Real Estate Investing: Accept These Truths Before Buying

by FI Fighter on February 10, 2014

in Real Estate Thoughts

hawaii-34

Real estate investing can be a very lucrative game. It’s no secret that real estate has been the vehicle of choice used by so many investors throughout time to help build extraordinary wealth. Land is scarce and finite. And people will always need a home to live in. Housing is a basic necessity for everyone, just like air, food, and water. If you own lots of properties, chances are great that you also collect a lot of rent checks each month.

And rent checks might just be the ticket you’re looking for to help you attain financial independence. After all, what could possibly be easier than collecting income for doing nothing else than renting out an empty building to someone?

But unfortunately, succeeding in real estate investing isn’t quite so easy. If it were that easy, everyone who attempted it would be filthy rich. There are a few catches… and some truths you must accept before getting started.

Maintenance and Vacancy Are Inevitable

The real estate investors who get into the most trouble are the ones who assume that rental property expenses are limited to: principal, interest, taxes, insurance (PITI) and property management (PM). The lazy, or uneducated investor will run spreadsheets with just these numbers accounted for, and assume that their net cash flow will be equal to:

Cash Flow = Rent Collected – PITI – PM

In expensive areas, rents don’t scale with purchase price, so you have to be extra careful when buying. In the Bay Area (early 2014), here’s how a lot of rookie investors get in trouble:

property_bay_area

http://www.redfin.com

san_jose_numbers

An investor who jumps on this deal is probably one who thinks that they can hold out for long-term appreciation gains. The thinking is that things will be ok in the short-term, because the property is still cash flow positive. $77.32/month in cash flow isn’t amazing, but it’s better than nothing, they will tell themselves. And prices will eventually go up, so isn’t it better to buy something now, before the investment ship sails for good?

What the above analysis fails to account for are maintenance (minor repairs, major repairs, upkeep, capital expenditures, rent-ready touch up, etc.) and vacancy (actual vacancy, lease-up/listing fees, etc.) which will invariably come up over time. If you are going to invest in real estate, you must account for maintenance and vacancy because they are unavoidable, and will happen.

Here’s what happens to the returns when you plug in vacancy (10%) and maintenance (10%):

san_jose_numbers2

The numbers look worse now, but are more realistic. Although 10% vacancy and 10% maintenance won’t necessarily reflect true reality (you may get lucky and land outstanding tenants), it’s still worth your while to plug them in, just to see how much wiggle room you have to work with.

The 50% Rule

A good rule-of-thumb commonly used by investors on Bigger Pockets forum is to use the 50% Rule. The 50% Rule estimates that in the long-run, a property will most typically return 1/2 of gross rents.

That is, 50% of your gross monthly rent will be used to pay for your operating expenses due to: property taxes, insurance, HOA, property management, repairs, maintenance, vacancies, lease-up fees, etc.

Operating expenses do not account for debt service. If you have a mortgage, you take the 50% number calculated above, and then subtract the monthly principal and interest payment. What’s left is your net monthly cash flow.

In this example, the returns would look like this after applying the 50% Rule:

san_jose_numbers3

In this example, the 50% Rule looks slightly better than the first example that used 10% for both vacancy and maintenance reserves. Your actual returns will most likely fall somewhere in between these two examples. If that’s the case, from an investment point of view, this looks to be a bad deal.

Maintenance and vacancy must be accounted for! It’s the admission price you have to pay if you choose to invest in rental properties. If the cash flow numbers do not work after accounting for these reserves, it’s a losing investment.

Move on and find something better! This is why I don’t invest in the Bay Area anymore…

Appreciation is a Game of Speculation

If you are considering investing in rental property, the cash flow numbers, with reserves accounted for, must be cash flow positive. And you should have ample margin to spare. That’s the only way to create an adequate safety net, which is an absolute must.

The real estate investor who gets burned bad is the one who invests in properties that don’t cash flow very well, and expects to make their returns strictly through long-term price appreciation.

Although it’s true that appreciation can make you a lot of money, the reality is that no one (unless you have a crystal ball) can accurately predict when the next market downturn will be.

Price appreciation is a dangerous game to be playing! If you play the appreciation game, you really aren’t investing, you’re speculating. You might as well go to Las Vegas and roll the dice, because there isn’t much difference between the two.

Investors who lost properties and went into foreclosure during the subprime housing crisis were the ones who had no cash flow coming in, and couldn’t sell because the their loan balances were higher than their houses were worth.

That’s a double whammy and a situation you never want to find yourself in. You cannot hope to succeed if you have a scenario where your property is both underwater and cash flow negative. Just like with dividend investing, you want to find a stock (house) that will keep paying (feeding) you, regardless of what Mr. Market decides to do. If Coca-Cola (KO) stock loses half its value, you don’t care too much because you know the dividends will keep coming in every quarter. In fact, you’ll probably use the downturn in the market to load up on more KO stock!

The same principles need to apply to real estate investing. When property values get slashed in half, the cash flow needs to keep on flowing. If you buy right, you’ll have enough margin to even lower monthly rent by a few hundred dollars (and still break even), should you absolutely have to resort to that.

Your Real Estate Agent Isn’t Your Friend

My local real estate agent is a great guy. He helped me win some awesome deals, and he’s extremely professional. I would definitely work with him again in the future…

With that said, I learned long ago that my real estate agent is not my friend. My agent has his own agenda, and won’t ever tell me everything I need to know about an investment deal. He will never have my best interest at heart, so I cannot trust him entirely. And unless you are working with a spouse, or close family member/friend (but even those can go wrong!), you shouldn’t trust your agent either.

After the returns in the Bay Area stopped making much sense (mid 2013), I started to question whether or not it would be a good idea to continue looking for local deals. When I ran this thought through to my agent, his advice was to keep looking because something worthwhile was bound to turn up. So, he kept on sending me Pro Formas and analysis sheets which showed sub 5% cash on cash returns. He massaged the numbers to make them look even better, and really just wanted me to keep on buying local properties (of course, so he could keep earning commission). He even offered me the sage advice of investing for appreciation, which he said was all but guaranteed. Hah! Like I didn’t know better…

Finally, I told him I was seriously considering investing into properties out-of-state. My agent scoffed at that idea and told me to my face that I was making a big mistake. He said that there was no better area to invest in than the Bay Area, and that low returns were the new reality. One that all investors would have to accept…

I didn’t listen to him. I revised my plan, and I’m now continuing on the march to early FI without him. It’s nothing personal, but only I will ever have my own best interests at heart.

If A Deal Looks Too Good to be True, It Probably is…

Last night, you came across a new investment property. You ran the numbers on your spreadsheet, and the returns look absolutely amazing! You cannot believe how high the returns came out to be. The property greatly exceeds the 1% Rule. You’re anxious to put in an offer because you don’t think it will last on the market for much longer. Lastly, you reason that because the cash flow numbers look so great, even if you end up having high maintenance and vacancy, you’ll still be ok in the long-run.

Those awesome numbers might look something like this:

Awesome_Deal

A 27.82% cash on cash return. Isn’t that something?!? Even with 10% maintenance and 10% vacancy factored in! If you applied the 50% Rule, you would cash flow $418.17/month, even better. What’s not to like about this deal?

If the deal looks too good to be true, it probably is. Before getting too excited, ask yourself these important questions:

  • How long has the property been on the market for? (If this was indeed a spectacular deal, there’s no way it should still be sitting on the market after six months…)
  • What type of neighborhood are you buying into? (If you aren’t sure, you had better find out first. Ask about crime rates, gang activity, disturbances, etc. A too good of a deal is typical for homes in C-/D neighborhoods. And you want to avoid those at all costs!)
  • What type of jobs are available nearby? What’s the employment rate in this area?
  • How many homes have been sold around this block in the last six months? What are the nearby comps selling for?
  • Is there any reason why you might be getting a special deal? Is it because you are paying all cash? Are you buying from a distressed seller? Are you a real estate mogul who has access to investing in the “fast track” lane? (If the answer is “no” to each question, your special deal probably isn’t so special.)

High-return properties that are worthy investments do exist out there, but the majority of them will turn out to be lemons. If cash flow is extremely high relative to the purchase price, there’s most likely a very good reason why the property is selling for such a low price. Prime real estate does not typically sell for a discount. If you want to invest in a desirable neighborhood with lots of job growth and strong rental demand from qualified tenants, be prepared to pay fair market value. Real estate in the best locations will always be expensive because you’ll be competing not only with other investors, but also homeowners who’s buying decisions are based on emotion, not cash flow.

When in doubt, ask. Network with other investors who are very familiar with where that property is located, and ask them what they think of the property as an investment. Don’t ask an agent. If you can’t find any investors to talk to, make a trip out there and talk with the locals. Go visit the next town over if you have to. If the deal seems too good to be true, you must be extra careful and perform even more due diligence.

No Two Properties Will Perform the Same

One day, you’re browsing the MLS, when you stumble upon what appears to be a pair of killer deals. Located on the exact same block of a wonderful neighborhood, you find a distressed seller who needs to unload some inventory. The absolute gems of the bunch are a pair of single family homes that are both priced well below market value. The two homes are so nice, you would even consider moving your family in to live in them. Since you don’t have sufficient funds to secure both properties, you pass on one of the deals to your best buddy. Since each property passes the eyeball test (inspection, appraisal, etc.), and all other important criteria, you each elect to go through with the purchase.

Ten years later, don’t be surprised if one of you is reaping the rewards of this “killer” deal, while the other person is struggling to break even. Although the properties are mirror images, even purchased for the same price, you can never expect any two houses to perform exactly the same. Real estate always has been, and always will be dynamic in nature. You cannot predict in advance what kind of tenants you will get. You cannot know for certain what type of damages they will do, or how much repair work will need to be made over time. Further, one of you just might get lucky enough to land a tenant who elects to stay for ten years and never misses a single rent payment. Unfortunately, the other person might undergo a string of bad luck and land one bad tenant after another… That’s just how the game goes sometimes. Real estate investing is far from a “slam dunk” guarantee…

All Pro Formas Are Inaccurate and Over-Estimate Returns

If you can’t trust an agent, then you definitely can’t trust a seller, or turnkey provider. It isn’t a bad idea to ask someone for a Pro Forma so that you can have a baseline to help you crunch some numbers. But never take a seller’s Pro Forma sheets to be accurate, because they never will be.

Sellers will always underestimate expenses (insurance, property taxes, even the utility bill if you’re responsible for that) and overestimate return on investment (ROI). Whether it’s cap rate, or cash-on-cash returns, these numbers will never truly reflect your real returns.

So, don’t rely on their numbers. Find out what the real numbers should be, and plug those into your own spreadsheet. For items that you are unsure of, ask around and try to find a reasonable answer. If you aren’t able to do that, then overestimate the expenses to a good degree. Don’t have any confidence in the seller’s numbers, and second guess everything. After you do all that, the numbers still need to work out to your satisfaction. If they don’t, again, move on to the next property. If you end up purchasing the investment property, and the actual returns exceed your estimates over the long-term, more power to you! 🙂

Summary

Investing in real estate can be a good way to help someone build semi-passive income. If you continually buy right, year after year, chances are good that you’ll be able to reach early financial independence through rental properties. During the process of buying, though, you must perform extra due diligence and accept certain truths. For one, vacancy and maintenance must be accounted for in any analysis you do. Next, never assume that any two properties you buy will perform the same, even if they are located next door to each other. Further, you must assess risk and know that if you are going to play the appreciation game, you are gambling on something that may or may not happen in the future. Also, never trust a real estate agent, or a seller’s Pro Forma sheets. Lastly, if a deal sounds way too good to be true, it probably is.

{ 22 comments… read them below or add one }

1 Liam @ HBS Real EstateNo Gravatar February 10, 2014 at 6:47 am

This is an awesome post. I was feeling like a million bucks with one of my properties. I had rehabbed it, rented it and was seeing all the cash flow. I felt like “repair reserves, what do I need them for”? I was about to spend some of that cash on non-repair reserve items and literally two days before I was to do so, a pipe burst and returns returned to average!

FI, you’ve invested in Indy right? Do you mind if I ask a few questions regarding a property I’m considering there?

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2 FI FighterNo Gravatar February 10, 2014 at 9:19 pm

Liam,

Thanks! I hear you on that one. It always feel great when you can get through a month without vacancy or maintenance. With this stuff, it’s just a matter of time though. Sorry to hear about the pipe bursting, but glad you didn’t spend that reserve cash!

Yeah, I do have a property in Indy. Feel free to ask any questions you might have. You can send me a PM as well if you want to go into specifics.

Cheers!

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3 writing2realityNo Gravatar February 10, 2014 at 8:22 am

Hell of a post FI! I agree with everything, especially the heavy questioning of the numbers in any proforma and provided financials. The importance of due diligence cannot, and must not, be understated.

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4 FI FighterNo Gravatar February 10, 2014 at 9:23 pm

writing2reality,

Thanks! Yeah, you have to be careful with proformas, especially if you’re just starting out. Over time, you get a better feel for the numbers and can better gauge what’s realistic, or exaggerated. This especially rings true for out of state rentals since you won’t start off knowing what the property tax rates, insurance, HOA, etc. should be.

To make life easier, don’t trust what the seller is telling you. Assume it to be false and run your own conservative numbers. It’s better to be surprised by performance (in a good way) than disappointed by lackluster results.

Take care!

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5 EvanNo Gravatar February 10, 2014 at 8:37 am

Why use a real estate agent at all? You do the research yourself anyway, no?

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6 BrettNo Gravatar February 10, 2014 at 9:04 am

Agents can be useful if you’re purchasing via MLS listings instead of going FI’s route and purchasing turnkey.

I use a real estate agent to send me filtered MLS listings that fit a certain criteria that I establish (I get about three emails a week that fit into my model). I look through them to find the properties that I like best (minimal rehab, low price, and decent area), and then contact her when I am interested in one. Like all professionals (especially those in the service industry), you need to know your client and what their needs are. Not all agents will try to give you a hard sell, and not all agents will try to be breathing down your neck like a used car salesman.

With regards on where to purchase, it seems obvious (based on FI’s posts) that making money in high priced areas like the Bay Area is probably a losing proposition when real estate prices normalize. That being said, purchasing in lower priced areas has its drawbacks, too. Where I live, it makes much more financial sense to own rather than purchase (I rent single family homes out at ~$950 that cost me half that in PITI). As a result, you will typically find that QUALITY renters don’t last more than a year or so because they are looking to purchase their own home in due time.

The caveat in this day in age is that we live in a time in which many former homeowners were recently foreclosed on because they overextended themselves. That means the getting is good for landlords because there are a lot of renters in the market, and demand for rental homes is at an all time high.

There will be a time (I believe in 5 years or so) that those former homeowners will once again begin to enter the market to look for own their own property, and landlords will need to compete more aggressively for renters.

I guess that shows another reason why purchasing single family homes (or even duplexes) is a sound alternative to purchasing multi-units: When buying and owning becomes in vogue again, you can sell your rental home at a tidy profit.

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7 FI FighterNo Gravatar February 10, 2014 at 9:29 pm

Brett,

Thanks so much for taking the time out to write such a detailed, excellent reply!

Yup, completely agree. If you are a buyer, there’s no reason not to use a real estate agent b/c it’s the seller who will be paying for the commission. Gaining access to the MLS can help you find more deals… and in a hot market, any advantage you can get helps. I found it especially helpful to have an aggressive agent by my side b/c he was very good at helping me get access to tour the properties, before the open houses became available to the public. This can help you put in a strong offer, and possibly win the bid before the open house takes place. I’ve seen this happen before!

Also, a good agent will help double check things and make sure you get all the disclosures, forms squared away. When I closed my two local properties, I let my agent take care of most of the paperwork. This helped ensure we were able to close on time, within 30 days. In a hot market like the Bay was in 2012, you had better close in 30 days, because if you didn’t, the seller would probably look for a way to get out of contract… Prices were rising that fast.

Great point on the rental/buying dynamic going on right now… Things will get interesting over the next few years. The reasons you listed are also why I’m a fan of SFH in good locations… Easy to sell, and easy to rent out.

Cheers!

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8 BrettNo Gravatar February 11, 2014 at 9:24 am

Definitely need an agent that knows what they are doing as far as contigencies and disclosures…..finding that out now as I attempt to venture into my first multi-unit/commercial space. A good agent will need to know how to write pro-rated rents into the offer, and how to handle existing renters and security deposit accounts, existing commercial equipment, etc.

You also don’t want an agent that isn’t looking out for YOUR best interest instead of their own. I recently had an acquaintance place an offer that wasn’t contingent on financing. When they couldn’t secure financing, they lost their 5% earnest $$…..yikes.

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9 FI FighterNo Gravatar February 11, 2014 at 9:43 am

Brett,

Yup, a good agent makes a huge difference. Finding one that looks out for your best interest… I’m sure they are out there, but good luck, they aren’t easy to find! 😉

Great point. I also make sure my offer is contingent on financing, appraisal, and inspection. Although I was willing to waive inspection on one property b/c it was short-sale and I knew I must win that property (located in a fantastic location). And you should always double check to make sure your earnest money is refundable! Very important!

Cheers!

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10 Dave @ The New York BudgetNo Gravatar February 10, 2014 at 1:50 pm

Another great post – definitely learning a lot from your real estate series!

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11 FI FighterNo Gravatar February 10, 2014 at 9:32 pm

Dave,

Thanks! Glad the real estate posts have been helpful.

Take care!

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12 EricNo Gravatar February 10, 2014 at 3:24 pm

You are learning grasshopper…

Now that you have sound a sound investing formula, compare it to your existing properties and see if you would have bought them again. You can use 5% as a vacancy expense as you will likely not be vacant for a month a year. Remember, lowering price increases demand. The ONLY reason why people are vacant is their price is too high, or their marketing is too low.

Once you have analyzed your own property’s cash flow, with the new method, analyze what you need to get great tenants. Look at Credit Score distribution and see where your own tenants fall on the scale. 658 is an average credit score for a renter, anything less is a sub-prime renter.

If you are charging too much in rent, you get worse renters. The economic law of substitution comes into play. A renter that will be rejected at most places will pay more for your place, if you take them. And if you take them, you will likely be less profitable even with the higher rent.

A word from an experienced landlord. Section 8 renters are for very experienced, hands on, property managers. Not for the rookies. Most experienced landlords do not take Section 8 tenants.

Good luck with your rentals, and your FI trip.

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13 FI FighterNo Gravatar February 10, 2014 at 9:38 pm

Eric,

Thanks, I’m doing my best to keep learning and progressing as an investor. Yeah, if I go back and run numbers on my first two rentals, the cash flow numbers aren’t very good. They are better than the example I showed above though… And like you mentioned, charging too much for rent can lead to trouble. Both my local properties are renting for under market, which hurts returns, but I was fortunate enough to land excellent tenants who always pay on time, and take great care of the property. I’ll take that trade anyday. Zero vacancy is my main focus right now!

In hindsight, those two deals were the best moves I ever made. Appreciation is speculation, but even back then I was buying mostly for long-term cash flow… Appreciation was never my focus, but if I can get it, I won’t complain! Those two properties are basically what will make early retirement possible…

Yes, you’ve pointed out your concerns with Section 8 properties/tenants. I am going down this road with caution… Perhaps i’m making a big mistake… Another good reason why I’m big on diversification. I’m definitely not putting all my eggs in that basket.

Take care!

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14 The First Million is the HardestNo Gravatar February 10, 2014 at 6:48 pm

Great insights into the world of REI. There’s a lot in there I never would have thought to consider. I swear I’m going to come back and scour your posts for detail before I buy my first rental property 🙂

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15 FI FighterNo Gravatar February 10, 2014 at 9:40 pm

Jay,

Thanks! Glad there’s some meat in those posts 🙂

Feel free to PM me if you have any questions regarding rentals.

Cheers!

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16 Laurie @thefrugalfarmerNo Gravatar February 11, 2014 at 4:56 am

Thanks for a great article, FI Fighter. We are thoroughly researching investment props right now as a form of income after we get the debt paid down. This is a huge help for us!

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17 FI FighterNo Gravatar February 11, 2014 at 9:44 am

Laurie,

Thanks! I’m glad you found it helpful.

Best of luck to you as you pay down the debt and get started into the world of REI. Very exciting times!

All the best!

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18 MarvinNo Gravatar February 12, 2014 at 2:04 pm

Perfect explanation of to avoid pitfalls that are out there right now. What do you think will happen to the real estate market when interest rates go up?

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19 FI FighterNo Gravatar February 15, 2014 at 10:25 am

Marvin,

Not entirely sure, but I do see prices stabilizing a bit if rates go up… This run up has kind of been insane (especially in certain parts of the country) and can’t go on forever… Well, from at investment point of view, anyway.

Just hoping to capitalize on a few more deals before it’s too late.

Cheers!

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20 MarvinNo Gravatar February 16, 2014 at 11:49 am

I’ve been looking into a lot of stuff and may try to keep educating myself and saving up. Then when the market crashes in some parts of the country due to interest rate hikes I can hop on a couple properties.

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21 FI FighterNo Gravatar February 21, 2014 at 11:43 pm

Marvin,

Yeah, it’s always a good idea to have cash saved up and at the ready in case something crazy happens to the markets. When there is another market crash, I would like to be in a cash strong position to pounce on the deals.

Best of luck!

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22 theFIREstarterNo Gravatar February 24, 2014 at 2:09 am

A sobering but necessary article there FI.
REI is clearly not just a get rich quick scheme and requires a lot of research, investigation, calculations and hard work to get where you are now.

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