Filed under: Investing
The allure of real estate investing is easy to grasp: it offers residual income, price appreciation, and the safety of owning a hard asset. I grew up living in a rental home and remember thinking how lucky my landlord was to get money every month without having to do anything! In an effort to replicate his residual income model, I would rent my toys out to my younger brothers.
I was appalled, at the age of 6, when my mother told me that I had to share instead of lend out my toys.
I learned the hard way growing up that owning assets -- and real estate in particular -- can be very difficult. The problem is that it is very capital intensive, particularly for those who don't already have assets. Tightening lending standards, which are arguably a good thing for the safety of the greater economy, further prevent normal people from acquiring rental property. Down payments can be as high as 40% for income property, which is a ton of money for 99% of Americans.
FHA is a great option, but may require that you live in the home, which puts you in an ethical tight spot if you want to rent it out. There is also a dearth of property available in many of the desirable markets around the country. I used to feel that the very idea of owning rental property was a sham -- only rich people were able to afford it!
The reality is that buying a good rental property is difficult, but it is also possible. Five years ago I graduated college, only to quit my private equity job in favor of a gig buying foreclosures for a company that paid me $3,000 a month. I was able to buy six rental homes in 18 months, which has since spring-boarded me onto larger and more profitable deals.
I can only really speak from experience, but I'm confident that anyone who is persistent enough can buy property using the steps below.
6 foolproof steps to acquiring investment property
Step 1: Learn about real estate
In a lot of ways, this is the hardest part.
You -- yes, you -- need to learn a ton about how real estate actually works. I read books like Real Estate Finance & Investments: Risks and Opportunities by Peter Linneman. The first time I read the book, I probably only understood about 25% of what was in there, but I kept working through it, and eventually I understood most of it. If I didn't know a term, then I would look it up on Investopedia or some other site. You can figure out anything with Google.
I would also talk about real estate to anyone I could. I was fortunate in that I was 22 years old, and people were eager to "impart knowledge" on me; it was socially acceptable for me to be ignorant. I looked very stupid for a while, but I was fine with it. In one of my first conversations, I asked a good family friend to explain what a "cap rate" was, a term that any basic real estate person should know. I was a little embarrassed that I didn't know the term, but I was glad that I wouldn't make the same mistake again. (Look up "cap rate" right now if you don't know what it is ... like, now! Go!)
The most important part of conversations is to ask questions. This is not a time to regurgitate every page of the real estate textbook you just read. This is a time to learn how someone else made their money. The beautiful thing about real estate is that there are a ton of ways to make a buck (investing, brokering, research, tech, appraisals, renovations, etc.). There is a reason that real estate is a huge driver for the US and global economy -- it touches every aspect of life.
Take a pay cut to learn. It may be by shadowing a friend, spending your weekends doing an open house for someone or taking an internship that doesn't begin to pay off your student debt. It is really hard for someone to say no to an offer to work for free. I should know -- I offered myself to just about every real estate person I knew after college.
It is humbling, but it is worth it.
The last point to be made in this step is to really learn about real estate. I'm a huge fan of practical knowhow. If you know someone who is exactly where you want to be, then go and ask them exactly how they got there. It may be different for you, but you might as well get their story and learn what worked for them.
Step 2: Commit to owning real estate
This is a crucial aspect of the process. I didn't come from any family money, and it took me years to be able to buy properties, but I knew that I was going to do it. No matter what it took, I was committed.
It is becoming increasingly difficult for people to buy investment property for the first time. In many ways real estate is a game of rejection. I look at about 100 flip deals for every one that I buy. That is a clean 1% success rate. I had over 74 meetings before I convinced someone to hire me for a real estate job that I thought was helpful to my goals. I don't look at percentages; I look at whether I got the task done or not.
Embrace the struggle, and use it as motivation. If you are committed, then you will get it done -- period.
Step 3: Develop a strategy
I'm going to give you a strategy that I think is attainable for most people: Buy a single-family house with an investor, and rent it out for income and price appreciation. Focus on this strategy and this one alone. Don't try and do flips, don't try and buy apartments, don't try and reinvent the wheel -- just find an investor, and buy one single-family home ... to start.
This step could also be called "focus." You need to focus on achievable goals, and this is it. Trust me. Flips have a small margin for error, apartments require a ton of capital, and reinventing wheels is a fool's game.
Your strategy is to buy a property that will cash flow positively. This means that at the end of the year, your outlay must be less than the property brings back to you.
First, you must find a property:
- Go to Redfin or Zillow or some other listing site and look at what is on the market in an area that is less than two hours' drive away.
- Click around until you find a house that may be a good fit.
- Once you find a house you think may work, you should then locate the agent's phone number and other contact info. Redfin and Zillow will usually have the listing agent's name. A quick Google search should produce their contact info — agents want to be found.
- Call the agent. Yes, on the phone. No, don't email them unless they don't answer your call. Human interaction is important in real estate because most people don't do it.
Tell the agent you are interested in the property and that you would consider having them represent you. There is some ethical dilemma for agents who double-end deals (represent both the buyer and seller), but in my experience it is an effective way to get a leg up on a deal.
- View the property in person.
- Do this process until you find a deal that you like.
- Once you find a deal you like, make an offer. For our purposes, let's say it ends up being $100,000.
Second, and once in contract, you must underwrite the deal:
- Go to PadMapper, and look up the property in question. PadMapper is a site that aggregates rental listings on a map from Craigslist. It's a convenient way to figure out how much your property will rent for.
Also, ask the agent you are working with how much they think the property will rent for. For our purposes, let's just say it ends up being $1,000 per month.
- Figure out how much taxes are. Usually, it is a function of the purchase price, but it depends on the state, county and city. I would start out by calling the county assessor's office.
Is it annoying waiting on hold? Yes, for sure. Do it anyway; you need to know exactly how much the taxes will be. Let's say it ends up being 1.5% of the purchase price.
- Get an insurance quote. Call up any of the 6,000 insurance agents in your city (State Farm, Farmers, etc.), and ask for a quote. Say that you are an investor looking to buy a lot of real estate and that you want their best quote. Let's say it ends up being $1,000 per year.
- Call a contractor, and have them give you a bid to fix up the property to a level where you can rent it. I won't go into extreme detail on this part of it, but my general recommendation is to make sure things are clean and working -- they don't have to be new and swank. Let's say it ends up being $10,000 total.
- You need to estimate maintenance. You should be conservative, and for that I will say to estimate $200 per month.
- Let's also assume that you will be managing this property yourself, at least to start. This will save you some bucks and also get you some great experience.
- Lastly, let's assume that you will have one month of vacancy, which would amount to $1,000.
- Enter all of this information into a spreadsheet like below:
|Annual Vacancy (One Month)||$1,000|
|Net Operating Income||$6,100|
Note: "All-In Cost" was calculated by adding "Purchase Price" and "Initial Renovation" cells. "Net Operating Income" cell, also known as "NOI," was calculated by subtracting "Annual Rent" cell by "Total Expenses" cell.
- The next step is to talk to a lender and figure out how much you can borrow, and how much that will cost you. Let's assume that you find a good lender who gives you a loan for 60% of your all-in cost, with a fully amortizing 30-year term at 4% fixed rate. (Please remember to look up the terms you don't know.)
In this scenario your loan would be about $314 per month, or $3,768 annually. I got this by using the payment function in Excel or by typing "=PMT(" into an Excel cell.
- With these numbers your return would be $2,332 per year. This satisfies the requirement that the property will cash flow positively.
Note: The reality is that you could have some major property damage at any time. For example, the roof could fall in, and you might need $10,000 to replace it. This is why you should have an investor -- and also keep reserves.
- All you need now is to find someone to give you the 40% down ($44,000) that the lender is requiring!
Step 4: Find an investor
I got lucky with this step. I was, however, also very prepared to lock down my first investor because I had done steps one through three. Here is my advice for finding an investor when you have no marketable experience: Always talk about your goal to buy real estate.
It may seem simple or arrogant or taboo, but it has worked really well for me.
I always talk about my goals in real estate when people ask what I am up to. I found my first investor for a single-family home at a bar after a high school basketball game. It's a numbers game, and you just never know when you will talk about investing in front of the right person. This is also why it is so important to be educated, committed and to have a strategy. You need to sound smart when you talk about real estate and have a plan that people can see works.
Investors have a language that they like to speak. It includes terms like "ROI," "Cash on Cash," "Principal," "Debt Service," and all other kinds of mumbo-jumbo. Learn the language, and then speak it, and you won't have a problem finding an investor.
I'm also a big believer that good deals find money. This is why I'm suggesting that you get a deal under contract prior to finding an investor and not vice versa. The steps could probably be switched, but this is how I went about it.
At some point any investor is going to want to know how much money they are going to make. I personally think that talking in terms of cap rates are the best way to go. Some investors will want to know what their cash on cash is or what the IRR is, but I would always suggest proffering up the cap rate first.
A cap rate is calculated by dividing the NOI by the All-In Price. In our example it would be ($6,100/$110,000), which is equal to about 5.5%. Be conservative. Investors will want to know how much vacancy, maintenance and other expenses you are allotting. If they think you are over-selling a deal, they will be turned off. Under-promise and over-deliver -- it makes your life way easier and also helps you build a longterm relationship with the investor.
Step 5: Purchase the property, and get it leased
You will need to create an entity with your investor, set up a bank account and likely file LLC docs in whatever state you are in. I actually like to set up my LLCs in Utah because it is cheap, and the state government is really helpful and friendly. In reality, any state will do.
At this point you will start renovations with the contractor. Ideally, you will have already had a renovation agreement in place prior to closing. This will take away the uncertainty of the fix up cost.
Having managed about 500 renovations in the past five years (never swinging a hammer once, for my own safety mostly), I know that something will go wrong with the renovation. Don't worry about it; just work through the details with your contractor and investor.
It may cost more than you initially thought, but the reality is that the margin for error in a rental home is pretty high compared to a flip. This is why I recommend doing a rental first.
I start marketing a property for rent as soon as I buy it. There are differing views on this -- some people will wait until the property is completely renovated. It really just depends on what market you are in and what your preference is. I like to use Craigslist for rental listings. It is free and has helped me rent a lot of homes. There are other sites out there that shouldn't cost you a lot, if anything, to list on. The key is to write a nice quick description and have a reasonable asking rental rate.
Final step: stay persistent, and always keep pushing
This is a simplified step-by-step process. There is a lot of intricacy that I simply can't sufficiently cover in this piece. You will have difficulties, bad tenants, renovation problems and all kinds of other issues. Don't freak out; work toward a solution, and never quit.
As long as you stay persistent, you will be successful.
Owning real estate for the first time can seem a daunting and insurmountable task. I know the feeling all too well. I used to watch the shows on television where people would flip a house in a few weeks and make some enormous sum.
Who wouldn't want to do that?
The reality is that real estate can be a risky business for someone who is just starting out. Buying a single-family home and then renting it out is the safest way, in my opinion, to get experience and also make money. You won't become rich in a week: this is a gradual process. You want to become wealthy, and that takes time.
The key to building this kind of longterm wealth is having compound interest work for you, not against you. Buying rental property is the most attainable way to do this.
This article originally appeared on Bigger Pockets and is Copyright 2014 BiggerPockets,
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