The Investment Scientist

How to invest in real estate: Part II

Posted on: September 13, 2012

house for sale

House for sale

My wife and I own a couple of rental properties, so I feel like I am qualified to give my 2 cents worth on another way of investing in real estate – owning rental properties directly.

Now let me be clear: owning rental properties is a business; it is no longer an arm’s-length investment. It is great for some people, people who are hands-on and disciplined, but it could be a disaster for others.

When we posted a notice to rent out our townhouse, the first person to answer was a single mother with three kids. My wife checked her credit – it was bad. When my wife said no to her, she could not hear the pleas of my bleeding heart: Rent it to her! She has three kids to take care of! We’ll waive her rent if she can’t pay!

You see, I am a good money manager, but I would not make a good rental property manager since my empathy would get the better of me.

In the end, we rented the townhouse to a plumber’s family with two incomes. The added bonus of renting to a plumber is that he can take care of everything. This surely beats renting to a lawyer. Imagine he couldn’t flush his toilet and you have to go fix it at midnight or he will sue you!

All our rental properties are productive because of my wife. The lesson I have learned is: if you want to own rental properties, marry a stern spouse who will keep bad renters out.

Joking aside, here are three pieces of advice I can give you about rental properties:

  1. Buy rental properties in up and coming areas with easy access to transportation and major roads.
  2. Choose your renters carefully since your rental returns depend on them. We required all prospective renters to submit a formal application and pay a $40 application fee. We then used landload.com to check their credit scores and interviewed them individually. We left little to chance.
  3. Buy umbrella insurance. You never know what you could be sued for when you are in the rental business. Your tenant’s parent could slip in the bathroom and it legally could be your fault. Some attorneys would recommend putting each property into a limited liability company. I can save you the hassle: just buy an umbrella insurance policy.

If you can do these three things, chances are that you will become a happy and profitable landlord.

Get my white paper: The Informed Investor: 5 Key Concepts for Financial Success.

2 Responses to "How to invest in real estate: Part II"

We have 9 single family houses in neighborhoods where people used to (before 0% down lending) buy their starter home. We buy REOs, HUDs, or other distressed properties. We renovate them to modern living standards; i.e. double pane windows, added insulation, updated electric, HVAC, and a bonus family/entertainment room in the basement.

We have a close working arrangement with our mortgage banker and she runs our credit checks. We check the clerk of courts website for evictions, convictions, warrants, etc. In reality, a lease is a promisory note for whatever the total figure is. You most likely wouldn’t lend $20-30K to a stranger. Why would you enter into a lease of equal value?

To qualify a potential resident must have pre tax income equal to 3 times the rent. When we deny an otherwise nice prospect we tell them part of our job is to not set them up for a failure. We want all our residents to thrive not struggle in our homes.

I was more or less forced into rental/investment real estate. At the same time of my retirement (lower income) the 2008 market shift erased most of the dividends I enjoyed. My home budget was underwater every month.

In a little over three years, with help from a real estate investor/mentor we have grown the top line of our business to just over $100k, and we keep about 55% of that after expenses.

Rents are market sensative. In central Ohio we’re doing OK. On either coast the same effort could easily result in 5-10 times the gross. Probably all the variables would increase in proportion.

The beauty of a RE portfolio is you model it to suit your needs or ambitions. I needed retirement income, so I focused on cash flow. A person with great income from a corporate job may need tax shelter and real estate can be structured for that too. In the modeling I developed the criteria for the property, the margin, the rehab cost, and exactly where we want to end up in a deal. If it’s a $100k property I want to have about 70% in it when finished. We can buy a turnkey for $69K, have it painted and rent it right away; or we can buy the ugliest place on the street for 35k, rehab it for 35k, and be in axactly the same place.

This 30% margin does several things. First, it becomes the profit in a rental. Without monthly positive cash flow there is no reason for me to purchase a property. Second, suppose this is your 1st property. You are nervous and not certain this is for you. This margin becomes a quick sale opportunity, since another investor will gladly take your finished property off your hands. Flipping is not a real option in our area because of tight margins and the tax consequences.

The ugly of an RE portfolio is that it is hands on. Those people who live in your properties become more than strangers. If they have problems it tends to become your problem. Our approach is to help them become better planners, savers, and believers in the American system. Someday I will want to sell off some properties and the people living in them are the best clients to sell to, if they qualify for a mortgage.

In the end, the numbers, whether credit checks, purchase price, rehab costs, or margins…all of them should be designed to mitigate risk.

Ron,

Thanks for the long comment. I knew you would give a response more valuable than my original post. There is a lot to learn about RE investment. I am glad that has helped to turned around your finances.

Also curious, what is your typical cash on cash return on your properties? By that I mean net annual rental income over initial purchase price.

I am trying to by properties that could give me 8% cash on cash return. I have found finding the right properties very time consuming. What’s your experience?

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Author

Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC. He is also a regular contributor to Morningstar Advisor and Physicians Practice. To explore a long-term wealth advisory relationship, schedule a discovery meeting (phone call) with him.



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