Meandering Into Real Estate Investing

Investing in real estate, specifically small rental properties where I’d buy single-family or multi-family houses for the purpose of renting them out has been one of the things I wanted to do. However, the three musketeers of fear, doubt, and uncertainty discouraged me from taking any action toward residential real estate investing. So far, the only real estate investing I have done include the purchase of my primary residence and some REIT investing.

Meandering Into Real Estate Investing

Fix 'em Up, Rent 'em Out: How to Start Your Own House Fix-up & Rental BusinessFortunately, I ran into Terry Sprouse of Fixer Uppers and Rental Houses a while ago and he sent me a copy of his book: Fix ’em Up, Rent ’em Out. Currently, I am about two third of the way through this small 133 pages book and I have to say I am very impressed. It’s a well-written Cliff Notes on real estate investing. I wish I had know about this book a long time ago — unfortunately, my introduction to real estate investing started with an infomercial and ended up with a purchase of Carleton Sheets’ books and tapes.

Terry Sprouse’s Philosophy

One of the things that stood out right away was this little section that Terry wrote:

Components of your new philosophy include:

  • Focus your energies on what gives you satisfaction and meaning in life.
  • Use problems at work to fuel your desire to succeed in real estate investing.
  • Recognize setbacks as opportunities in disguise.
  • Absorb new information like a sponge when learning to make your own repairs.
  • Don’t pay others to do what you can learn to do yourself.
  • Make time to learn the necessary skills to earn money with fix-up houses.

There are a few more bullets on this list. What impressed me about this list is that it could be generalized beyond real estate investing and used to help you succeed in any endeavor.

Why do I want to be in real estate investing business?

I have long recognized the value of becoming a landlord as a way to build wealth. In his book, Terry clearly spelled out the three principal ways that you can make money from real estate investing:

  1. Appreciation — Just like any other real assets investment, historic home values have increased on average about 5% per year adjusted for inflation. It’s hard to imaging that in 1940 average home values in the U.S. was less than $20,000! Although we hit a little bump in the road with the sub prime problem we are having, I have no doubt that this long-term trend will continue
  2. Rental Profit — The difference between rent and PITI+M (principal, interest, taxes, insurance, and maintenance) is what you get to keep as profit.
  3. Principal Pay Down — Lastly, the amount that goes toward paying your principal portion of the mortgage is also part of the profit.

Moreover, I believe investing in real estate teaches you a lot of valuable skills, including property management, repair and maintenance, negotiation, business analysis, etc.

Why I haven’t started with real estate investing?

As good as it sounds, I haven’t started pursuing my dream for several reasons:

  • I don’t want to deal with bad tenants — I think this is the biggest fear for most prospective landlords, and Terry confirmed this in his book. However, Terry shared many ideas, tools, and resources that could be use to effectively address this issue.
  • Investment money — Currently, single-family home prices in my neighborhood average around $600,000. To avoid private mortgage insurance (PMI), I’d need 20% down payment or $120,000. I don’t have this kind of money because most of my money is tied up in retirement accounts. However, Terry demonstrated a creative way of coming up with the initial down payment for someone in my situation.

Aside from the two reasons above, I guess the ultimate roadblock for me is finding a property that can generate positive cash flow. I am borrowing this cash flow calculation worksheet from Terry to demonstrate my example:

Description Amount
1. Sales Price $600,000
2. Down Payment $120,000
3. Amount of Mortgage (1 minus 2) $480,000
4. Interest Rate (30 years fixed rate) 5.95%
5. Monthly Principal & Interest Rate (P&I) $2,862
6. Taxes & Insurance $360
7. PITI (5 plus 6) $3,222
8. Rental payment — Median rental price according to Rentometer $2,325
9. Monthly profit -$897

This is based on my house and from what I can see, it would be very tough to get positive cash flow in my neighborhood. Terry’s rules of thumb are to either make a minimum of $100 in monthly profit, or charge 1% of the mortgage amount. I doubt that my neighborhood will support a $3,322 or $4,800 monthly rent for a single-family home.

If you are interested in real estate investing, I highly recommends Terry’s book: Fix ’em Up, Rent ’em Out and be sure to visit his blog: Fixer Uppers and Rental Houses. Also check out Two Wise Acres and Single Guy Money for more real estate investing articles.

About the Author

By , on Mar 19, 2008
Pinyo
Pinyo is the owner of Moolanomy Personal Finance. He is a licensed Realtor specializing in residential homes in the Northern Virginia area. Over the past 20 years, Pinyo has enjoyed a diverse career as an investor, entrepreneur, business executive, educator, and financial literacy author.

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Leave Your Comment (17 Comments)

  1. JMickers52 says:

    How are REITs different than Mortgage Investment Corporation investments (MICs)? They both are secured by real estate, they both pay annual dividends, depending on the type of real estate and region the rate of return is quite good. Other than REITs being traded on the market they are pretty much the same aren’t they?

  2. Terry says:

    Everyone I know that has started in SFR’s (Single Family Residences) has graduated to commercial real estate as soon as they had the equity. It is just too much of a pain in the butt for the money. I would wait till I could afford a decent NNN to try my hand at real estate. A quick look at http://www.loopnet.com will show you what is out there. You can stil find NNN deals at a 6% to 7% cap rates. Leveraged you could be looking at a 8% return with just a little bit work compared to the SFR’s.

  3. Llama Money says:

    I’m totally against the property in this scenario. Even *if* you could pull a $100 per month profit from this scenario, it’s a terrible use of your money. $100 per month for 12 months is $1,200 per year.

    You put down $120,000. Invested very very conservatively, at an annual return of just 6%, you would earn $7200 per year. And realistically, *anyone* can pull off a 6% return with very very little risk. So you have a choice – earn $7200 per year with miniscule risk, or earn $1,200 per year. In the house scenario, you’re stuck with maintenance and repair costs as well. It’s not hard for these costs to eat away your $1200 per year profit in a hurry.

    With that much money down, I don’t like real estate investing at all.

  4. Jonathan says:

    “Aside from the two reasons above, I guess the ultimate roadblock for me is finding a property that can generate positive cash flow. ”

    Exactly. I’ll wait patiently until owning a home becomes less popular (or easy creditwise). The numbers just don’t add up right now in my neck of the woods.

  5. Tim says:

    I agree that the leverage COULD make real estate investing worthwhile, however, being highly leveraged also makes it VERY hard to find a property which produces a positive cash flow (especially in the areas that will appreciate or where you will attract quality tenants). You may be able to pick up cheap properties in undesirable areas, be highly leveraged, and make a good positive cashflow. However, these are also the properties that are not in the best neighborhoods (why you got them cheap in the first place) and dont really appreciate.

  6. FourPillars says:

    5% sounds pretty high.

    One of the big advantages of real estate investing is the huge amount of leverage that you use. Even a small annual appreciation will probably make it worthwhile, unless of course the value goes down in which case you lose big time.

    The funny thing is that if I tell people I borrow money ($50k) to buy stocks they think I’m some kind of nut. If I were to say I borrowed $450k to buy a rental unit, they would call me a genius…

    Mike

  7. MoneyBlogga says:

    Pinyo – As one who has been in the trenches and is actually still there, it is definitely the smart thing to do all the research you can. I really didn’t do any at all and bought a multi unit apartment building to boot. I invested a total of $250K and climbing. I have high interest rate mortgage loans due to poor credit BUT I have absolutely no intention of walking away. Now that I am somewhat smarter, I know what I need to do to make this property a “going” proposition, though whether or not I can do it remains to be seen. There are the obvious positives in owning real estate, but the downers can really kill it for you if you don’t have the landlord mentality (and many people don’t).

    First and foremost, your tenants can and will make or break your investment – tenants who don’t pay their rent or who start using or dealing drugs are a nightmare. Finding good tenants is the most important thing, but oftentimes the neighborhoods don’t support that and you end up having to rent to just about anyone in order to make the mortgage payment. In California, this is a real problem.

    Maintenance can be another money drain. I just had to replace a water heater and a gas range in the same month – not unusual.

    However,if you have a landlord mindset, it will roll off your back and you will find a way to make it work.

  8. Tim says:

    I just got out of the rental property business…

    If you don’t have the money to put a large amount down (50% or more), it is very tough to find properties that have even a small positive cash flow. The ones that I did get which cash flowed $200 a month or so ended up losing money after factoring in vacancy, tenant damages, tenants losing jobs and not paying, legal costs, city inspection costs, etc. Not to mention I was always fixing things that shouldn’t have normally gotten broken, like a tenant who had OCD and washed the floors too much…it eventually destroyed the flooring and it had to be replaced…

    In any case, check out my blog, The Money Kings. Since I’ve gotten out of the real estate investing business, my business partner and I have been posting about our experiences. Our latest post discusses transitions to warm weather, and how this seems to bring the freaks out for a few days…

    I’ve learned so many stupid little things that I never considered when I was searching for the properties to buy. Looking at who/what comes out of the woodwork in a neighborhood during the warm months shouldn’t be overlooked. My first property I made the mistake of buying in the winter when the neighborhood looked quiet and calm…As soon as summer came, it was a ghetto with fights everywhere, shootings, and prostitutes. Not the best conditions for when you have to go work on or show the property!!!

    Tim

  9. Mark says:

    Pinyo – I was in the same mindset you have regarding buying a property to rent in a high priced neighborhood. Open your mind!

    Think small college towns, think PA, think other states where cost of homes are at least 50 percent less than grand ole New York. Once I got past the price roadblock, I realized it was all about proportion.

    You can still invest in real estate rental properties in a different state. However, in order to reduce the landlording issue, you would have to use a property management agency which is still in your favor because of liability issues. There is a whole world out there to learn. I must have read a dozen different books and read hundred of different websites. Everyone has their own way but find the common thread and you will find the way.

  10. Adfecto says:

    The price appreciation given as 5% adjusted for inflation is very very wrong for the vast majority of the country. If your average house in 1940 cost $20,000 and the average house today costs $220,000 that is an 11x increase over 68 years. That equates to a 1100% return, however that is only 3.59% annualized return which is BEFORE INFLATION ((220,000 / 20,000)^(1/68) = 1.0359). If you take out inflation you wind up with right around 1% annualized price appreciation. Now if you look at Manhattan (it’s an island!) or coastal areas the land value does go up faster than inflation + 1% but that is only due to location specific factors. That type of investment is pure speculation imho. The appreciation rate I calculated also makes sense because the limiting factor on the cost of housing is income, in other words, house prices SHOULD only go up as much as wages (like magic this historically turns out to be about inflation + 1%).

    The vast majority of money that is made in real estate is from collecting rent (resulting in free cash flow and/or mortgage payments creating equity) over the long term. Think of your purchase like this, if it cost $600,000, you would need to collect $48,000 in rent for it to have a “yield” of 8%. Ideally you want properties that throw off cash in the 10-12% range annually (your proposed investment is more like 5%).

    Also, I think the $100 premium is far too little when you consider that you only have a cushion of $1,200 a year or 0.2% of the purchase price for “unexpected” outlays. A much more realistic amount would be 2% of the purchase price. Think about what happens when you have to replace the carpet and paint the walls every few years, plumber to fix the toilet, and then replace the HVAC and roof a few years down the road too. This also must account for marketing, general upkeep, and potential vacancies.

    I live in an area where profitable real estate investing is possible (4-plex for sale at $199,999 with current tenants renting for $425 per month) so it isn’t a complete fantasy. I think you have definately made the right call to forgo investing in your area. Your rental rates versus purchase price seem at least 30% out of whack (but 50% out of whack compared with my target of 10-12%). Clearly you are better off in the stock market or looking elsewhere for property. You’ve made the right call, 100%.

  11. eden says:

    Great article, this has been one of my secret goals for a long time. I really like the idea of owning real estate and building equity with a small cash flow. However, I’m a long way off from being in the financial position to do this. The good new is, that gives me a lot of time to learn the business. I’ll have to check out the resources you recommended.

  12. Phil says:

    The last time I moved, I came very close to renting out my old place, which was paid for, and using the collected rent to pay for property taxes on my old place and at least part of the mortgage on my new place. After interviewing a few prospective tenants, I chickened out. Also, I could never get the numbers to add up.

    I looked into hiring a property management company, which would be the way I would have to go so I could sleep at night. They would do all the tenant-finding and such, and wanted the first month’s rent and 10% of rent after that in return. If the house sat empty, they got nothing. It sounded like a fair deal to me.

  13. Kelly Abrajano says:

    I enjoyed your post. Currently, besides my own home, the only other real estate investment that I feel is safe and will give me an excellent return on my money is SoCal landbanking. I own 3 parcels. Each parcel has all of these criteria within a 3 mile ring:
    1. flat and developable
    2. have abundant water supply
    3. be in proximity to large population
    4. have accessibility by freeway
    5. have existing master plan for streets and highways
    6. have adequate utilities
    7. have existing and planned industries
    8. have an educational system
    9. have commercial and residential development
    10. have pro-business city government

    In order for consolidators and developers to be interested in my land in the future for their projects, the parcels must have ALL of these criteria. The will then solicit me for their projects. I want to be the last landowner to hold out to get the best return. I may even end up leasing at the time to have passive income.

    With this investment, however, you must be able to earmark your money to be put away for about 10 years. You have to forget about it, although some investors have seen a return within 18 months.

    Feel free to visit my blog at http://www.savvymominvestor.com to find out more.

  14. Pinyo says:

    @Pete — Great summary of residential real estate investors’ worst nightmare. That’s one of the factore that prevented me from taking action. I also know someone who’s a landlord and his house was completely trashed by a bad tenant.

    @GBlogger — The problem with having a rental in another part of the country is finding and paying someone to take care of the place.

  15. GBlogger says:

    I know it holds some other risks/issues — but have you thought about purchasing a property that is not in your neighborhood, perhaps in an area of the country where homes are more affordable but are also growing? We have the same issue in terms of our neighborhood — so we bought a house in another part of the country.

  16. AJC says:

    Pinyo – you may be better off buying a BIGGER rental investment (e.g. multi-unit apartment – google Dave Lindahl, Apartment House Riches, as an example) because you can probably afford the 6% – 9% for a professional property manager to handle the tenants.

    But, the general principal is that income-producing buy-and-hold real-estate is the traditional path to wealth because you can buy more of it for your money (a property that increases by the average 7% per annum, will sell for 10 times what you paid in 30 years … if your deposit is only 25%, you get back 40 times what you put in!).

    Right now, with BOTH real-estate and mortgage rates so cheap, I think this represents a historic opportunity IF you have that 20 – 30 year outlook.

  17. Pete says:

    I have a friend who had 3 rental houses that he bought. He thought it was going to be a great deal where he could have these houses, rent them out and be gaining equity all the while never having to pay the mortgage on his own..

    The problem was that he had problems finding renters, the ones he did find were low income folks who didn’t take care of the place and didn’t end up paying their rent. Then he had to go through the process of evicting them, and fixing the damaged they caused. In the meantime not all of his houses were rented out, and it was a quick financial slide into a problem area. He is now really struggling, and one of the houses has already been foreclosed on. The other two will probably follow soon.

    Moral of the story: it can be a great deal to be a landlord and own your own property, but be aware of the pitfalls as well. Its not all peaches and cream..

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