Value Investing in Rental Real Estate Properties
I am writing this post on a 2 hour American Airline flight to Detroit Metro Airport. My wife has fallen asleep next to me and I am wide awake.
Michigan is where I started my real estate investing endeavors, and this trip has inspired me to write about how I got started and the potential in value investing in rental real estate.
One year after graduating from a masters program and working in Corporate America, I had gathered a healthy amount of discretionary income and was contemplating how to invest it. Since I had maxed out my retirement accounts (401k and Roth IRA), my options were either to lock the funds in a saving account or CD, or invest it in other income producing assets.
I figured I was young enough to be able to digest more risk, so I studied various investment options that were more aggressive in nature. Of all options considered at the time, value investing in real estate appealed to me the most to start off.
So I shopped around for the best financing deal at the time, got pre-approved and searched for my first rental property. I bought my first condominium in a rather affluent area at a 15% discount from a motivated seller who was looking to get out of Michigan ASAP.
Because of my stellar credit score, a decent balance sheet and a stable cash flow from a secure job, I was able to secure an 80/20 loan, with the 80% of the loan amount at 5% fixed interest rate, and the 20% at a variable rate. I was able to finance 100% of the purchase price, and negotiated the seller pay all closing costs.
After factoring all management expenses, my mortgage, taxes and a small reserve, I was netting a $100 per month positive cash flow. That is $1,200 annually. Although the amount may not seem much, think about the fact that my tenant was essentially paying off the property on my behalf.
What does this mean? This means that since I bought a property worth $145,000 for $120,000 with nothing down, the rent payment received from the tenant over the next X years would pay the property off completely. Assuming the worst case scenario of no appreciation, I will essentially end up owning a property worth $145,000 at year X without having invested a penny into it.
To understand the true return on investment, one must factor in the principal payments that the tenant was paying on my behalf. So if my loan reduced from $120,000 to $118,000 at the end of year one because of rent payments received from the tenant, I essentially made an additional $2,000 on top of the $1,200 positive cash flow (difference between incoming rent and outgoing payments related to the property). This amount increases over the years as more principal is paid off and less interest.
There are two other factors to the total return on investment – appreciation and tax benefits. Appreciation of the property is never a factor in my investment decision making. If the property appreciates, I consider the appreciation icing on the cake. The tax benefits are nice, and should be contemplated as well as part of the decision making process.
Two Types of Real Estate Investing
Various books will tell you there are various types of real estate investors. In my book, all these types really boil down to only two kinds, the value investor and the speculator.
Speculative investing is what partially led to the housing bubble and burst eventually. It is a style of investing where investors speculate on future growth or appreciation of the property.
Speculative investing was at its peak in “glamorous” cities within States such as Florida, California and Nevada. Investors bought and sold properties by the minute. In fact, many were simply buying purchase contracts (the right to buy the property when it is built) and flipping them for healthy profits before even ground-breaking.
Things were absolutely nuts as “flippers” made all sorts of money. Websites went up by the day where buyers and sellers met and transacted their real estate. The activity levels alone were artificially driving up demand and therefore the prices of properties.
Value investing on the other hand is a more conservative approach and one that doesn’t involve guessing or speculation. Value investing evaluates the underlying asset being purchased, and its true income generating potential now and in the future while factoring in the residual value of the asset itself.
Value investors are interested in protecting investment capital and are welcoming of slow, steady growth. They have a lower risk appetite, and usually tend to make decisions based more on the best available option relative to others under evaluation.
The differences between speculative investing and value investing in real estate is the same as it is for a stock market investor, or any other investor in any other discipline. Which one are you?
I am a Value Investor
I was never interested in flipping properties to make a quick buck. Whenever I evaluate properties for investment, I always ask myself “am I going to make money the day I buy the property?” If the answer is yes, then I usually go for it.
If I know I can close on a property today and rent it out tomorrow for positive cash flow, the deal is a no brainer for me. Whether that property appreciates is irrelevant for my value investing purposes. If it does, like I said, I think of it as icing on the cake.
Does that mean I don’t flip properties? Of course not. I have flipped them in the past when the deal has made sense. But is this the core style of my value investing approach? Absolutely not. I once bought two purchase contracts in a city that houses a popular university. 3 months into holding the contract, an investor came by looking to do the same.
Because I had built a relationship with the developer and had sent him 6 other leads that bought from him, he connected me with the new investor. I ended up selling one of the contracts at a 28.5% gain. No development had started at that point and I profited from a piece of paper.
The investor is a friend of mine today, and we both enjoy a very healthy cash flow from our investments in the project. Looking back in retrospect, this investment was a gem because of the cash flow it generates, and I shouldn’t have sold the contract to him. I still tell him that today.
Many of my properties have appreciated over time, and after factoring in the reduction in loan principal thanks to my tenants, I am sitting on a nice chunk of equity in all of my properties. However, that hasn’t changed my investing style. I am still a value investor today as I was years back when I first started.
My Winning Investment Equation
You will find all kinds of investing equations depending on what real estate investing book you read or what Guru you hear preach. For me, I have always stuck to one equation and have always come on top. My equation is as follows:
- Monthly Rent
Minus
- Mortgage Payment (Principal & Interest)
- Taxes
- Association Fees / Dues
- Repair Reserves
- Vacancy Reserves
- Property Management Reserves
- Insurance
= Positive Cash Flow
Positive Cash Flow / Initial Investment = First Year Rate of Return
Example:
This example refers to a condominium I purchased in 2007. I found the property on an MLS alert I received from a local agent in the area where I wanted to buy.
When I decide where I want to buy, I usually contact a local agent immediately and spend 20 minutes communicating my criteria, frequency of updates and what variables I want the update reports to show. This allows me to play at my convenience and evaluate the property based on the variables I am interested in most.
I found a property listed for $90,000 that was valued at $125,000 when I reviewed the comparables and price history. I saw that the property was initially listed for $123,500 and subsequently reduced 3 times within a 3 month period down to $98,000.
I had a feeling the buyer wanted out immediately, so I scheduled time to visit the property, and after drinks over dinner with the selling agent, I managed to extract from him that the property was fully paid off and the owners lived in Florida.
To make a long story short, I was able to purchase the property for $70,000. Based on my research of the comparables in the area, I knew that I could get $1,200 per month in rent.
Let’s now look at the expenses, or outgoing funds.
- Mortgage Payment (Principal & Interest) = $490
- Taxes = $2,800 per year or $233 per month
- Association Fees / Dues = $190
- Repair Reserves (5%) = $55
- Vacancy Reserves (5%) = $55
- Property Management Reserves (10%) = $110
- Insurance = $170 annually or $14 per month
Total Expenses = $1,147 per month
Positive Cash Flow = $53 per month or $636 per year
My initial investment was approximately $2,000 in closing costs, inspection of the condo, and a few other miscellaneous bills. I structured the deal with no down payment. The following is my first year rate of return on investment.
$635 / 2,000 = 31.75%
Am I really that desperate for $635 a year to accept all the headache associated with property ownership? No I am not desperate. Consider that the $635 will only grow over time, and that I will own a property worth $125,000 in a few years essentially without having to pay for it.
I will enjoy positive cash flow and tax benefits in the short term, and the property may also appreciate down the road. Mostly, replicating this over multiple properties adds up, especially over the long haul.
Because the appraisal reports came near $120,000, I was able to get the Private Mortgage Insurance (PMI) waived. Lending institutions typically charge a PMI to protect their interest if the loan amount is over 80% of the property’s value. Since my loan to value was much lower ($70,000 / $120,000 = 58%), I was able to get the PMI waived on the deal.
Note that the equation doesn’t factor appreciation and tax benefits. It only focuses on whether the property yields in positive cash flow in its current state. It also measures rate of return based on the first year of investment only, because subsequent years will only be higher.
If the return is acceptable at year one, it will only increase over time as the principal component of your mortgage payment decreases over time. I understand that other variables such as taxes may increase, and you can adjust the rent to pass on the increase to the tenant.
I usually study the going rent figures in the area where I am looking to buy by scouring through Sunday classified ads, web listings as well as contacting local real estate brokers in the area. Brokers have access to Multiple Listing Services (MLS) that advertises available properties for sale or rent. It is very easy to pull comparable properties in the exact area you are looking in to get an idea for what the going rents are like.
The last point I want to make is regarding property managers. If your equation is coming up barely short, consider eliminating the 10% property manager reserve. I hand over my properties to managers so I do not have to deal with the tenant and issues arising from the relationship.
Most property managers charge 10% of the rent amount monthly to “manage” the property. Honestly, I don’t think they do much at all and property management is a lucrative business if you can get into it and build a healthy portfolio. The peace of mind is worth it to me however, even if they only make one trip a year to my property to unclog the kitchen sink drain for my tenant.
Parlaying Snowball
I realized the tremendous potential of rental value investing in real estate after purchasing my second property, then third and so on. By parlaying one onto another, your cash flow, tax benefits, appreciation, equity build up all increase.
The biggest and most impactful aspect however is the ability to expedite paying off one property from the cash flow of another. Consider this scenario. You buy your first property and enjoy a $53 positive cash flow monthly. That is $636 a year that you can use to pay down its principal and expedite paying off the property.
Alternatively, you can invest in your second property and use the cash flow from the first one to expedite paying down the loan on the second. Once you have just one property paid off, your cash flow will increase significantly. In the example I provided above, the $490 principal and interest payment will become all yours. Added to the $53, your monthly cash flow will be $543, more than enough to pay for a brand new mortgage on another property.
The idea is to roll the cash flow from one to another and keep the snowball going. Over time, you may decide to sell a property here and there and benefit from the one-time windfall of cash resulting from the sale. You also have the option to draw a line of equity from banks even when a property is not fully paid off as long as you have positive equity in it. I call this the parlay effect of rental real estate investing.
As successful as I have been value investing in the stock market, I enjoy value rental real estate investing a lot more.
Rental Property Management
A common factor that turns off many potential rental real estate investors is the hassle involved in managing tenants and properties. I have been doing this for years and if you ask me, I don’t think there is any major hassle involved at all.
Sure, things have come up here and there but I wouldn’t call them hassles. The little bit of work involved is well worth it given the far superior and long term benefits to be derived from rental real estate investing.
The work involved will also not bother you if you are truly passionate and enjoy what you do. You know how the saying goes.
With that said, I have always believed the key to my success has been targeted value investing in quality areas that attract quality tenants. If I wanted, I could own four times the properties I own today if I invested in lower quality areas and therefore paid less for each property. That is not my cup of tea however.
I want quality tenants with good, stable jobs, who will also take good care of my property. I also don’t want my property managers (and occasionally I on a random visit) running the risk of getting hurt when they go to collect rents.
If the work involved or “hassle” is really what’s keeping you away from value investing, consider hiring a property manager. The reason I hand off all my properties to professional managers is exactly that, to create more time and peace of mind while I focus on growing my portfolio and depositing the monthly checks.
I suggest however that you manage one property on your own the first year you get involved. It is important to understand and learn the ins and outs involved in rental real estate investing. Develop relationships with handymen and contractors, or take a class and acquire the basic “know-how” on maintenance around the house. Even if you don’t have to use it, no one can ever take your education away from you, and you will be able to speak to contractors more intelligently.
At some point however, there comes a turning point when you just have to relinquish control to property managers, either forcefully (because other priorities take over life such as bigger fish to fry) or voluntarily (just because you want to).
Entity Formation & Liability Protection
I could have lived without this section but since we still have some flight time and this post is getting lengthy as is, I thought I might as well throw in the kitchen sink.
I choose to buy my properties under an independent Limited Liability Company (LLC) that has its own bank account and Employee Identification Number (EIN). Further, I choose to have the LLC under a living revocable trust structure.
Why do I do this? I do this to protect myself from any liability related claims. By separating each property in its own entity shell, I am protecting each from the claim of the other. I am further protecting myself by creating objective separation between myself and my “companies”, which are really properties. I do not co-mingle funds from one LLC to another or into my own personal account either.
The total cost of setting everything up is less than $300, and the benefits well worth it. None of the deeds or titles are owned by me. Instead LLC X, Y or Z owns them. Yes, I am very poor on paper, and I like it that way.
In a trigger happy society that we live in today, anyone can file a frivolous lawsuit against you. I have a lot of respect for lawyers and they are some of the most intelligent professionals out there. However, they too need to make a living.
When a lawyer contemplates taking a lawsuit case against me, they know that it will take a lot of time navigating through the LLC / trust structure, making it more expensive than beneficial to take on the case. A Lawyer’s time is very expensive, and they understand that they are better off working on easier cases and making that $250 an hour billable rate.
You can either spend months learning how to do all this and do it yourself, or hire an attorney to set these up for you. There will be some serious fees involved, but the benefits are worth it. An alternative to hiring a lawyer is Socrates, a website founded and operated by lawyers.
Socrates provides all the forms and documents you need to do it on your own. Your work is reviewed by a lawyer to ensure it is accurate. I love this service and use it often for all my businesses.
One last point – always carry ample insurance on each one of the properties. In addition, get an umbrella insurance policy. The extra $400-500 in annual premium is well worth it. It is also tax deductible.
Tax Benefits
Investing in rental real estate has its tax advantages. If you are actively involved in your rental property business, you can claim business-related expenses such as the miles you drive, car depreciation, car insurance, cell phone charges, etc. If you manage your properties from home, you can even deduct part of your mortgage or rent, utility bills, etc. You can read more about my discussion on tax deductions here.
In addition to all the expense deductions, you can also elect to benefit from a non-cash deduction, which is the depreciation on your property or properties. Non-cash deductions mean that you get a tax break (in form of a deductible expense) without having to spend actual cash out of pocket.
How is that possible? The Internal Revenue Service (IRS) allows you to depreciate your rental property over 27.5 years. So if you buy a rental property for $100,000 in January, you are allowed to deduct $3,636 ($100,000 divided by 27.5) come tax return time. The deduction would lower your taxable income, and essentially lower your effective tax rate.
You can deduct the same amount every year until you have deducted the entire $100,000 on a cumulative basis 27.5 years down the road.
Resources
A lot of what I have learned through the years has been a result of practical experience being involved in the trenches. There is no better way to learn in my opinion than on the job training.
That said, there are a handful of resources that I used which helped prepared me prior to me putting any skin in the game per-se. These resources provided me with the “know-how”, tips, tools, contacts and more than anything else, confidence in what I was about to get into.
The resources are as follows:
Various real estate books purchased from FedEx Kinkos stands, Borders and Amazon. I have learned that all real estate books (and I have read 14,000 of them) really preach the same fundamentals but just in different angles. Pick up a few of these to start off, any of them, and let the material sink in. I made my first two investments after reading various books.
The following three resources however kicked things into HIGH GEAR for me, as I still refer to them today as continuing education material and resources whenever I start contemplating a new deal.
Creative Real Estate Help – A very good soup to nuts, end to end real estate investing system.
Charrissa Cawley’s Real Estate Power Investor Program – I have met Charrissa personally and this lady is quite amazing and such an inspiration. I love her comprehensive system and DO IT YOURSELF style. The program does a very good job training a newbie on how to walk the real estate ropes.
Austin Davis’ Commercial Real Estate Course – Great resource for acquiring commercial real estate regardless of your income, experience or credit status. I do recommend getting your feet wet with residential rental real estate first however before diving into commercial.
These resources also advocate developing an expert support group, which today surrounds me and whom I reach out to when in need. This group includes real estate attorneys, agents, brokers, negotiation experts, bankers, accountants, government officials and others.
Conclusion on Value Investing
Sure there are other factors to consider in rental real estate investing which I have purposely not included to keep things simple and my point straight. You need to think about the time commitment and whether you have the ability to get involved in this type of venture. Like anything else except breathing, it is not for everyone.
You need to consider the repairs and maintenance involved in rental properties, as well as potential vacancies or periods when your property is not rented out. This is why I like to build a reserve as demonstrated earlier in my investing equation above.
I am wrapping up this post as the flight attendant just made the announcement to turn off all electronic devices and stow them away. Ever noticed there is no consistency on when they tell you to do this? Sometimes it is five minutes prior to landing, and sometimes it is twenty-five. I sometimes wonder if it even matters? I really don’t think it does.
Scrolling back up to what I have managed to include in this post, I hope I have been able to clearly explain the concept of value investing in rental real estate properties. The subject is obviously vast and there is much more to learn if you are interested in pursuing this venture. The resources above will certainly help you do so.
I am looking forward to discussing this matter further through the blog comments below.
Readers: What are your thoughts on value investing in real estate? Do you have another approach which you recommend? Why?
Read how Wiki’s contributors define value investing here.
Sunil
Parlaying
Next: I am Joining the Yakezie (Yah-KAY-Zee) Personal Finance Network
36 Responses to “Value Investing in Rental Real Estate Properties”
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You write this all on a 2 hour flight mate? If so, impressive! I love this topic, and it’s so good to look at real estate now with all this QE2 pump priming. PErhaps inflation will finally come one day.
BTW, what is your Twitter handle? Perhaps you can incorporate that in your tweet button when I or others tweet your posts?
real estate is my bread and butter and my gateway to entrepreneurship some years back. although other ventures have proved very lucrative as well, my heart still beats real estate. i can talk about it endlessly and welcome conversation along those lines.
I tried incorporating the Twitter handle once before based on your comment in the past and apparently failed at it. what is the best way to ensure the handle appears on the Tweet button?
you are a more experienced blogger than I Sam – thoughts and suggestions are always welcome.
Hi! I have gone ahead and bookmarked http://easyextramoneyonline.com/blog/2010/11/value-investing-in-rental-real-estate-properties on Friendfeed so my friends can see it too. I just used Value Investing in Rental Real Estate Properties as the title in my bookmark, as I figured if it is good enough for you to title your blog post that, then you probably would like to see it bookmarked the same way.
I appreciate the kind gesture.
Very interesting post. I found the section regarding “speculative investing” very intriguing as one of the causes of the bubble burst.
Welcome to the blog Zoliath. Speculation certainly got us in trouble (usually the case)
what a $70,000 property getting $1200 rent. I have never seen that anywhere on the west coast at least. So you put each individual property in their own LLC each with separate bank accounts ? I would go crazy dealing with so many LLC’s and all the state filings/tax paperwork for each one…..especially with 1031 exchange record keeping……..Our estate lawyer says LLCs dont hold up for protection and umbrella policy does just about the same thing and just have them in a trust.
the West coast is def more challenging from a cash flow perspective, hence I don’t own any there. tried exploring the Midwest? quite shocking the kind of arbitrage you’ll find even these days. yes they are all in individual LLCs, which are owned by a “management company”. I have a trust as an umbrella entity. I don’t have an umbrella policy for properties but I do have one personally. can you recommend companies that specialize in rental property umbrella coverage? it sounds more complicated than it is, especially when you have tax professionals handling the compliance aspect.
ps – i was just thinking……$1200 rent on $70,000 property is less than a 5x gross rent multiplier…..I would be lucky to ever find a 10x gross rent that was habitable and in a reasonable location on the west coast. ….I like looking at gross rent multipler initially because estimating cap rate or cashflow has so many variables for each property
I don’t look at it in that way, not that I disagree. I look at minimum current positive cash flow (the day after purchasing and renting it out – in theory). just saw a 55k condo that rents for $950 (based on rental comps, minor repairs needed – carpet/paint) last weekend. they’re still there.
Sunil,
Great blog post. If you had to pick just one resource of the 3 you recommended, which one would you pick?
it really depends on your objectives and where you stand. personally, Cawley’s course helped me a lot because it’s primarily geared for beginners. I got into more specialization later on.
Peculiar article, exactly what I needed.
welcome
Thanks for the tips about credit repair on this
particular site. The thing I would tell people is
always to give up a mentality that they buy right now and fork out later.
As being a society many of us tend to make this happen for many things.
This includes vacation trips, furniture, as well as items we wish.
However, you’ll want to separate a person’s wants out of the needs.
While you are working to fix your credit score you have to make some sacrifices.
For example it is possible to shop online to save cash or
you can click on second hand suppliers instead of pricey department stores to get clothing.
did you mean to comment on another article Leonor?
Great post. Incredibly helpful and wish I had this when I started renting my home out.
never too late Matt. perhaps apply it to the next one?
Investing in real estate properties is really one of the best ways to have great return of income. Though the industry has its own share of ups and downs, clients can still decide on how they will deal with their investments.
but like anything else Sarah, no risk no reward right 🙂
Sunil,
Hi, what are your thoughts on financing one’s investment, 15 or 30 yr loan terms. Is building equity while having cash flow better or building equity tops all? Or is it a personal choice? Thanks
I may be reading your Q wrong, but both seem the same to me. when you borrow, you leverage other people’s money and thus capitalize on a larger percentage gain (appreciation). this, coupled with short term cash flow and tax benefits make RE investing wonderful. thus you build equity and you benefit from cash flow
I am just looking for the real estate investing blogs for getting some information. Then I found your blog. It looks really interesting for me.
you’re welcome Kate
I realize this article was written years ago but WOW! I have read Start small Profit big in real estate, and this one article explains things better than that whole book! I am a young guy (25) looking to buy my first home and I am going to be looking at it as a future rental property. I think owning rental properties is my future! Sunil, or anyone else who likes talking about this sort of thing, please add me on facebook!
What do you do now? How do you plan to raise capital? Are you looking to get in as a full time endeavor or as a passive income generating mechanism on the side?
My hubby is a handyman. We have rentals but just moved to Dallas and there is a lot of competition for properties. We have done handyman work for tons of realtors, but haven’t found anyone to help us find a good deal on a property for us to fix and rent. We have done plenty of residential and commercial improvements and management, but are in need of help in finding a good deal.
Property must be categorized as per the needs and multi-family residential property generally delivers the most stable returns, as no matter what the economic cycle, people always need a place to live. Losing a tenant has minimal effect on a multi-family residential property in comparison with other type of property.