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:
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%):
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:
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:
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! 🙂
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.