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Getting People Who Live in Houses to Pay You

This is part of a series. If you have not read the articles that build up to this one, I recommend that you do so first.

If you’ve ever watched HGTV, they make it seem so easy for you to buy some investment real estate, slap on a couple of coats of paint, and sell it for 150% more than you paid for the property. If it was that easy, though, everyone would be a real estate investor, and there wouldn’t actually be any houses where people lived. Despite some of the challenges, investing in real estate can be a profitable venture. I can’t guarantee that we’ll turn you into a Donald Trump (the real estate tycoon, nothing else) or that you will make money in real estate; however, this article will get you educated on the basics of what you need to know about investment properties.

First off, let’s look at why you might be interested in investment real estate.

If you look at the top 10 assets held by people under age 70 with net worth of more than $2 million, you can see what’s the top ranking holding.[1]

Leading the pack at 17.7% of assets is investment real estate. Donald Trump, for all of his horrible hair and apparent buffoonery, is no fool (that’s no political statement, mind you).

Why is investment real estate attractive?

  1. It provides a source of income. When other people rent from you, they pay you for the use of your asset. Assets should generate either income or growth. Most investment real estate generates income. Furthermore, the income that you receive should be tied to inflation, so you will not lose purchasing power over time.
  2. It can provide a source of growth. While the inflation adjusted price of real estate has remained effectively flat for the past 100 years, you’re buying investment real estate for different reasons than you’re buying a house that you’re going to live in. The buying criteria are different and, therefore, you should be able to create or gain value out of your investment properties. Capital appreciation – the difference between the price you purchased the asset for and the price you sell it at – is a secondary consideration. It should be an added bonus to the income.
  3. There are tax incentives to own investment properties. You don’t get to take depreciation on the house you live in. You get to take depreciation on investment real estate. You don’t get to get tax breaks on repairs or improvements you make on your own home. You do for investment real estate.

There are, to me, four types of real estate you can purchase for an investment:

  1. Properties which you purchase to hold on to, expecting appreciation. This is usually land. You buy land somewhere that you think a development or a major highway will go through, hold it for a while, and try to sell it at a profit. You’re not expecting income generation on this type of investment, although you could rent it out for pasture land, farm land, or temporary use.
  2. Land which you purchase with the intent of developing. You buy the raw land and build structures (or have someone build them) – residential or commercial – on it. You will then either sell or rent out those properties. You can do this on spec, meaning that nobody has offered to purchase or rent the structure you’re going to build, or you can wait until you get a contract to put a structure on the property.
  3. Properties which you purchase to improve and then sell. This is what is commonly called “flipping.” You buy a property in a less than desirable condition, add value to it via repairs, and then sell it.
  4. Properties which you purchase to rent out. These are rental properties designed to generate income. You may or may not have to improve the properties before you rent them out. You may manage them yourself or you may hire a property manager to deal with everything.

I have done all four types of real estate investing. I was unsuccessful at the first, had mixed results with the second and third, and have been very happy with the fourth type.

If you have sufficient capital, patience, and deep ties with your local zoning board, you can attempt the first type I had none of those, so it is no surprise that I did not succeed.

If you have built houses before, have a strong and trustworthy relationship with a builder or a carpenter/handyman who will cut you a deal to build/work, or are very handy, then you could go after the second and third types of property investments. To develop land, you also need a lot of capital, since you have to fund both the land purchase and the construction, and if you’re building a spec property, you may have to fund the carrying cost if the property doesn’t sell by the time construction is complete. The same holds true with a property you’re planning on flipping; you have to be prepared for the scenario where it does not sell by the time you’re done with the repairs and renovations.

However, for a vast majority of you, those categories do and will not apply. Therefore, I’m going to cover the fourth category – buying investment properties with the intent of renting them to create a stream of income. I’ll discuss some strategies which overlap with the buy/improve/flip category, but won’t go deeper.

What follows is the process I use to determine whether or not to buy a property as a rental property.

How Do I Find Rental Properties?

The most important thing to remember about rental properties is that they are a business investment, not an emotional purchase like can happen when you purchase a house that you’re going to live in. Things like granite countertops, pergolas, and heated floors may make your house more enjoyable to live in, and, therefore, worth the investment to you, but for a rental property, it is completely a dollars and cents decision. Therefore, you must not look at rental properties with the perspective of whether or not you would want to live in them, but, rather, with the eye of whether or not tenants would want to live in them for the price that you need to charge to make it economically feasible to invest in.

Thus, we begin our search with numbers.

How to Calculate the Value of a Rental Property

The value of a rental property to you boils down to a simple equation:

Rental income that goes in your pocket per year (net rental income, or annual rental income minus annual expenses) / Total price you pay to acquire and fix property

In rental property parlance, this is known as the cap rate.

There are two ways to arrive at the cap rate. The first is to calculate all of your income and your expenses. These include:

  • Annual rental income minus
    • Property management (if any)
    • Property taxes
    • Income taxes
    • Insurance
    • Repairs (not the repairs that you make to get the property into rentable condition the first time; those go into the total price you pay to acquire and fix the property in the denominator)
    • Advertising (if any)
    • Accounting/legal (if any)
    • Mortgage servicing (if any)
    • Long-term maintenance, such as roof repair. Even though you might not pay for a new roof in a given year, you need to be accounting for that cost as you go, establishing a reserve of cash to pay for it, since, if you own the property long enough, you will have to pay for it eventually.
    • I count this as an expense if you calculate annual rental income as what you can rent the property for per month X 12. If you adjust the annual rental income to account for vacancy, then you don’t need to double count it. I usually use 10% of the monthly income as a vacancy expense.

Then you need to add up the total cost to purchase the property. These expenses include:

  • The actual purchase price plus closing costs. In other words, the amount of money you need to bring to the closing to get the property in your name.
  • Repair costs to get the property into rentable condition. Remember, you’re not trying to turn a rental property into the Taj Mahal unless the rents justify it. Use the cap rate as your guide. If you can spend something on an upgrade which has an appropriate overall cap rate, meaning you can increase the rents by a percentage equal or greater than the cap rate, then you can do so. Otherwise, the return will not justify the investment.
  • I always get a property inspection from a qualified inspector. If you’re exceptionally handy and can identify all of the issues yourself, you probably don’t need this.

Let me add a quick word about titles. You want to purchase a property with a general warranty deed. That type of deed means that there are no encumbrances, e.g. liens, competing claims, etc. against the property you are purchasing. It’s the easiest to get title insurance for, and will be the easiest to sell when you sell the property. Otherwise, you’ll need to quiet the title, which is a lengthy process and requires more advanced knowledge and experience to complete and deal with.

There is an easier shortcut for estimating expenses. I have found, and many other real estate investors agree,[2] that, outside of mortgage servicing, which we’ll discuss later, expenses account for 50% of your rental income. Therefore, your cap should be (Rental income – .5 X rental income).

Once you have the net rental income and the total acquisition/repair price, you will have a cap rate.

What cap rate should you aim for?

I generally aim for a 10% capitalization rate. I’ll usually settle for anything above 8%, but I’m happiest when I get 10% or higher. This means that my return on investment is 10% or more IF (and only if) I can get the rental income that I project and keep my expenses at or below the total expenses I project.

If a property comes in at a lower capitalization rate, then I know I will have to offer less for the property to make the numbers work. If I can’t buy the property at an appropriate price, then I simply walk away.

To determine how much cash you’ll get from your property every month, you’ll need take your rental income, subtract the expenses (or 50% of the rental income if you’re using the rule of thumb), and subtract your mortgage payment if you have a mortgage.

How Rental Property is Tax-Advantaged

When you purchase rental property and actually put it into use as a rental property, the IRS gives you some advantages that other, normal investments don’t offer.

The first is a concept called depreciation. Depreciation means that, over time, an item wears down and loses its usefulness. Think of cars. If you drive a car enough, you’ll eventually run it into the ground, no matter how much you take care of it. Buildings are the same way; eventually, they’ll become uninhabitable.

To account for this loss of value, the IRS allows you to take a tax deduction on what it estimates as the loss of usefulness of the property. Of course, it doesn’t send an agent out to your rental property to inspect it and see what condition it’s in compared to the condition it was in at the same time the previous year. Instead, it uses a simple rule to determine how much you can deduct: basis in the property / 27.5. The basis in the property means the cost that you paid to acquire it plus any upgrades and major repairs you made to the property. Changing a light bulb or putting on a fresh coat of paint doesn’t count as a major repair, but adding a new roof or putting an addition to the property does. So, if your total basis in a property is $100,000, for 27.5 years, you get to deduct $3,636.36 off of your taxes. If your marginal tax rate (the highest tax rate you pay) is 28%, that means you will pay $1,309.09 less in taxes. Now, if you only reached that rate on the last dollar of income, you won’t save as much, but this should give you an idea of how depreciation is calculated and how it benefits you.

Remember, though, when you sell the property, you will have to pay taxes on what is known as depreciation recapture. This is because for each year you take depreciation – and you should, because the IRS will tax you as if you did, regardless of whether or not you did – you are reducing the overall basis in your home. The depreciation recapture rate is 25%. So, let’s say that you owned your rental property for 10 years and did nothing to increase your basis. Over that time, you’ll have reduced your basis by $36,363.63, making the adjusted basis in your property $63,636.34. If you sell the house for $110,000 after commission and closing costs, then you will have two different types of gains. The first gain is capital gains off of the original basis. In this case, you’ll have $10,000 in capital gains, which you’ll pay the long-term capital gains rate on. Unless you’re in the highest income tax bracket, your long term capital gains tax rate is 15%, so you’d owe $1,500 in taxes. The second gain is one caused by depreciation. In this case, it’s $36,363.63, so you’d owe $9,090.91 in taxes for depreciation recapture, and your total tax bill would be $10,590.91 on the sale of the property.

There are two ways around this: 1031 exchanges, which defer depreciation recapture, and inheritance. If you pass on a property to a heir, then the heir receives the property with a basis at the current market value. These are more advanced, long-term strategies; for the sake of this article, it’s sufficient to be aware of the depreciation recapture tax.

The second way in which the IRS benefits investment property owners over homeowners is in mortgage interest deductions. Now, we’ve already explained that you can get a mortgage interest deduction on your personal home if you itemize your deduction and the deduction is already above the standard deduction before you include the amount you pay in mortgage interest. This isn’t a requirement for a rental property. Since rental property income and expenses are calculated separately from your deductions, you can deduct the mortgage interest from the rental income you receive. Remember, though, that you cannot deduct principal; you can only deduct mortgage interest.

Thus, for as long as you have a mortgage or depreciation on your investment property, you’ll have an after-tax income which is higher than your in-pocket income from the property. Put another way, your tax return will be lower. It doesn’t mean that you won’t have to pay taxes on the rental property. You may or may not owe taxes, depending on how much you make. What it does mean is that your tax bill will be lower than it otherwise would have been.

It is crucial for you to keep records of ALL expenses associated with your rental portfolios, including mileage driven. That way, you can accurately include all expenses when you file your taxes.

To Mortgage or Not to Mortgage

We do not use mortgages to purchase our investment properties. For us, it’s a risk-reward ratio. I do not want to face a perfect storm of having several vacant properties and needing to cover the mortgage for an extended period of time. While improbable, it’s not impossible, and not a risk I’m willing to take.

The risk does get mitigated as you have more properties, which means, on the other hand, that if this is your first investment property, you’re particularly subjected to risk, especially if your property is vacant for more than the period of time you accounted for in your initial estimates. You will need to be able to carry that mortgage payment without rental income for a significant amount of time.

First, we need to identify the goal of owning investment properties. The goal, simply put, is to translate your cash into an asset which generates income, and, if we’re lucky, growth, although the growth is not necessary. I’ll use my family as an example. We retired early, at 46 for me at 45 for my wife. We have run budgets and knew, pretty accurately, how much we would spend monthly in retirement. Since we do not have 401ks, we cannot access our IRA funds until age 59 ½. Therefore, we will need to generate income through our taxable investment accounts and through our investment properties. Our goal was to own enough rental properties so that 50% of our rental income – since we have to account for expenses – is more than our monthly household expenses. Once we get into our 60s, we’ll probably start slowly selling off our properties, as we will want to move into investments which are even more passive.

Mortgages allow you to use leverage to purchase properties. I know this sounds redundant; you knew that already. In this case, though, a mortgage should be used to expand your real estate portfolio faster than you would otherwise be able to. However, mortgages should not be used to increase your pocketable cash flow.

What do I mean by this?

Let’s say you were able to completely finance the purchase of a rental property. Assuming you bought a property under the right financial conditions, through the use of creative financing, you would be able to increase your cash flow simply through the use of financing. If you used that extra money to increase your lifestyle, then you would run the risk, for the term of the loan, that you would have the property go vacant, need an extra repair, or any number of things that could go wrong, which you would then have to find the income from another source to cover.

Compare this to a house which you purchase for cash. While some expenses do not go away if you have a tenant or not – insurance and taxes – some of them do – property management. The amount you need to keep the house rentable is much less than if you have a mortgage. When the property is rented, you get a much higher cash flow.

Therefore, the decision on whether or not to have a mortgage rests on two factors:

  1. Do you need the money today?
  2. Can you afford to cover the mortgage if there is no tenant?

If the answer to #1 is no and the answer to #2 is yes, then you could use leverage to acquire a property. However, if you do this, you need to follow these rules:

  1. Put at least 20% down
  2. Get a 30 year fixed mortgage
  3. The property must generate monthly pre-tax free cash flow
  4. Use the after-tax free cash flow generated by the property to pay down the principal on the loan
  5. You must be able to pay off the loan completely within 15 years using the after-tax free cash flow from the property

The goal here is to minimize your risk of putting yourself in a foreclosure situation if something bad happens. That’s why it’s not worthwhile to save what will likely be ½% to ¾% on your mortgage interest rate while significantly increasing your required payment by using a 15 year mortgage. If you’re going to take risk, you want to take as little risk as possible to get the outcome you seek.

Let’s look at an example.

Assume you can buy a house for $75,000. You will put 20% down. The property will rent for $1,100 per month. Using the 50% rule, expenses are $550 per month. You can get a 30 year mortgage at 5%. Rents increase 3% every year. Your mortgage payment will be $322.09 per month. Your marginal tax rate is 28%. In the first year, the after-tax cash flow of such a property would be $2,468.79. It will increase slightly each year as you pay down the mortgage. If you pay off additional principal each month using the free cash flow, you will pay off the mortgage in 141 months, which is well within the 180 month rule. In the year after you have paid off the mortgage, your free cash flow will jump to $7,537.44, which, adjusted for inflation, is the equivalent to $5,515.68 per year when you start, or a 123.4% increase.

In the same property, if you had no mortgage, you would have $5,516 in after-tax cash flow in the first year. It would take 142 months, or a little under 12 years, for you to generate enough cash flow to buy another $75,000 property free and clear.

Thus, using a mortgage won’t get you one free and clear property much more quickly, but the use of multiple mortgages, if done wisely, can get you many more free and clear properties in an equivalent timeframe.

There is a risk/reward continuum for having mortgaged properties. In a(n im)perfect storm, you could owe mortgage payments on every property on which you have a mortgage. That’s why buying the right property in the first place is critical, and having a great system in place for placing tenants into those properties or having an aggressive property manager who can place tenants for you is almost as important. Vacancy is your biggest risk and having a tenant who destroys your property is the second biggest risk.

If you’re a beginning real estate investor, I would not mortgage more than one property for the first couple of years. You need to have a good understanding of how accurate your estimations are and if you or your property manager have sufficient skills to keep expenses at an appropriate level. Once you determine how your expenses compare to your estimates and you have a feel for the types of tenants and ability to fill the property that you or the property manager are able to place, you can start to expand your leverage, but again, I cannot caution this enough: make sure that you have sufficient cash reserves to weather a longer than expected dry period. Foreclosures are a risk in this strategy and can be very harmful to your long-term retirement prospects.

How Do We Manage Rental Property Cash Flow?

We use a property manager, so our cash flow management is relatively simple. We set aside 50% of what our rental income (not the check, but the amount the tenant pays) each month into our investment account. The remainder of the check goes into a side account that we use to pay insurance, taxes, and occasional expenses that the property manager does not deduct from our rent check.

If you are managing the property yourself, then take a similar approach. Use 50% of the rent check to go into your rental property billing account. If you have a mortgage, pay the mortgage with the remainder. If your property becomes vacant, use the rental property billing account to pay the mortgage for as long as you can.

If you are using actual expenses rather than the 50% approach, you will still need to keep a reserve. I recommend 10% for the vacancy allowance and 10% for a maintenance reserve, meaning that you set aside 20% of your rental check each month into a side account.

How do I Look for Houses?

My process is relatively simple for looking at houses. I’m looking for sellers in distressed situations who are looking to get rid of their houses quickly. Alternatively, I am looking for foreclosed properties, since the bank is not going to be emotional about the house and want to get the property off of their books – a house is a liability to a bank rather than an asset.

I use five main websites to look for properties.

  • http://www.hudhomestore.com – This website is where HUD foreclosures are listed. Be sure that you only search for investor houses. Buying an investment house while stating that you are an owner-occupant is fraud.
  • http://listings.vrmco.com – This website is where VA foreclosures are listed.
  • http://www.auction.com – This website lists houses which are auctioned online and also many judicial foreclosures – the auctions at the courthouse steps for foreclosed properties. Beware, if you go to a courthouse auction, expect a lot of competition, so don’t expect some great bargain.
  • http://www.williamsauction.com – This website lists houses that are auctioned online. I have found when they do have auctions – they seem to be losing market share in many states – the auctions tend to bring in lower prices than auction.com. It’s probably why they’re losing market share, but if you can find an appropriate property in your area, it’s worth checking out.
  • http://www.zillow.com – I use this site both to get rough, ballpark estimates on a house’s value as well as to check for foreclosed properties.

I do not use realtor.com. It’s a website designed to help Realtors, not you. Realtors have an incentive for you to pay as much as possible so that they get more commission. There’s a conflict of interest which does not help you, the buyer.

To find distressed properties – usually estates or pending foreclosures, I also use my property manager. She is also a Realtor and is very well-connected in the community. She can tell me right away how much she can rent the property for and gives good estimates of how much it will cost to get a property into rentable condition.

To help you work through these calculations, I have included a worksheet.

There are a few items you will need to fill out to accurately estimate your cash flow.

The cells in yellow are ones that you will need to fill out. The worksheet will calculate the remainder for you. The section on the right is the monthly cash flow projections and cap rate projections if you use the 50% rule. If you plan on purchasing the property with all cash, simply enter 0 in the mortgage amount cell.

Below that, the worksheet calculates out 30 years of rental income, expenses, and net income, including totaling up an annual after-tax cash flow.

You can scroll down to see how much your income will rise once the mortgage is paid off, if you have a mortgage.

If you take it cautiously, wisely, and intelligently, investment real estate can be a valuable part of your overall investing portfolio. However, if you go overboard in getting mortgages for a ton of properties and get emotionally involved, getting buyer’s fever, you can get in some deep trouble. Go slow. Don’t get an itchy trigger finger. Be wise about your spending and remember, just because you didn’t get one deal doesn’t mean that another one won’t pop up soon.

 

Now that we’ve looked at the top investment asset that people who have over $2 million in net worth utilize, in a subsequent article, we’ll look at the second most popular investment asset – starting your own small business.

 

Related Articles:

How NOT to Invest in Real Estate

Depreciation Recapture: The IRS Giveth and the IRS Taketh Away

Using Zillow to Grow and Manage Your Real Estate Investments
 

[1] https://www.themillionairenextdoor.com/2013/05/the-top-ten-assets-owned-by-millionaires/

[2] http://www.biggerpockets.com/forums/52/topics/16385-5-rule

The next article in this series is “Starting Your Own Gig and Managing the Band.”

By Jason Hull, CFP®

Jason Hull, CFP®, was the co-founder of Broadtree Partners, a firm that acquires $1-5MM EBITDA companies. He also was the co-founder of open source search consultancy OpenSource Connections, a premier Solr and ElasticSearch firm. He and his wife FIREd (financial independence retire early) at 46 and 45, respectively.

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