SECTION PROCESS
GOOD NEIGHBORHOODS ONLY
Good neighborhoods don’t always stay that way, but usually they do for a long while. People want to live in nice places, so obtaining and then retaining suitable tenants is easier, and paying for the property is easier when other people are willing to do it for you. Tempting as it may be to buy a property with lower rent but much lower price, chances are it won’t work. Avoid the temptation of trying to win the game with Baltic and Mediterranean. No one ever wins that way. Stay away from the low rent districts.
BUY A LOWER END HOUSE IN THE GOOD NEIGHBORHOOD
Any neighborhood has its upside potential. The best house in the neighborhood is not worth as much as that same house in a better neighborhood. The worst house can be fixed, and upgraded to be an average to better than average house, so the upside potential is far greater for the lower range house in a nice area. Of course the down side is the magnitude of the cost of repair. If it is too much to fix it, move on, that must be included in your cost analysis. Look for a lower than average house in the nicer parts of town that can easily be brought up to the neighborhood norm or better with a little TLC.
MATH FIRST
Pre-qualifying a house for purchase is never a guarantee for success, but it is a good start. It is important to know if it can make sense financially before you even look at it. It doesn’t matter how pretty it is if you can’t afford it. I use a very simple mathematical formula to pre-qualify a property.
There are three major costs of home ownership that everyone must consider; mortgage, taxes and insurance. If the house (tenants) can’t reasonably pay these three major costs by itself, you don’t want it. In other words, if the rent you can get is reasonably expected to be less than the mortgage payments, insurance and taxes, - don’t buy it.
Of course there will be times when you will have to kick in some additional money, a furnace breaks, the AC goes out, a plumbing disaster. In non-emergency repair months you should be able to pay the three major expenses from rent. Save the money from the good months to help out in the bad because those times will absolutely happen when you don’t want them. This is just common sense – and Murphy’s law. Murphy was a pretty smart guy.
If you are looking at condos, you have a fourth major expense – condo fees, be sure to include that cost in your analysis. Condos also have assessments as well, be aware you may be hit with communal costs of property maintenance or repair.
You will know what the property taxes are from the town; your insurance agent can tell you how much the insurance should cost; but the mortgage could vary more. The analysis should start with a 15 year mortgage. A fifteen year mortgage at 5% will cost about 50% more per month than a 30 year mortgage – but you pay for half the time. A 20 year mortgage will cost about 25% more than a thirty, and here you save ten years over the standard 30 year note.
Start your analysis with a 15 year mortgage to see if it will work. The shorter term mortgages usually offer slightly lower interest rates too, so you save even more. If not 15, then go up to 20 and maybe even to 30. Over time, you should try to pay it off faster as rents increase, especially if you have a longer term mortgage.
Example:
A $100,000 mortgage at 5% for 15 years will save about $50,000 in interest payments over a 30 year loan. So, if you can do it, get it done faster. If not, start with the longer mortgage, and over time, try to pay it sooner. The sooner you kick the bank to the curb from tenant rental payments, the sooner all of the rent (almost) is in your pocket and not on the champagne table of bank board members’ yachts.
Positive cash flow is a MUST. If you expect to pay out of pocket regularly, you will be limiting your future. If you make only $5.00 a month, you can move on to the next property and continue buying more forever. If you get in the habit of paying out of pocket to support your rentals, you will be limited by your personally earned income, and eventually have to stop looking for property because you are supporting too much of it with your own money.
THE TEMPTING LURE OF THE BAD NEIGHBORHOOD
Many properties will seem to work financially in bad neighborhoods. For example, with only 10% down this house will work! The rent in the area is $500, a fifteen year mortgage, taxes and insurance is only $300 – WOW why not buy a hundred of these!!??
WRONG – refer to – Think Monopoly – low rent areas almost always don’t pay – the rent may be set at $500, but it is more likely that you will get nothing, have toothless deadbeats cooking meth and it will take a year and a half to get them out. By then you’ve paid all of the expenses for that period, eviction fees, the property is likely destroyed, and you have a court order demanding that the slime-ball who destroyed your house has to pay you back rent and damages - but that is worth about as much as the paper it is written on – nothing - he never pays. Now you’re looking for a new sucker to take the property off of your hands.
Low rents attract low quality tenants. Call me jaded, but it is true. The lower the rent, the more likely it is that you won’t get any at all. If that is not politically correct, so be it.
I once looked at a six unit trailer park, the sale ad boasted $3,000 monthly rent. The math worked great. It would have covered the expenses twice over and a new car every other year or so. When I asked for a copy of the tax return showing the rental income declared for the property, it was about $9,000 for the year, not $36,000. Why? Bad tenants are attracted to bad areas, and bad tenants often don’t pay. They know they can get away with it because real estate laws favor tenants and are weak for landlord protection. We landlords are the evil rich oppressors, so we lose. Sure the rent was $500 per month for each of six units, but most of the tenants didn’t pay it. Baltic Avenue.
DON’T PAY FOR POTENTIAL
Never buy “Potential”. You can make it better, potential can be earned, but it should never be bought. If the previous owner didn’t bring the property to its potential, there was a reason. What he has for sale is the property as it is, not as it might someday be. The potential of what he didn’t do is worthless to you because if it were easy to do, he would have already done it, and could have gotten paid for it.
LOW DOWN PAYMENT
Banks like to see a buyer put a deposit of 20% (sometimes more) for rental property purchases. If you can get away with less, and the property will support itself, pay less down. The greater portion of the mortgage the tenants can pay for your house, the better it is for you. The greater the leverage you have, the more property you can buy with someone else’s money, and the sooner it becomes retirement income.
CASH BUFFER
Despite the benefits of real estate, it is not perfect. There will be times when the income is not enough to cover the expenses. Maybe you have a repair to make, a tenant might leave, or even worse, you have a tenant who has not been paying for a while and is saving money to move and stiff someone else down the line. To be safe, we need to have a few months rent for every property in the bank to maintain a safety level. When these things happen - and they will, you will be ready.
Hopefully, you can start with a few thousand dollars and over time, the excess of rent over expenses can increase to the point where maybe you can take some out for personal fun.
RENTAL BANK ACCOUNT
Since we are on the topic of cash reserves, lets jump to rent collection. Set up a bank account for each property near the rental house, and have the tenants deposit money into that specific account for rent. This way, you will never get the “The check is in the mail, you should get it any day now” excuse. You will know exactly when payments are made, it is easier for you, easier for them because it is close to their house, everyone wins.
MATH AGAIN
When you bought the house lets assume you had to pay 5% interest on the money, and you got a 15 year mortgage the payment would be $633 per month. Real estate has operating expenses, so you would have at least taxes and insurance, say another $200 / month and a repair or two here and there. So you need $900 rent for this to work.
Now, if you really like the property, and the math doesn’t quite work, you can get a 20 year mortgage and reduce the monthly payment by about $100. Twenty years is a long time, and I would recommend accelerating the payments to get it done a little earlier, but it still works – just takes a little longer. Sometimes great pyramids take longer to build.