Wealth Building Lessons

In a previous post, I mentioned why real estate is such a good investment. However, some people commented that they had gotten burnt by real estate. As with all investments, if you don’t know what you’re doing, there’s a good chance you will lose money. Real estate is no different. So I’ll try to go over some of the basics of investing in real estate.

1. Stick to bread and butter homes

Bread and butter properties are just your basic, no-frills 3 bedroom, 2 bath, 2 car garage homes which are usually around 1250-1500 sq ft. These properties will give you the best rent-to-mortgage ratio.

Try and buy these entry-level homes in middle or upper-middle class homes neighborhoods. Don’t go for luxury or high-end homes or war-zone areas either.

Depending on the geographic area, the prices of these homes can range from $50,000 to $500,000. The rents can range from $500/month to $2500/month. If you buy in cheaper places like Oklahoma your rent will be about 1% of the purchase price ($500 rent/$50,000 cost *100 = 1%).
However, if you buy in places like California, the rent will be a maximum of 0.5% of the purchase price, and probably less.

If you want to cash-flow, you should definitely try and find properties where there rent is at least 1% of the cost.

2. Understand Real Estate Market Cycles

Real estate prices are dependent on the local economies, inward migration, and mainly how much can people afford to pay. If you buy in a location that has quadrupled in price in the past 5 years there’s a good chance you’re buying near the top of the cycle.

If you’ve never seen a down market in real estate, you have no idea how bad it can get. Don’t be fooled into thinking this time will be different. Places that have inflated a lot will come down in pricing. Places like Texas and Utah that haven’t appreciated a lot will continue to appreciate depending on the local economy and places like Michigan which have been flat for 20 years will probably stay that way for the next 10! If the numbers don’t make sense, be very careful. While leveraged real estate does well in an appreciating market, it can completely wipe you out in a down cycle.

3. Know how to do the math

You’ve seen everyone around you buying investment real estate and making oodles of money. You attended a $5,000 real estate seminar and are all pumped up to buy something. The “guru” tells you to buy in your own backyard.

Unfortunately, you have no idea how to calculate the numbers on investment properties.

You end up buying a 2200 sq ft, 4 bedroom, 3 bath, 3 car garage house in San Diego for $650,000 and you use your HELOC to pull out the $80,000 that you use for closing costs and for a down payment. With a 6% interest-only loan and 1% property tax, your monthly outlay with insurance and rental tax to the city of San Diego is about $3560.

Unfortunately, the beautiful house only rents for $2600. You’re already in the hole $1000/month and then you realize that you also owe $600/month on the loan on your HELOC! You lose money every month until you’ve cry uncle and give up.

You need to consider all the different expenses when calculating your holding costs.

Make sure you know what the local property tax rates are. They vary from 0.7% of the purchase price to over 6%. And find out whether the value of the property will be reassessed every year and whether it will affect the taxes. Also find out the insurance costs. It can cost between 0.5% to 6% too. Not know these numbers can set you back substantially. Also factor in vacancy and maintenance costs, which will differ based on the area.

If you don’t know what to consider when running the numbers I strongly recommend Frank Gallinelli’s book, What Every Real Estate Investor Needs to Know about Cash Flow… And 36 Other Key Financial Measures.

4. Understand how mortgages work

Maybe you got an option-ARM mortgage with a 1% start rate. You’re only paying $1200/month PITI (principle, interest, tax and insurance) for the first 2 years and cashflowing $1000/month! Unfortunately, you didn’t know it was a negatively amortizing loan and when it resets you find out that

(a) the rate wasn’t really 1% - it was really 7.75%
(b) the amount you should have been paying was $3000/month instead of $1200/month and now your mortgage balance is $43,200 more than the original loan amount.
(c) you have a 3 year pre-pay penalty and if you refinance before then, it’ll cost you an extra $26,000!

Ok, so maybe this is the extreme worst case scenario, but there have been cases where home owners have been swindled by mortgage brokers and have unknowingly gotten terrible loans.

There have also been cases where investors (and home buyers) lied on the loan applications and got in over their heads. Lying on a mortgage application is a federal offense and the FBI can get involved. Not a pleasant situation.

At the very least, if you know how to read a HUD-1 mortgage closing statement, you’ll know how much money your mortgage broker is making and whether you’re getting ripped off. Always ask for a Good Faith Estimate and a rate sheet before you commit to a loan. And if the mortgage broker is responsible for the late closing a loan, if you’re charged any penalties make sure he pays it.

I normally get a 5/1 interest-only ARM since I don’t plan on keeping the loan for over 5 years. If the property appreciates a lot, I’ll probably refinance to pull out equity, or if it isn’t working out I’d sell it and cut my losses. However, in the few times I expect to hold the properties for a long time, I have gotten a 30 year fixed loan or at least a 10/1 ARM.

For those of you that don’t know what 5/1 ARM is, its an Adjustable Rate Mortgage with the interest rate fixed for the first 5 years. Thereafter, it adjusts once a year. Its tied to some index and a margin is added to that. For example, you can get a loan with the index being the Cost Of Funds Index(also called COFI) with a Margin of 2%. If the index is 3%, you loan will be 5%. There is a also a lifetime cap on how low or high the interest rate can go.

Definitely read How To Save Thousands On Your Mortgage. Even if you never buy investment property, you’ll still end up buying a home. Read this book or you really will end up thousands more than you need to.

5. Hire good property management

Contact a good property manager before you buy a property. Find out how long it takes to rent out a place and how much you can rent it for. Then see if it makes sense to even buy the property in the first place.

Make sure you get referrals from a few different investors about property management. Ask them how long they been in business, how many units do they have under management, how they handle evictions, and how much they charge. Also find out who does any repairs and maintenance? Is it in-house (and thus its a profit center for them and a loss-center for you) or do they outsource it and charge you a management fee on top of that?

6. Be wary of unethical agents, appraisers and mortgage brokers

Every real estate investor at some point will come across unethical agents who will tell them anything to make a sale. It may be a terrible investment but they’ll try to sell it to you anyway. More common is the mortgage broker who will get you in a very expensive loan that will make them a bundle. Its not uncommon for mortgage brokers to make 3-6% of the value of the loan. (Sub-prime loans are especially profitable for them).

There are also scams out there that you need to watch for. The agent, appraiser and mortgage lender are usually in on the scam. They sell a house thats way over-priced ( and supported by an over-inflated appraisal) to a buyer who’s usually in on the deal too. Everyone splits the excess profits, no mortgage payments are ever made and the bank suffers. These scams usually end in jail time for the parties involved.

Also look out for unscrupulous buyers and home builders who are trying to offload a problem property. Always hire a competent home inspector to uncover any defects in the house like a cracked foundation or leaky roof. These can be quite expensive to fix so you should know about it before hand so you can adjust the price of the house accordingly (or just walk away).

Conclusion:

This isn’t a comprehensive list on how to buy investment properties, but it a good starting point. Hopefully you’ll realize that you can’t buy a $400,000 house that rents for $1500 at the top of the market cycle and expect to make any money. However, if you can go out of your city or state, it is possible to buy profitable real estate.

But as with any investment, as more and more people chase it, prices go up and yields go down. So you definitely need to do your homework before you buy.

Just don’t believe everything you read and definitely don’t pay some guru $10,000 to learn how to buy real estate. (Send me the money instead!)

Recommended Reading:

1. Value Investing In Real Estate

2. The Weekend Millionaire’s Secrets to Investing in Real Estate: How to Become Wealthy in Your Spare Time

3. How to Create Multiple Streams of Income: Buying Homes in Nice Areas With Nothing Down

4. Landlording: A Handymanual for Scrupulous Landlords and Landladies Who Do It Themselves

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