’t have a tenant to pay the rent, so research the neighborhood, and seek property where you have a reasonable expectation of high occupancy.
- Hire a skilled property manager. Remember, this is what makes your investment fairly passive. I believe the best way to vet a property manager is through referrals from existing clients. This way, you can learn their communication style, how well they kept up the property and if the home always had a tenant. Although a guitar can produce harmony or discord, it isn’t the guitar’s fault. Likewise, a property can produce either profit or pain based on the performance of your manager.
If you, the market and your property manager all align, I believe you are ready to begin assessing your finances and looking at properties.
Consider the property’s potential financial benefits.
In my experience, an acronym that helps make it easy to remember your operating expenses (except the mortgage) is “VIMTUM,” which stands for vacancy, insurance, maintenance, taxes, utilities and management.
If you seek a passive monthly income, your rent amount minus the mortgage and VIMTUM should be a positive number.
In my experience, to get ahead, you must ethically employ other people’s money. You can utilize outside funding in three ways simultaneously: by using a tenant’s rent as a passive income stream, a bank loan to help you invest and tax incentives to help maximize profits. Once you’ve implemented outside funding into your investment, I believe there are five simultaneous profit centers:
1. Appreciation: Until May, real estate is expected to appreciate at a national average of 4.4%. Let’s say you invested $20,000 in a $100,000 property; it would likely appreciate to roughly $104,000 over the course of a year. This might not sound like much, but consider that your $4,000 gain is based on the $20,000 you invested. You’ve achieved a 4% return on both your $20,000 down payment and the $80,000 you borrowed from the bank. This means the return on your skin in the game is 20%.
2. Cash Flow: In my experience, the best estimate of your property’s rent amount typically comes from a manager, not an agent. Say your monthly rental income (minus the mortgage and VIMTUM expenses) leaves you with just $150 of residual income. This is called “cash flow.” Annually, this is $1,800 of cash flow, which you can then divide by your $20,000 down payment. The result, called your cash-on-cash return, would land at 9%.
3. Loan Paydown: Unlike how you pay down your own principal for your own home, in a cash-flowing rental property, your tenant can pay this for you. With an $80,000 loan, 6% interest rate and 30-year amortization, that’s roughly $900 of your mortgage principal that your tenant pays annually. Divide this by $20,000, and you have another 4% return on amortization.
4. Tax Benefit: Depreciation, mortgage interest deductibility and your ability to pay zero capital gains tax are real, but they can be hard to quantify. In short, depreciation means that a portion of your rental income is sheltered from income tax. With a 1031 tax-deferred exchange, you can defer your capital gains tax infinitely (I’ve never paid capital gains tax). Though this becomes more difficult to measure, your approximate benefit is 5%.
5. Inflation-Profiting: In my experience, even advanced investors fail to understand this. Your mortgage that’s repaid by your tenant is an asset. Just like you wouldn’t keep $80,000 in the bank for thirty years because inflation would erode its purchasing power, oppositely, when you borrow money from a bank, you repay in nominal dollars (the value of the dollar at the time you assumed the loan). As wages and prices escalate over the years, your debt is debased at the rate of inflation, roughly between 2% and 3%.
Adding your total rate of return from your five profit centers equals around 40%.
This is nothing new; it’s just buy-and-hold real estate investing. Risks exist, and you will surely have bumps along the way that could cause you to lose money. We also didn’t account for your buyer closing costs upon purchase; the seller can often help you pay these. We did assume that you made a full-price offer.
I believe external funds should be seen as “good” debt because your payments are outsourced to tenants. Without utilizing any outside funding, your return could erode. Paying all-cash would increase your cash flow, but you would lose leverage, tenant loan paydown, some tax benefit and your inflation-profiting benefit.
Now you know how to “keep score” with your real estate investing. This is important. Many investors are losing when they think they’re winning, and vice versa. When you keep score, you’d better know what and when to buy and sell. It all begins with the understanding that to get ahead, you need to both be strategic and think differently from the herd.