INTRO TO CONSERVATIVE REAL ESTATE INVESTING
Conservative real estate investing is the smartest way to invest in real estate and the best way to build wealth and assure you don’t become a casualty during the next economic downturn.
I especially believe it is important to practice conservative real estate investing for your first deal.
Conservative real estate investing is simply investing in residential real estate with at least 20% down on fixed 30-year mortgage. You do this in places where you can ensure that you will have cash flow, even if appreciation is stagnant or mediocre.
Another important part of conservative real estate investing is not getting involved in complicated or questionable strategies that leave you or your partners in a high-risk situation.
Here is commonly accepted wisdom on real estate. All of these have flaws:
- It’s Easy to Invest with No Money and Bad Credit
- You can get Rich through Appreciation
- Renting a Property is Throwing Money Away
- Buying is Better than Renting – Pay Down the Mortgage
- If your Rent covers your Mortgage, you are Breaking Even
- Paying off a Mortgage is a Bad Idea
Well said, Dwight.
I believe all of these are FALSE.
I’m afraid mainstream media and real estate gurus with a penchant for marketing have skewed your understanding of real estate investing.
MY PHILOSOPHY ON REAL ESTATE INVESTING
There are so many books, blogs, courses, and websites that claim they will tell you how to make money in real estate investing. I’ve googled all the search terms about how to invest in real estate and read the “best” of what’s out there.
I don’t like most of the advice I see. It’s risky and misleading.
My philosophy on real estate will become clear as I explain the conventional wisdom I disagree with.
It’s Easy to Invest with No Money and Bad Credit
This is by far the most pervasive lie in real estate.
Some strategies for no money down are possible, but not easy for experienced investors with sufficient cash reserves.
But no-money-down strategies are often marketed to new investors with no money saved up as an easy entry into real estate.
Here’s some truth bombs on no-money-down tactics:
This is when you convince the current owner of the property to sell to you privately without involving a bank. Usually they own the property without a mortgage, which is key to making this work. Since they own the property, they can act as the bank.
Usually, you take this approach because you have no money, poor credit, unsteady or low income, over-leveraged, or a combination of these issues.
In these seller financing deals, the seller agrees to no down payment or a small down payment in exchange for a higher interest rate and not having to deal with lenders and real estate agents.
A couple of problems with this…
In a hot real estate market like the one we are currently in, there is not much of an incentive for someone to agree to this type of financing.
You have to convince them not to take their equity now when they easily could.
They could likely get their equity and a better price selling through a real estate agent, even if if the property is in rough shape.
Also, these properties tend to be in bad shape if they are candidates for seller financing.
Is seller financing really going to work for you as a beginner with no money?
If you are inexperienced and don’t have any money or credit, how are you going to…
- get the money to do the large rehab it needs?
- successfully supervise a large remodel without overspending?
- pay for unexpected expenses that pop up?
I’m by no means saying it is a bad practice or an impossible strategy. I’m am saying it will be challenging for someone with no money and little experience.
It’s a wonderful tool for a more experienced investor with some cash reserves or at least equity to grow faster when maxed out on typical financing options.
Other People’s Money
These “gurus” try to teach you not to use your money, but find somebody else’s money.
In reality, this means find someone else to take on the financial risk of your real estate deal.
I don’t know about you, but I don’t sleep well when I convince someone else to take on my financial risk.
If you have no money and no experience, who will you be hitting up to take on your financial risk for you?
Unfortunately (for them), probably friends or family that trust you.
Clearly, Grandma has plenty of money.
Again, you don’t have a track record. You don’t have experience. You could fail.
Maybe instead of someone giving or lending you the money, you can partner with them…
The gurus love to talk about partnering up when you don’t have any money or experience.
They say if you find a good deal, the money will come to you.
It’ll be easy to find a partner who wants a good return.
Here’s the problem…
What are you bringing to the table in this partnership?
You’re not bringing the money!
You’re not bringing the experience!
Typically, you bring one or the other.
The gurus will say you are bringing the deal.
If your new to real estate, the likelihood that you’ll find a better deal than more experienced investors and get it under contract without having much money or experience is unlikely to say the least.
When you do partner up, there are a lot of other things that complicate the issue.
- What if one of you wants out of the partnership?
- What if there is a large expense and you disagree about who will pay for it?
- What if your partner is not doing their fair share of work?
Partnering up is like getting married.
You better love your partner and get along well!
Hard money is a high interest, high-fee loan with a short repayment window.
It’s commonly preached as a great method for beginners with no money to be able to finance their fix and flip.
Some Pros to Hard Money:
Fast – Can get the money in days as opposed to a month with a bank
Easy to Qualify – If the numbers look right, you’ll get this with a low credit score
The Cons of Hard Money:
High interest rates – You’ll pay a rate much higher than a bank, possibly double digits
High fees – You’ll also pay possibly points on the loan and a high origination fee
Short-term – Often, you just pay interest, and then the entire amount is due in less than a year
“Gurus” will tell you that if your deal is good enough, it’s worth buying with a hard money loan. They claim you’ll be able to pay it back when you add value and flip the property successfully.
Again, this sounds easy in theory, but it’s very difficult in practice.
Especially when you are new and inexperienced.
If you can’t pay back on time, or refinance when the entire amount is due, they foreclose on your property just like a bank would.
There are a lot of things that can go wrong when you have no funds and little experience, and large renovations on a tight timeframe is a complicated task.
Problems with contractors, inspections, unexpected delays, and surprise expenses are common.
If you are doing this from long distance, that makes it magnitudes more difficult.
While you’ll hear stories about the few that do well with hard money, most of those people already have a proven track record flipping.
There’s a good chance a newbie will get themselves into trouble by using this aggressive real estate investing tactic.
No Money Down Wrap Up
These no-money down-strategies are not inherently evil.
They are advanced tactics that are difficult to execute successfully without some money and experience.
While many real estate investing websites argue you can buy a house with no money down or try seller financing or use hard money lenders, I have a suggestion…
Put 20% down on a 30 year fixed loan and do it the safe and proven way.
But I don’t have 20% down, and I want to invest NOW!
Then save up some money for a downpayment.
I know. That’s lame.
You’ll thank me later.
If you are willing to invest in real estate the slow, steady, and smart way, stick around.
How to Not Suck at Saving Money (Featured on Business Insider)
Get Rich through Appreciation
I call this The Appreciation Myth.
It’s the biggest mistake real estate investors make.
Housing appreciates at a rate of approximately 3% a year.
It keeps up with and sometimes outpaces inflation.
This is quite a bit lower than the 7-8% a year the stock market in general has been getting on average over the last several decades.
It’s also far less than most people believe housing appreciates at.
Real estate sometimes appreciates massively at certain locations over certain time periods for reasons nobody is able to predict.
In real estate investing, those that think they know when and where big appreciation in real estate is going to happen are just guessing.
It’s like guessing whether or not a stock will go up. It’s essentially gambling.
I saw significant appreciation on my townhouse in Washington D.C. right after I bought it in 2003.
It went from $280k to $450k in a little over a year. I thought I’d be rich.
Unfortunately, over the next 11 years, it really didn’t appreciate much at all, and I ended up selling for $400k, which came out to less than 3% appreciation a year.
My good friend and celebrity surfer-blogger Doug Nordman who blogs at The Military Guide bought two houses in Hawaii and has owned them for decades.
Everybody makes money on appreciation in Hawaii, right?
His appreciation on these two houses over long time frames has been unimpressive.
His appreciation averaged at 3-4% a year, even though some years it jumped as much as 20% (these periodic jumps are what you always hear about on the news).
I recognize that you can use leverage to magnify appreciation.
That’s all good.
But if you jump on the no-money-down leverage bandwagon and hit a downturn in the market when you are vulnerable, the downside is also magnified. You could end up in trouble!
Don’t buy real estate for appreciation. It’s a bonus, but don’t count on it.
Buy for cash flow.
Never buy a property that doesn’t cash flow well, but that you hope will appreciate to make up for it.
Recipe for disaster.
Read my post on What You Didn’t Know About Appreciation in Real Estate
Renting is Throwing Money Away
A good friend told me once when you pay rent, that’s the most you’ll pay each month. When you pay a mortgage, that’s the least you’ll pay each month.
I’ve found that to be true, having done both in my real estate career.
All thing being equal, renting a property is cheaper than buying. That’s because if you rent a property for $1,000 a month, there are no additional expenses. The landlord is responsible for all expenses beyond the rent itself.
When you buy a property and your mortgage is $1,000 a month, there are several items you still need to pay on top of this.
- Property taxes
- Capital improvements
- HOA fees
- Closing costs and commissions on the purchase and sell
Renting frees up money to invest elsewhere.
The exception to this is when you buy a property that cash flows well as a rental.
Most primary residences don’t meet this requirement.
Buying is Better than Renting – Pay Down the Mortgage
You might hear the argument buying is better because you’re paying down the mortgage instead of throwing money away on rent, but it doesn’t happen as quickly as you would hope.
At the beginning of your loan, a large amount of your payments go to interest instead of principal. The first payment is often close to 85% interest / 15% principal, and stays in that range for many years.
Here’s a typical example of an amortization table on a 30 year loan.
Notice how little you are actually paying in principal compared to interest at the end of 12 months, and even halfway through the loan (see payment month 180).
After paying a loan for five years, you would be surprised how little you’ve actually chipped away at the final balance.
Even at the halfway point, you are still paying 60% of your payment to interest!
And how many people end up refinancing?
That starts the entire amortization cycle over again with high interest and little principal on monthly payments.
If you want to dive deeper into appreciation, amortization tables, and buying vs. renting, read my article:
If your Rent covers your Mortgage, you are Breaking Even
This is wildly misunderstood by most people.
As I explained earlier, there are several expenses that are not included in a mortgage payment. You pay those out of your pocket throughout the year causing you to lose money on your rental without realizing it.
There is something called the 50% rule in real estate investing. It means approximately 50% of rent received ends up going to expenses. This is MUCH HIGHER than most people imagine.
So as an example, if your mortgage is $800 a month, and your rent is $1,000, you might tell people you have a positive cash flow of $200 a month.
And you would be wrong!
Approximately $500 of that rent goes to expenses
If your rent is $1,000 and you subtract $500 in expenses, your cash flow is $500 before mortgage expenses.
$500 cash flow – $800 mortgage equals a negative cash flow of $300.
Ouch! I thought real estate was easy!?
So you are in negative territory when considering all the additional expenses on top of your mortgage.
This is extremely common in the military when people buy their homes, and then rent them out when they move away after 1 to 3 years.
It’s pretty common outside the military too!
To dive deeper into calculating expenses and cash flow accurately, read the post.
Paying off a Mortgage is a Bad Idea
Wait Rich on Money, Are you crazy?
Interest rates are so cheap!
You are giving up opportunities to make huge money by paying off your mortgage!
I know, I know. I’ve heard it all.
First, I want to admit the benefits of paying off a mortgage early are more psychological than financial.
In the past few months, I actually purchased 10 units and a personal residence with loans.
I have to admit, I really don’t like that feeling of investing with loans.
I’m so much happier, comfortable with, and proud of my 20 paid-off properties.
Conservative real estate investing is awesome!
There is also enormous peace of mind in not having mortgage payments once you give up your traditional 9 to 5 job and lose that safety net of a paycheck.
Especially during global pandemics! (Shout out to 2020)
I bought my rental properties in an area where house prices were around $40-$60k. That allowed me to pay cash for twenty houses.
I can’t tell you how much faster money accumulates in your bank account when you don’t have a mortgage!
Actually, I can.
When I owned six houses outright, it didn’t take long until the income from those six bought the seventh. Once you have ten, the eleventh even comes faster.
It creates a real estate cash flow snowball.
Once I had twenty properties, it only took five months of passive income from rents to have enough income to buy number twenty-one.
That may sound impossible for you, but I did it on a single military income. I did it slowly and systematically.
I paid off all my debt early in my career, lived frugally, invested smartly, and bought high cash-flowing properties.
You could likely build your real estate empire faster with leverage. It can be done responsibly, but don’t go overboard with the no money down, refinance, pull out your equity, reinvest, repeat strategies.
The smart move is to invest 20% down payment as a minimum, and then be sure your property is stabilized before moving onto the next with another 20% minimum down payment.
Being highly leveraged has massive default risk that doesn’t exist with prudent real estate investing.
Default might seem unlikely, but it was very real last time the real estate market tanked. It’s also real when you become disabled, lose a job, have a string of bad luck, or in the unlikely event of a a global pandemic (sarcasm intended).
Read my post where I analyze the pros and cons of paying off a mortgage.
I just told how to not invest in real estate.
Here’s the right way.
REAL ESTATE INVESTING THE RIGHT WAY
Here is the best way to invest in real estate.
- 20% Down
- Residential Property
- 30 year fixed loan
I will break the reasons for each of these down for you.
I’ve been watching real estate investors for almost 20 years, as well as investing myself.
I’ve also had significant contact with real estate gurus through this blog and from numerous podcasts.
There is no better way to invest than the most simple one.
Nothing beats putting 20% down on a residential property (single family home up to 4-plex) using a 30 year fixed loan.
There are a myriad of options for down payments, ranging from 0% down, which is entirely possible (but not advisable), to paying cash for a property.
So why 20% down?
This is that minimum amount down that most banks will accept for a residential loan with a fixed interest and up to 30 years amortization being possible.
Banks have figured out that with 20% down, which gives you 20% equity in the home, you have a margin of safety that is strong enough to survive most real estate dips, vacancy spikes, or temporary unemployment periods.
Unlike the stock market, real estate rarely drops quickly in a short amount of time. Additionally, real estate appreciates at about 3% a year on average.
With less than 20% down, you will likely pay private mortgage insurance, which adds to your monthly cost.
Additionally, you have less equity in the home, so real estate dips, vacancy spikes, or temporary unemployment periods could put you at risk of being unable to pay your mortgage and expenses.
Another danger to being unable to pay the mortgage is that you won’t be able to sell the property, because you will owe more than the property’s sale price.
That’s why having 20% down can be smart. If you were forced to sell because of a downturn, there is a much higher chance you won’t sell for less than the amount of your loan.
This is a margin of safety that is important to survive long-term in real estate.
The more properties and loans you have, the more devastating a lack of at least 20% equity would be during a downturn.
There are many different types of real estate you could invest in.
I say residential properties, which I define as single family homes up to 4 unit properties (quad-plexs), are the best type of property to invest in.
The reasons for this is financing.
When you have 4 units or less, you qualify for conventional loans.
Conventional loans can be amortized over 30 years and the interest can be a fixed rate.
We’ll get to why that’s helpful in the next section.
When you finance a property that is over 4 units, you must use a commercial loan.
Commercial loans are considered riskier than conventional (residential) loans.
The main issue that makes them riskier is you can’t get a 30 year fixed loan on them.
Commercial loans are often much shorter, with a 10 year loan being common. Sometime the balance of a commercial can be due even sooner then 10 years. I’ve seen loans recently that are due in 5 to 7 years.
This means that you make regular monthly payments until the loan is due. Then you have to pay the entire loan off, or refinance at whatever new interest rate and loan term you can get.
This subjects you to interest rate risk. If interest rates go up a lot, and then you are forced to sell or refinance, this hurts you financially.
If you refinance at a higher rate, it could make your monthly payment much higher, and could wipe out your cash flow.
If you sell, you may lose money because higher interest rates drive down the price of commercial properties.
It’s also possible that you can’t sell, because the sales price might be less than the remaining balance of the loan.
I’m not saying commercial real estate is a bad idea. I own a small 6-unit commercial property myself.
You just need to be clear that is has more risk than a residential property.
More risk also equals more opportunity for profit. Risk is a double-edged sword.
30-Year Fixed Loan
Why is a 30-year fixed loan best?
I already explained why you wouldn’t want to have the balance on the loan due early, like in 5 to 10 years.
This would subject you to interest rate risk, forcing you to refinance at a new rate, or sell to hopefully payoff the balance of your loan.
For a conventional or residential loan, you are faced with two fairly straightforward choices in your financing.
You can get a 15-year or a 30-year loan.
You also can choose between a fixed interest rate, or a variable interest rate.
30 years is better than 15 years because your monthly payment is much lower. This allows you to cash flow more on the property with your mortgage. With a 15 year loan, you’ll either have less cash flow or a negative cash flow.
You may think a conservative investor would pay off his mortgage faster.
I consider that ultra-conservative.
While there is amazing peace of mind in having paid off properties, when you do the complicated math, controlling more real estate by responsibly using debt will make money faster than the cash method.
I should know.
I had 20 paid off properties for most of my investing career. It was awesome peace of mind.
I also made good money, but I’ve run the numbers, and I would have made more if I used leverage and purchased more properties with at least 20% down, fixed 30-year loans.
I find the sweet spot for down payments to be 20%, but you can go higher for a better margin of safety. When people approach a retirement where they will no longer generate any type of paycheck, they sometimes like to pay off or pay down their primary residence as well as investment real estate.
A fixed interest rate is better for an investor than a variable interest rate.
With a fixed rate, you know what your payment is, and can estimate your future cash flow.
If you get a variable rate, the rate is sometimes lower, but this can be misleading.
if interest rates shoot up while you own the property, your monthly payments will go up, and your cash flow will decrease, or even be wiped out.
Fixed rates are the smart move.
Now you have my philosophy on real estate investing.
Next, you need to educate yourself.
You need to spend enough time, but not too much time, getting the knowledge you need before you do that first deal.
Some people spend years reading blogs, taking courses, and buying books on real estate investing, but never pull the trigger and buy a property.
Conversely, others try buying a property without doing any research at all. Those people are called reluctant landlords.
I know hundreds of them.
The right answer?
Once you are in a financial position to comfortably purchase an investment property, set a reasonable goal for how long you will spend in the knowledge accumulation phase.
When are you financially ready to invest in real estate?
My short answer is, when you are out of debt, investing wisely in retirement accounts, and have a downpayment saved up.
If you want my long answer…
Read my post on knowing when you are ready to invest in real estate.
As far as how much time you need to get the knowledge to move forward, three to six months should be enough. Longer than that, you’re draggin’ your feet.
In order of importance:
Read My Blog
Read everything about real estate investing you can on my blog. Whether you decide to buy in cash like I did, use traditional mortgages, VA loans, or something more unique (riskier), you’ll still benefit from understanding my unique approach to real estate.
My method is especially beneficial to the military, others who need to move a lot, or anyone who wants to invest in a location they are not currently living (out-of-state, from overseas).
Some other great RE Blogs
Read everything on Coach Carson. He has a wealth of experience and is a conservative real estate
investor who is also a prominent member of the financial independence retire early (FIRE) movement. Check out my good friend Eric Bowlin at idealrei.com. He used debt responsibly to build an impressive real estate portfolio. www.affordanything.com by Paula Pant is also another great real estate blog. It’s such a great blog, that reading it was what inspired me to start a blog myself.
Use www.biggerpockets.com to listen to their podcasts. I’ve listened to most of them to get an idea of all the different real estate investing options available (still like my podcast episode the best). Once you’ve done this, you’ll really have a good idea what type of real estate investing is right for you.
Word of warning: You are witnessing selection bias. You are only hearing the success stories, and many of them use risky leveraging techniques. It’s kind of like late night infomercials with that warning at the bottom “results may vary“. Many that try similar aggressive tactics end up unsuccessful, in debt, and not on podcasts.
Find a mentor or mentors. Find a group of real estate investors in your area and connect with them. Many cities have something like a Real Estate Investors Association (REIA), or some similar organization you can find online.
You can often find investors by using the forums organized by city on the biggerpockets.com website. A word to the wise: Don’t expect something for nothing. Find a way to help these investors so they’ll have a reason to help you. Example: Offer to do free work for them in exchange for a little bit of their time and advice.
Read some Books
Read a few books on real estate investing. No books have blown me away, but there are a few I like. I’ll recommend The Millionaire Real Estate Investor by Gary Keller and The Book on Rental Property Investing by Brandon Turner.
Get out and DO IT!
While all this prep work can help, nothing in the world is better than actually going out there and buying that property. The school of hard knocks (real life) is the best teacher in the whole world. Expect that not everything will go perfectly with your first property, but hopefully you will have mentors as wells a professional team to rely on when you start hitting those inevitable roadblocks and challenges.
We will get to the building a team part later.
Next, I will discuss investment types and strategies. You want to pick your specific expertise in real estate, often called niche.
There is a steep learning curve with real estate, so trying to do many different things at the same time just wouldn’t work. After educating yourself you may get an idea what type of investing will work best for you.
Choose an investment type and strategy, and then move forward with putting a team in place and start making offers!
REAL ESTATE INVESTMENT TYPES
Single Family Homes
This is the type of investment I’ve focused on. These tend to be the best investment for beginners in real estate. Getting financing for them is easy, making them an attractive option for investment in the United States.
It also ends up being the most common choice for the novice. It’s a good place to start.
Although the simplest to buy, these can be difficult to find deals that cash flow well. This is why sometimes it’s prudent to consider multi-family.
If you look through my blog, and see the 20 paid-off homes I currently own, they are all single family homes.
Duplex, 3 and 4-Unit
The next progression up is a 2 to 4 unit. These are sometimes known as duplexes, triplexes, or quads (4-plex).
Now you are into what is called multi-family, but on the small end.
These are great investments, as there is less competition than with single family homes. Getting financing is fairly easy, as banks look at a 2 to 4 unit the same way they would a single family home.
This means it’s much easier to get a 30 year loan for these. Getting 30 year fixed loans on large multifamily is typically not possible.
These properties tend to cash flow better than single family. They have economies of scale, one loan securing several units, one roof, and one yard, among other benefits.
These houses have the special benefit of lending themselves to the practice of househacking.
Househacking is when you either live in a house and live in one room and rent out the rest, or live in a multi-family unit and live in one unit and rent out the rest. This can work really well on a 3 or 4 unit property.
With 4 units or more, it’s not uncommon to work things out where the rent from the other units may cover the mortgage and all expenses, and you live in your unit rent-free.
I just bought a 4-plex, and the rent from one unit covers the entire mortgage. This is the textbook way to cash-flow well with a mortgage.
Military readers: If you qualify for a VA Loan, you can use it to purchase a 2-4 unit property no money down, and live in one unit renting out the others (househacking!).
Read my post on The Complete Guide to Investing with VA Loans
When you go past 4 units, you no longer qualify for conventional financing, but need to understand commercial lending to get money. There are some notable differences. You may need at least 25% down.
Getting financing depends largely on the income the property is generating. Comparable sales do not matter like they would with a residential property.
The 5 to 50 unit properties are an interesting area to shoot for because it’s too small for full time property management to be on-site. This means large investors and syndicator will not mess around with it, so you have less competition.
It’s also too complicated for novices. This allows an interesting entry point for the brave investor who wants to scale quickly. Cash flow and value-add is much easier to achieve here, with the goal being to
fix management, decrease expenses, and increase rent and income.
While there isn’t a clear line of when you go from small multi-family to large, at a certain point beyond 50 units, you get into the size of property that costs millions of dollars and has full-time management on-site.
There may also be work-out areas, pools, and a staff for handling marketing. These properties can give you a predictable income and be fairly hands off with the right team in place.
Sometimes, large apartment buildings are purchased by syndications. This is when a group of investors pool their money together and purchase the property in a somewhat complicated legal entity. There are ways of doing this totally passively or as a larger stakeholder who helps put the deal together and makes sure everything runs smoothly.
Multi-family is something I have some experience in. I recently bought a 4-plex and a 6-plex. I’m not yet into large multifamily, but it is something I’m strongly considering.
A mobile home park can be an interesting alternative to multi-family. It can actually be quite a bit cheaper vs. the amount of units you collect rent on because in multi family you buy the structure and the land.
With mobile homes, there is an option to purchase just the land, and allow tenants to own the mobile home on the land.
A big advantage of mobile homes is the maintenance side. When tenants own their mobile homes, they are responsible for the upkeep. Tenants tend to move less often due to the difficulty of moving or selling a mobile home.
REAL ESTATE INVESTING STRATEGIES
Buy and Hold
This is the most basic and maybe the easiest way to invest in real estate. Simply put, this involves purchasing a property and then renting it out for a long period of time. The investor seeks to make a profit first by the cash flow from a long term rental and then potentially by selling it at a profit sometime in the future.
This is the method I have been focused on with my 30 units in Montgomery, Alabama. I also owned a townhouse in Alexandria, VA for 13 years that was a buy-and-hold rental.
The key here is to ensure you have calculated correctly that you will have a positive cash flow. Some people will try to tell you to time market cycles correctly and try to buy where you believe property prices will rise quickly. I don’t play this game.
If appreciation happens in your area, take advantage of it, and sell if appropriate. You should never buy a property that won’t make money unless it appreciates. Don’t count on or hope for appreciation. This is a losing strategy.
Variations on Buy and Hold
This program is also known as the housing choice voucher program. It is a program where eligible families can receive a voucher for a large portion of the monthly rent plus utilities, and they are sometimes responsible for paying the remaining portion themselves.
Advantages of this program are:
- on-time guaranteed monthly rental income
- lower vacancies
- expanded pool of tenants
- above market rental rates
- additional advertising for your rental property listing
- a tedious and grueling inspection process
- special eviction rules
- difficulty getting support from the public housing authority
Turnkey Property Companies
A turnkey property is real estate that has been purchased in poor condition and renovated by a company. In some cases this company will put a tenant in the property and provide a management company and then sell the property to an investor.
The turnkey provider will make a profit between what they buy and renovate it for and what they sell it to the investor for. I personally feel like this profit is something an investor shouldn’t give up. I don’t believe turnkey companies are a good choice.
There are several other potential pitfalls of investing in a turnkey provider. I wrote an article about it:
Wholesaling Real Estate
Wholesaling is an interesting niche within real estate. You are essentially someone who finds deals for investors in your market. You find great deals in your market and put them under contract without actually buying the property yourself. You then search for buyers who will pay a higher price for the same property.
You reassign the contract to them, and pocket the difference in price.
You never actually own the property as a wholesaler.
This is an investment strategy taught in seminars as something you can do with no money or experience. I suppose that’s possible, but being able to find better deals than investors themselves is no small feat. Success may be a little more difficult than advertised.
I’d rather find the deal myself and keep that profit then give it to a middleman (or woman).
That being said, an experienced and professional wholesaler can be an asset to you.
I recently purchased my 4-plex from an investor that wholesaled it to me.
Flipping Real Estate
This is an investment strategy that most people are familiar with. There are cable shows that dramatize this. It’s when you buy an ugly fixer-upper, make the interior, exterior, and yard beautiful through extensive remodeling and landscaping, and sell it for a higher price.
Sounds easy. It’s also easy to screw up! For one thing, when I fixed houses, I bought my flips with mortgages. When my buyer fell through on his purchase and I had to start the process over, I ended up paying several more months of mortgage out of pocket. That really cuts into your profits.
Also, when you are less experienced, you will find you underestimated repairs, or found damage that was more extensive than you imagined. Also, sometimes contractors can be difficult to work with, and not necessarily follow through on what they promise you.
The tax consequences of these sales are also high, and you may have to pay a self-employment tax that does not apply to buy and hold investors.
I’ve flipped about 8 homes, and in general made money. I plan on trying it again in the future. Some make very lucrative careers of this. It’s no walk in the park, and not for the faint of heart.
I’ve blogged a little about my experience with this:
TYPES OF LOANS
TAXES AND REAL ESTATE
There are several ways to decrease, delay, or outright avoid paying taxes by using real estate.
Capital Gains Exclusion
For your primary residence, and not investment properties, if you live in it 2 out of the last 5 years, then the capital gains when you sell are not taxed.
A single person filing can exclude up to $250,000. Married filing jointly can exclude up to $500,000.
I used this exclusion on the townhouse I bought in 2003. I sold in 2016, but was still able to avoid paying capital gains. That’s because there is a little known exclusion for military members that extends the five years ten additional years.
Read my post on the military capital gains exclusion
You can deduct several types of expenses from your taxable income, saving you lots of money.
These expenses include mortgage interest (not principal), property tax, operating expenses, and repairs.
Essentially, you can deduct all necessary expenses for managing, conserving, and maintaining your rental property.
You can also deduct depreciation, which is complicated enough to warrant its own section.
Depreciation is the loss in value to an item over time due to age, wear and tear.
You are allowed to depreciate items such as houses, buildings, roofs, landscaping, appliances, and HVACs to name a few.
The way depreciation works is, you can’t deduct the value of the entire item all at once, you deduct on a schedule of years depending on what type of item it is.
Residential buildings are deducted over a 27.5 year schedule. Commercial buildings over 39 years.
You do not depreciate land value. Land does not wear out over time like a building would.
What that means is, you have to separate the value of the land from the building, and then only depreciate the building’s value.
Use this formula:
Cost of Building – Value of Land = Value of Building
Value of Building / 27.5 years = Yearly allowable depreciation
This yearly allowable depreciation can be written off your taxable income as an expense.
In most cases, this depreciation will eventually be taxed when you sell the property, but you get to depreciate the property and write it off until then.
When you sell an investment property, you will pay tax on the capital gains and the depreciation that you’ve taken or should have taken.
This can be a massive tax bill.
The way to get around this is to use section 1031 of income tax code. It’s also commonly known as a 1031 exchange, like-kind exchange, or starker exchange.
Remember, this only applies to investment real estate. It does not apply to your primary residence. The tax trick for your primary residence is living in it 2 of the last 5 years for a capital gains-free sale.
When you do a 1031 exchange, you roll the capital gains into the next property you purchase. In theory, when you sell the 2nd property, you’ll pay the capital gains from the first and the second. The way around this is to do another 1031 exchange avoiding paying taxes again.
You can avoid being taxed on your property entirely by dying and leaving the property to your heirs.
They will not have to pay the taxes (depreciation recapture and capital gains) that you would of if you sold it in your lifetime.
You have to do a 1031 exchange in a very specific way. You must use a qualified intermediary, which is kind of like a neutral party that understands the process.
You have 45 days to identify by address your replacement property.
You have 180 days to make the purchase.
If you screw the process up, then the sale of your real estate gets taxed.
If you want to know more about this read my in-depth post on 1031 exchanges.
BUILD A DREAM TEAM
Before you make an offer on a property, you will need a team of people in place. I call this my dream team.
I know, it’s cheesy.
Real Estate Agent
The importance of a great real estate agent can’t be overstated.
Ideally, these real estate agents understand real estate investing. If not, they need to be taught by you.
Some people will try to buy or sell without using a real estate agent. I rarely see people come out ahead doing this.
My advice is, a good real estate agent is worth the commission you’re paying them. And then more.
They are worth their commission for many reasons, some of which are their contacts, experience, ability to negotiate for concessions on your behalf, and removing yourself from the process to avoid emotional confrontations.
For me, I was often buying real estate from out of state or even out of country, so my real estate agent was also my eyes and ears on the ground.
A real estate agent will make a commission from you. Make sure they earn it.
Most real estate agents just want that commission, and want it fast. If you don’t get the service you want from them, let them know. If they don’t adjust their service to what you need, find someone else.
There is a mismatch in incentives between a real estate investor and a real estate agent. Investors want to make multiple low offers on lots of properties hoping that eventually someone accepts their offer.
This is a lot of work for a real estate agent, so most aren’t willing to do this.
You need to find the ones that are.
Real estate agents want to make offers on just a few properties and close the sale quickly, so they can make money faster.
You will get protests from real estate agents when you make low offers:
“They’ll never accept an offer that low!”
“They’ll laugh me out of the room!”
“They won’t take me seriously!”
My real estate agent in Montgomery made lots of comments like this when I first starting working with her.
Eventually, I starting buying properties and she started getting commissions from me.
She’s helped me buy 20 properties over a period of 3 years, and quickly understood the reason why I make multiple low offers on several properties on a weekly basis.
She came to understand the unique needs I had as an investor.
There is another thing I have trained my real estate agent to do to meet my needs.
Since I’m purchasing from out of country, I like to see additional pictures on top of the ones on the websites. I ask the real estate agent to take additional pictures of the property on her phone and send them to me.
Again, either a real estate agent is willing to do what you need them to do, and you keep them, or they are not, and you get rid of them. No middle ground.
Their commission is high. You’ll find someone that meets your needs.
IMPORTANT NOTE: Be careful about signing a listing agreement!
Sometimes, real estate agents want you to sign an agreement that you’ll only work with them, and won’t buy property with anyone else. This isn’t a good idea for a real estate investor.
I would offer to sign an agreement for any property they show you. Just make sure that agreement doesn’t cover properties you find on your own of from another agent.
If you are going to sign it, make sure you understand how to get out of the contract if you are unhappy with their service. Discuss this. If they tell you that won’t happen, that’s not good enough.
Trust me. It happens.
You may decide to manage the property yourself, and that’s possible. I manage my 30 properties now.
I lived overseas, however, for most of my military career and used a professional property manager to manage for me, be my local expert, and boots on the ground.
In real estate investing, finding a great management company is one of the most important things to ensure success. I can tell you from experience, when you find a good management company, they are worth their weight in gold.
Their knowledge of the rental market, neighborhoods, local contractors, streamlined listing process, managing turnovers, and the systems they have in place make it worth more than the fees you’ll pay them.
But that’s only if they are HONEST AND DEPENDABLE.
Many of you have had experiences with bad management companies or heard others talk about it. I have fired a few management companies myself.
The important thing to do is find a good management company through proper vetting.
Luckily, in my military career, I was an investigator. I’m accustomed to gathering information about people.
I decided to put that skill to use in my real estate business life (legally, of course).
The first thing I feel is important is looking at their fee structure. How will they charge you? Compare it to other management companies in the area. One important factor to consider is how do they charge for putting a tenant into the property for you? Also, how do they charge for having a tenant renew a lease?
My current company charges a 10% management fee, but doesn’t charge anything to find a tenant or re-write a lease. Some companies charge 7 or 8%, but charge one months’ rent to find a tenant. These additional fees are important to consider.
Another important thing to consider is how does it work if you are unhappy with their service and want to stop using them.
I’ve seen situations where you essentially sign a lease with the management company which means you have to give several months notice before you stop using them. This even applied to being unhappy with their service.
I had a management company that tried to get me to sign this. I took that part out of the contract.
I later ended up firing them.
Now it’s time to approach the management company from the renter’s perspective. At this point, I go to their webpage and Facebook page and look around. I see how easy it is to navigate. I see how good a job they do with their listings.
I’m concerned how quickly they respond to emails, if at all. Also, how quickly they move from email to getting you on the phone and having you look at a property. How efficient are their systems?
I’ll call the phone number posing as a renter and I try to make an appointment to see a property. Then, I ask a bunch of questions about the property and see what questions they ask me about my income and situation. Next, I may act difficult or unpolite and see how they handle it.
I’m concerned about how easy it is to get a person on the phone. If I get voice mail, how quickly do they call me back.
A big problem would be not getting answers by email and not getting through to a person by phone.
Once I’ve satisfied that test, I move on to talking to the owners of the management company.
Here are examples of questions you can ask to understand the management company better.
- How old is the company?
- How many rental properties do you own yourselves?
- How many rental properties do you manage for investors?
- How many different real estate investors are you managing for?
- Will you let me speak to some of these investors about their experience working with you?
- How do you handle evictions and how will I be charged for it?
- What is your vacancy rates?
- What is your criteria for screening tenants?
- What are your income requirement for tenants?
- What is your pet policy?
- Can I see a sample rental report that you send investors each month?
- Will you let me speak to some of your tenants about their experience working with you?
Check the Better Business Bureau and BiggerPockets forums.
Do internet searches on their company.
Here is another thing I’ve been using my management company for above and beyond just management. These are important for me because I live outside the country and buy properties that I can’t see.
Before I buy a property, I make sure my management company approves it. There are two different considerations here.
One is the house. Will tenants like this house? Will they like the floor plan or the flow of this particular house? The management company knows this better than the real estate agent or my inspector. They know because they show houses to tenants all the time.
Next is the location. Even if I know this company manages properties in this general area, sometimes one particular street can be bad, and the next street over can be great. These are differences only a management company would be privy to.
This is where a management company can really help with real estate investing. I believe I’ve saved a lot of money by turning houses down based on my management company’s input.
The most important thing I use my management for is this…
It’s probably been the key to my success.
I negotiated with my property management company for them to supervise large rehab projects for me. When I buy an investment property, it’s usually something in bad shape that needs a lot of work. They arrange for and supervise all the work. I paid them a 10% markup on their cost.
This has been key to my success. The trickiest part of long distance real estate investing is arranging for and supervising rehab projects from long distance. This is what stops most people from investing long distance. This is my solution to that problem, and it has worked out great!
Read more about my 5 secrets to finding the best property manager
General Contractors and Contractors
Another thing you need before you buy a house is access to some general contractors and contractors such as plumber, carpet, hardwood floor, HVAC, tree, lawns, landscaping, roofers, etc. A great management company will already have many of these contacts.
Angie’s list is also a paid service that gets you access to vetted professionals. It’s ideal for real estate investing. The biggerpockets forums is another place. Networking with other investors will give a few more. The REIA I spoke of earlier is another location to share this type of knowledge.
Another great method is the referral system. A good handyman knows good roofers. Good roofers know great tree guys. A great plumber can recommend the best HVAC guy.
You get the picture.
I find myself a good inspector and get every house inspected before purchasing. I use the results of the inspection to drive the price of the property down or ask the sellers to fix certain things.
At a minimum, it’s a hedge against having some huge surprise with the property after I buy it. It also acts as a punch list of items for the management company to fix before the first tenants move in.
If you are buying a house with a mortgage, an appraisal may be required. I always buy my houses with cash, so they are not required, but I still get an inspection. Just remember who the appraisal is working for. In the case of a mortgage, the appraiser is more concerned about the bank’s interests than yours.
That’s why if I’m financing the property, the bank will get an appraisal, but I’m still getting an inspection done by my guy.
The inspector is looking out for me, not the bank.
If you purchase the house with a mortgage, you will be required to get an insurance policy. Even when I pay cash, I still get an insurance policy.
The insurance company I use does their own inspection of the property for me and tells me what I need to fix before they will insure it. This is free of charge, and I just think of it as another free estimate and check and balance on the property ensuring it will be safe.
How much of a deductible you have on your fire insurance will affect your premiums. I have a very high deductible, $5,000. This means my policy is cheaper, but I can’t really use the policy unless I have a pretty big loss.
If money is tighter for you, and you can’t just pull $5000 and fix it yourself if a roof gets damaged, then you’ll want a lower deductible. Understand that means higher payments, but less expensive when something unexpected happens.
START MAKING OFFERS
Paramount in real estate investing is understanding the multiple listing service, or MLS. It has gotten a lot easier to look at the MLS in recent years, mostly due to sites like Zillow and Trulia, which seem to show pretty much the same thing. We’ve found the ability to shop real estate on these sites almost as effective as what real estate agents have access to.
The MLS is a database of properties for sale in a regional market, set up by a group of cooperating real estate brokers. In the old days, the only way to have access to the listings in the coveted MLS was to work with real estate agents. This is no longer the case. Trulia, Zillow, and other websites have somehow cracked the code, and most information from the MLS is also listed on those websites.
Realtors will try to tell you that often the information on Trulia or Zillow is incorrect, but I have done most of my investing purely using Zillow, and been quite successful doing so. I back it up by having my real estate agent look it up herself, but 97% of the time, it’s the same information.
I’ve bought several of my properties straight off Zillow and Trulia.
A short sale is a sale of real estate in which the net proceeds from selling the property will fall short of the debts secured by liens against the property. In other words, selling the house would not pay off the mortgage. The lien holders (probably a bank) agree to accept less than the amount owed on the debt and take the loss themselves.
I have bought a few houses this way. It can happen fairly quickly in rare cases, but usually takes several months. In one case, I made an offer that was accepted by the bank six months later. This allows you to buy at a discount, but there is more uncertainty and a long wait involved.
Sometimes you’ll find houses listed on the MLS that are foreclosures that were originally owned by Fannie-Mae, HUD, or some other entity. You’ll see that there is a special process to go through to purchase. There may be a website you have to use such as www.homepath.com or www.hudhomestore.com or even www.auction.com.
I have purchased houses through these websites at a discount. There is more ass-pain involved in dealing with foreclosures and you buy them as-is, but that is what keeps the novices away.
You can benefit by reading the fine print, dealing with the red tape, and you may walk away with a good deal or two like I have. Sometimes, real estate investors are prevented from bidding on foreclosures until a certain amount of time has passed.
I’ve found both short sales and foreclosures to be great ways to buy houses in real estate investing. You can usually find these on the MLS, but they are more complicated, and you’ll get a better deal than the traditional MLS buy.
It’s time to make offers on some properties.
How can you be sure a house you are thinking about buying could be a good rental? The quick way of telling is using the 1% rule.
The 1% rule
The 1% rule is widely used in real estate investing. Monthly rent should be at least 1% of the acquisition price. The acquisition price may be a higher number than the purchase price. Its purchase price plus the money to get the house ready to rent.
If you buy a house for $80,000 and spend $20,000 remodeling, for a total of $100,000, the house should rent for at least $1,000 a month to meet the 1% rule. This mean it might be a good rental.
If you are actually thinking about buying it, then you need to break out the calculator and do a bunch more calculations. I previously did a post on how much money will I make from my rental property that explains these rules and calculations in much more detail.
Once you are sure the numbers will work for the property, make that offer.
As I talked about early, I like making lots of low offers for properties on the MLS that could make good rentals. If you get a decent counter-offer from the seller, then you know you have something to work with. If you get no response, nothing lost, nothing gained.
Make sure when you negotiate your price, you are clear on the highest price you are willing to pay. I always made a decision what my lowest return on investment I was willing to accept was.
You need to remember that it doesn’t always make sense to invest in every city. High cost of living (HCOL) cities usually end up being bad investments because you can’t get close to the 1% rule.
This is also true in areas with good school districts or areas that are new or newer homes.
Sometimes, certain parts of the city are better than others for investing. An example of this is when I moved to Montgomery, Alabama. Even though we wanted to buy the house we were going to live in, the numbers didn’t work, so we rented. It was in a gated community with good schools and the homes were newer.
These kind of homes don’t always meet the 1% rule and don’t make good rentals.
A few miles away, we ended up purchasing several houses in a different neighborhood that met and exceeded the 1% rule.
You have to buy the right house in the right location. It has to be able to make good money as a rental, or don’t tie up your money in it!
Buying the right house is illustrated well in an article I wrote called Real Estate Mistakes Military Members Should Avoid
In real estate investing, bargaining tactics can make a big difference in your bottom line. They say you make money when you buy the house, not when you sell it.
One of my favorite bargaining tactics is as follows. This may seem simplistic to you, but it has saved me lots of money on my home purchases. I got home inspections on my properties before I purchased them, and my offers always had a subject to home inspection contingency in them. That meant if I found something I didn’t like, I could back out.
I would use items found in the home inspection to subtract from the offer price. In other words, if I offered $60,000, I would subtract $5,000 from that based on several different items found in the home inspection. Often, the seller would agree to the new price, or at least meet me half-way. Sometimes, they would agree to fix certain items themselves before closing.
When inspections came back with complicated problems such as termites, foundation, or roof issues, this gave an opportunity for a large price reduction. While I’ve found termites not to be a big deal, it really scares off the novice purchaser, and really puts a bad taste in most people’s mouths. I’ve got some steep discounts this way. By the way, always get a termite inspection before buying for this reason.
Another great bargaining tactic is to keep track of the houses that you lose out on, but that end up coming back on the market later because the original contracts fall through. This usually means the buyers ended up not qualifying for their loans.
In my case, I was often a cash buyer. I would go back to these sellers who were upset and desperate after having their first buyer flake out at the last second. I would usually come back in at a lower price than my original offer, but it would be cash, and they would accept to avoid losing another few months on the market.
If you can’t buy in cash, just make sure you have solid financing lined up. Make sure you can show a pre-approval letter and proof of funds for down payment. This will put the seller at ease.
So you’ve found a way to get your offer accepted.
You either get it move in ready yourself and turn it over to your management company, or you find someone to do it for you. I was out of the country for 5 years, so I used my management company for that.
You could use a real estate agent, contractor, friend or relative for this.
Make sure they know what they’re doing!
CONGRATULATIONS! YOU’RE A REAL ESTATE INVESTOR
Hopefully, you’ve got a good return on investment on this property.
While I bought many of my earlier properties in cash, I’m now responsibly buying with 20% downpayments.
I still think conservative real estate investing is the smartest way to go!
Some people are happy having multiple mortgages, especially while rates are still low. Just make sure you can handle a downturn in the market, and could survive if you lost your day job, or if renters stopped paying for a while.
Made it this far? Congrats and thanks for reading!
Here is a link to an article I wrote on buying long distance real estate.
This is a living document that I’ll keep adding to.
What are your thoughts on my conservative approach to real estate?
What do you disagree with or think it’s missing.
Comment. I will reply!
Rich on Money