Chapter 3: Real Estate Investments: Niches and Strategies
Very narrow areas of expertise can be very productive. Develop your own profile. Develop your own niche. -Leigh Steinberg
While at first it may seem important that you learn everything you can about real estate investing, in reality, it is best to focus on two things: an investment vehicle and a strategy for using that vehicle. This chapter is going to introduce you to some of the most popular investment vehicles, as well as the most common strategies for moving forward.
In This Chapter We'll Cover
- Why Real Estate is Like a Box of Chocolates
- Choosing Your Niche
- Choose Your Real Estate Investing Strategies
- Buy and Hold
- Moving On
Real Estate Investments are Like a Box of Chocolates
Have you ever received a box of chocolates as a gift over the holidays? There are always so many choices, and sometimes, you need to take a little bite of each one to figure out what exactly you're going to find inside. In a way, learning how to invest in real estate is like that box of chocolates. There are dozens (if not hundreds) of different ways to make money as a real estate investor, and it's up to you to choose the niche you want to get into.
You might absolutely love some niches and strategies, while others might make you shudder. However, unlike that box of chocolates, as an investor, you are able to get a full view of the many different choices available to you, and you can then choose the one(s) that you enjoy the most. Best of all, you don't need to choose them all. Learning how to successfully invest in real estate is about choosing one niche and becoming a master of it. This chapter is going to open up that box of chocolates for you to sample and let you see some of the most common niches you can get into when investing in real estate.
Remember: Once you know the niche you want to get started with, you will be able to narrow down your focus, become an expert, network with individuals within that niche, and begin building wealth by taking action and executing a plan of action.
Choosing Your Real Estate Investment Niche
The following list includes the most common property types that you are likely to deal with as a real estate investor. Each of these has many subsets as well, but remember, you don't need to know them all. This is merely a list to help you get started understanding what options are available from a 20,000 foot view.
Raw land is nothing more than basic earth. Land on its own can be improved to add value, and it can be leased or rented to create cash flow. Land can also be subdivided and sold for profit. Some investors choose to buy raw land with hopes (or plans) that someday the land will become much more valuable due to external developments like the construction of a freeway or from a development being built nearby.
For More Information on Raw Land, see:
- Residential Land Development – Part 1
- Developing Real Estate: How to Price Land for Profit
Perhaps the most common investment for most first time investors is the single family home. Single family homes are relatively easy to rent, easy to sell, and easy to finance. That said, in many areas, the rents derived from SFRs (single family rentals) won't be enough to provide positive cash flow.
For More Information on Single Family Houses, see:
- Secrets of Single Family Rentals
Small multifamily properties (2-4 units) combine the financing and easy purchasing benefits of a single family home. Bought properly, these can cashflow quite well, and there is often less competition than what you'd run across bidding on single family homes. Best of all, these properties can serve as both a solid investment as well as a personal residence for the smart investor. Another perk of the small multifamily property is the ability to take advantage of "economies of scale," as only one loan is needed to secure the 2, 3, or 4 units in the property. One of the things that makes these investments so appealing is that most banks look at small multifamily properties with four units or less with the same guidelines as a single family house, which can make qualifying for a loan much easier.
For More Information on Duplexes, Triplexes, and Quads see:
- Small Multifamily Properties = Big Profits
- Financing a Fourplex Real Estate Investment Property
- New Investor Strategy: How to Buy Your First Multi-Family Investment Property & Live Rent Free
Small apartment buildings are made up of between 5 and 50 units. Though the line between small and large apartments is not set in stone, most investors typically draw the line between small and large apartment buildings at around 50 units. These properties can be more difficult to finance than single family homes or 2-4 unit properties, as they rely on commercial lending standards instead of residential ones. That said, these properties often provide significant cash flow for the investor who can deal with the more management-intense nature of the properties. Additionally, competition is generally seen on a lower scale for this property type, as they are too small for large, professional REITs to invest in (see below), but too large for most novice real estate investors.
Instead of being priced based on comps, the value of these properties are based on the income they bring in. This creates a huge opportunity for adding value by increasing rent, decreasing expenses, and managing effectively. These properties are a great place to utilize on-site managers who manage and perform maintenance in exchange for free or decreased rent.
For More Information on Small Apartments, see:
- How to Find the Best Commercial Apartment Deals
This class of property -- Large Apartments -- refers to the large complexes you might see all across the country that often include pools, work-out rooms, full time staff, and high advertising budgets. These properties can cost many millions of dollars to purchase, but can produce stable returns with minimal personal involvement. Many large apartments are owned by "syndications," which are small groups of investors who pool their resources.
For More Information on Large Apartments, see:
- Anatomy of the Grand Slam: How I Made $800,000 on One Flip
REIT stands for a Real Estate Investment Trust. In the most simplistic definition, a REIT is to a real estate property as a mutual fund is to a stock. A large number of individuals pool their funds together, forming a REIT, and allow the REIT to purchase large real estate investments, such as shopping malls, large apartment complexes, skyscrapers, or bulk amounts of single family homes. The REIT then distributes profits to individual investors. This is one of the most hands-off approach to investing in Real Estate, but do not expect the returns found in hands-on investing. You can buy shares in a REIT via your stock account, and they often have a relatively high dividend payment.
For More Information on REITs, see:
- Is Now a Good Time to Invest in a REIT?
Commercial investments can vary dramatically in size, style, and purpose, but ultimately involve a property that is leased to a business. Some commercial investors rent buildings to small local businesses, while others rent large spaces to supermarkets or big box megastores. While commercial properties often provide good cash flow and consistent payments, they also may carry with them much longer holding periods during times of vacancies; commercial property can often sit empty for many months or years. Unless you are starting from a very solid financial position, investing in commercial real estate is not recommended for beginners.
For More Information on Commercial Investing, see:
- BP Podcast 004: Commercial Real Estate Investing With Frank Gallinelli
- 3 Things You Need to Know to Invest in Commercial Real Estate
- Commercial Real Estate Listing Tools, News & Discussions
You can start investing in mobile homes with little money out of pocket. Whether it’s a home in a mobile home park or on its own land, many of the strategies used in other types of real estate investing can be applied to mobile homes.
For More Information on Mobile Homes, see:
- Mobile Home Investing with Creative Strategies
- Mobile Home Investing: AKA The Moolah Maker
When homeowners don't pay their taxes, the government (local, state, or federal) can foreclose and resell the property to investors for the amount of taxes owed. This can often mean incredibly inexpensive properties, but be sure to do your due diligence and don't just jump into this kind of investing unprepared. Tax lien sales are complicated transactions that require research, knowledge, and experience.
For More Information on Tax Liens, see:
- Tax Liens: What They Are and How to Use Them In Your Business
Investing in notes involves the buying and selling of paper mortgages. When a home is purchased with a loan, a “note” is created explaining the terms of the contract. For example, an apartment owner decides to sell his property for one million dollars. He offers to carry the full note (thus allowing the new buyer to avoid using a bank loan), and the new buyer will make payments of 8% per year for thirty years until the full one million dollars is paid off.
If that owner decided they no longer wanted to be involved, he might choose to sell that mortgage to a “note buyer." Just like any other real estate investment, many times a note will be sold for a discount when the seller is motivated to sell. A note buyer will then begin collecting the monthly mortgage payments and will have the right to keep the note or sell it again in the future.
For More Information on Investing in Notes, see:
- Cash Flow Notes: 5 Steps to Investing Through "Lien Landlording"
A Summary of Your Real Estate Investment Niche Choices
We've just outlined ten different investment niches, or vehicles, that you can invest in to take you on your journey through real estate investing. When starting out, it's helpful to simply pick one (or, at most, two) niches to focus on and become a pro at that niche. You can always expand later as you get more experience and knowledge.
While you can use any of these investment vehicles in your career, you must next learn an investment strategy that you can apply to that niche. The next section will look at several different strategies that investors use to make money with the various niches already covered.
For More Information on Choosing Your Niche, See:
Choose Your Real Estate Investing Strategies
The section above looked at a number of different investment vehicles that you can use to invest in real estate. However, when learning how to invest in real estate, it is not enough to simply know what these property niches are. Instead, as an investor you will use a variety of strategies when dealing with these investment niches to produce wealth. The section below explores three of the most common strategies that you can use to make money with these vehicles.
Buy & Hold
Perhaps the most common form of investing, the "buy and hold strategy" involves purchasing a property and renting it out for an extended period of time. It's probably the most simple and purest form of real estate investing that there is. Essentially, a "buy and hold investor" seeks to create wealth by renting the property out and either collecting monthly cash flow or simply holding the property until it can be sold for a gain in the future. Among the advantages of this strategy is that during the time that you hold the property and rent it out, the mortgage is paid down each and every month, decreasing your principal balance and increasing your equity in the property.
One of the most important things for a new buy and hold investor to understand is how to evaluate deals and opportunities. By far the most common mistake that we see new investors make with this strategy is buying bad deals because they simply don't understand property evaluation. Other common problems include underestimating expenses, making bad decisions on tenant selection, and failing to manage properly. These mistakes can all be avoided, however, if you simply learn the business; jumping in without proper education can be extremely costly financially and sometimes, legally.
To properly carry out the buy and hold strategy, an investor should learn how to properly identify the ebbs and flows of the market that a property is located in. Ultimately, when they perceive the market and the properties they are interested in to be at a low point (prices low, inventory high), the buy and hold investor seeks to purchase properites. When the market becomes over-heated, an experienced buy and hold investor will usually stop buying until they see things settle back down. During these slow periods, they may sell or simply continue to hold their properties. Some buy and hold investors never sell a property, choosing instead to pay the mortgage off and live on the cash flow or may ultimately sell using "Seller Financing" (see chapter 8 for more on exit strategies).
Check out the following image for a simplified example of how the real estate market cycle works:
Ultimately, there is much more to buy and hold than meets the eye, but if you can learn how to evaluate and buy good deals, find quality tenants, and manage properly, you're going to be on your path to running a successful business.
For More Information on the Buy and Hold Strategy, See:
Flipping Real Estate
One of the most popular tactics for making money in real estate, due largely to the numerous shows on cable TV that promote it, is flipping houses. House flipping is the practice of buying a piece of real estate at a discounted price, improving it in some way, and then selling it for a financial gain. In reality, the flipping model is quite similar to the "buy low, sell high" model of most retail businesses.
The most popular type of property to flip is the single family home. Following a rule of thumb known as the 70% rule, an experienced house flipper will buy a home for 70% of its current value less any rehab costs. For example: Home A should be worth $100,000 if it were in good condition, but it needs $20,000 worth of work. A typical house flipper will purchase the home for $50,000 ($100,000 x 70% - $20,000) and seek to sell it for the full $100,000 when completed. This is simply a rule of thumb, and actual numbers must be verified and adjusted to ensure a successful and profitable flip.
Check out the FREE BiggerPockets 70% Rule Calculator to quickly check if a deal is a good one using this rule of thumb.
One of the key aspects in flipping a house is speed. A house flipper will attempt to buy, rehab and sell the property as quickly as possible to ensure maximum profitability and to avoid many months of expensive carrying costs. These carrying costs include monthly bills such as financing charges, property taxes, condo fees (if applicable), utilities and any other maintenance bills required to keep the house in good financial standing.
Flipping is not a "passive" activity, but instead is just like an active day job. When an investor stops flipping, they stop making money until they begin flipping again. Many investors choose to use flipping to fund their day-to-day bills, as well as provide financial support for other, more passive investments.
If flipping is an activity you want to get more into, we'd highly recommend that you check out the BiggerPockets newly released book, "The Book on Flipping Houses," along with the free bonus book, "The Book on Estimating Rehab Costs." These books can be fundamental in helping you learn how to start a profitable house flipping business. To learn more about these valuable resources, click here.
For more information on flipping, please see:
- Simple Things When Flipping Houses
- 9 Steps to Flipping Houses (Infographic)
- Fixing and Flipping: A Business or a Job?
- Six House Flipping Tips
- BP Radio Podcast 001: Building a Successful House Flipping Business and Losing Millions with Marty Boardman
- BP Podcast 010 : Flipping Houses 101 with J Scott
- BP Podcast 018 : Flipping, Marketing, and Wholesaling with Danny Johnson
- BP Podcast 022 – Building a Marketing Machine, Spec Houses, Flipping & Wholesaling with Tucker Merrihew
- BP Podcast 023: Flipping While Working a Job, Partnerships, and Military Investing with James Vermillion
- BP Podcast 024: House Flipping and Deal Analysis with Michael LaCava
- BP Podcast 027: Fix and Flipping, Wholesaling, Marketing, and More with Jason and Katherine Grote
- BP Podcast 032: Luxury House Flipping, Finding Deals, and Discovering Your Niche with Will Barnard
- BP Podcast 039: Dirt Cheap Land Flipping and Reaching Motivated Sellers with Seth Williams
- BP Podcast 041: How to Profit Through Long Term Flipping and Lease Options with Douglas Larson
- BP Podcast 044: Creating Systems to Flip Houses While Still Employed with Michael Woodward
- BP Podcast 050: Getting Started and No Money Down House Flipping with Mike Simmons
- BP Podcast 058: Flipping and Wholesaling Homes While Working Full Time with Justin Silverio
Don't overpay for your next real estate flip!
Use the BiggerPockets Fix & Flip Analysis & Reporting Tool to easily weed out bad deals & estimate your next big profit.
Wholesaling Real Estate
Wholesaling is the process of finding great real estate deals, writing a contract to acquire the deal, and then selling the contract to another buyer. Generally, a wholesaler never actually owns the piece of property they are selling; instead, a wholesaler simply finds great deals using a variety of marketing strategies (see chapter 7), puts them under contract, and sells that contract to another for an "assignment fee." This fee is typically between $500 and $5,000 on average -- or more depending on the size of the deal. Essentially, the wholesaler is a middleman who is paid for finding deals.
Some wholesalers sell their contracts to retail buyers, but most sell their contracts to other investors (often house flippers) who are typically "cash buyers." When dealing with these cash buyers, a wholesaler can often get paid within days or weeks and can build solid connections in the real estate community.
Many investors choose to begin with wholesaling due to its reputation of being an easy strategy and one with low start up costs when first beginning. Because the property is never actually owned by the wholesaler, there are no rehab costs, loan fees, contractors, tenants, banks, or other complications. Wholesaling is the most popular strategy taught by real estate gurus and often receives the most attention as a result, though it is not as easy to become a successful wholesaler as they make it sound.
Wholesalers must continually seek out the best deals in order to have inventory to sell to others and must have a well designed marketing funnel to continually attract these leads. Wholesalers also must continually seek out buyers for the deals they acquire. While promoted as a strategy that anyone can do -- even someone with ZERO money -- you ultimately do need to have financial resources to build your marketing funnel. That said, those who persist in growing their wholesaling skills often find great success and a good source of income while they grow their knowledge of other, more profitable strategies.
For more information on Wholesaling, please see:
After reading this chapter, you should now have a clearer understanding of the many different real estate niches and strategies that you can use to build wealth in real estate. Don't worry if you don't know exactly which one you want to pursue yet -- this is simply the beginning. Learning how to invest in real estate can take time. As you move forward through this guide, you will gain a better understanding of the kind of investing you want to engage in. Throughout this guide, we will give you numerous tips and sources you can use to narrow down your plan further. As mentioned earlier, be sure to check out the BiggerPockets Forums, where you can ask questions, and, of course, search the site to find any more help that you might need.
You are probably excited to get started making money in real estate. Before you do, however, there is one major step that will make all the difference between early success and failure: building your business plan. Chapter 4 will explore this topic.
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Jump to Another Chapter:
- Chapter 1: How to Invest In Real Estate
- Chapter 2: Your Real Estate Investing Education
- Chapter 3: Choosing Your Investing Niches and Strategies
- Chapter 4: Creating Your Real Estate Business Plan
- Chapter 5: How to Find Investment Properties
- Chapter 6: Financing Your Real Estate Investments
- Chapter 7: Real Estate Marketing
- Chapter 8: Real Estate Exit Strategies
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One of the primary objectives of my real estate business is to acquire income-producing rental properties that ROCK.
What makes a rental property “rock” you might ask?
It doesn't necessarily need to pump millions into my bank account each month, and it doesn't need to be a “no money down” deal either (although either of these things would certainly sweeten the pot).
To put it simply, a great rental property is one that makes every one of my invested dollars work hard. I want every penny to work overtime, producing as much revenue as possible while simultaneously paying off any debt associated with the property. When you buy properties with this goal in mind, there is basically no limit (mathematically speaking) to how far you can grow your net worth and personal income.
When I first got started as an investor, I spent a lot of time trying to find these types of properties. I remember spending hours upon hours scanning my local MLS listings, desperately trying to find a deal that would make financial sense.
After running the numbers on dozens of properties, I was shocked at how difficult it was to find just one single property that would justify my investment.
At the time, it was 2005 and housing prices were through the roof – which made this a very difficult task (especially when I limited myself to ONLY the properties that were “listed”, with a realtor sign in the front yard). Needless to say, it was an extremely discouraging time in my journey.
I eventually realized I was dealing with two fundamental problems:
- I didn't have an effective way to find motivated sellersand get them calling me. I was relying ONLY on unmotivated sellers who were holding out for top dollar. This was a losing strategy that wasn't going to cut it.
- I didn't have an effective way to analyze properties or determine their potential profitability. I needed a basic, but highly reliable method so I could calculate exactly what I was getting into.
After a lot of research and learning, I was able to find some very effective ways to solve BOTH of these problems.
Both issues are equally important to deal with but for obvious reasons, problem #2 cannot be addressed until problem #1 has been dealt with. In other words, you can't start working on your analysis until you have something to analyze. This may seem obvious, but it's important to reiterate this so you can prioritize correctly and deal with first things first.
The Reason For This Case Study
The purpose of this guide is to show you exactly how I handle Problem #2 (above). If you haven't figured out how to find motivated sellers yet, go and readthisorthisfirst and THEN come back to this case study.
I often find myself evaluating rental properties and consulting with other investors on how to find, evaluate and buy their own deals – so the purpose of this blog post is to explain exactly how I do this. This article is intended to provide a brief education, where I will show you the entire process that I go through when buying a rental property, which includes some of the following steps:
If you're reading this, you may very well fall into one of these categories:
- You don't know how to find a legitimate, profitable rental property.
- You understand the theory, but have never actually purchased a rental property before.
- You don't understand how to analyze and evaluate a rental property the right way.
- You need a better understanding of how the entire process works, from start to finish.
- You don't have a proper set of expectations about what a rental property should produce, and why investors buy them in the first place.
This blog post is intended to show you exactly what steps I go through, what my expectations are, and how I ensure my (or my client's) return on investment is something they can be proud of.
I'm a pretty big fan of “on-the-job training”, so I figured the most practical way to show you this process would be to use a real life example I dealt with just a few short years ago.
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First Contact with the Seller
In early December, I received a voicemail in response to one of my direct mail campaigns (I had used Template #3 for this particular mail campaign, and I pulled my list using the same process I describe in this blog post).
This mailing was actually sent out the previous summer (over a year earlier) – this guy had simply held onto my postcard and called me about 16 months later (gotta love the residual benefits of direct mail).This was his first voicemail to me:
(note: caller's name and address have been removed from this recording for privacy)
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Quick Property Evaluation
Once I got this message and learned the basic details about this property (i.e. – the owner's full name and property address – which were edited out of the above audio clip), I went to work.
I was fortunate in some respects, because I was very familiar with this neighborhood. I had sold a similar house a few blocks away for $88,900 in late-2009 (by which time, the market had already taken a dive), so I had some perspective on what a house like this would legitimately be worth.
Before I called the prospect back, I went through my quick property research process and learned most of the pertinent details about this property. It was a single-family home with 2 bedrooms & 1 bathroom. According to the seller, it generated approximately $750 per month in rent. Using AgentPro247, I learned that the seller had purchased this property eight years earlier for $55,000 – which gave me some perspective on where he was coming from.
Armed with this basic information, I called the prospect back.
After roughly 4 minutes on the phone with the property owner, I asked him (point-blank) if he would sell his property for $30,000 – $40,000.
He replied very quickly with, “Yes, I would consider that.”
Later in the week, I called the seller back and told them that our offer would likely be for $25,000. He said that he would think about it.
A few days later (after hearing nothing from him), I called him again to see what he was thinking. He said that he was hoping for something more in the $30K – $40K like I initially stated (*kicking self*). I realized pretty quickly I should have suggested an even lower number to begin with. Setting his expectation in the $30K – $40K range right out of the gate probably wasn't smart (it's generally easier to start low and negotiate up, than to start high and negotiate down). Lesson learned.
Eventually (after a few more discussions) we settled verbally on a price of $27,500 cash, with all closing costs paid by the buyer. In other words, the buyer (aka – me) would have to cough up another couple thousand dollars in order to close the deal (this includes things like title insurance, closing fees, property insurance, pro-rated property taxes, etc).
Show Me The Money
Now, most people don't have $27,500 sitting in their checking account at any given time and at the time, I was no exception. Luckily, I knew some other investors who did.
I called one of my cash buyers and gave them a quick overview of the deal. They were very interested in finding out more. Like most people, they were stuck with Problem #1 (above). They had plenty of money to invest, but they didn't know how to find good deals. These are excellent people to have on your buyers list because in their minds, any property at 70% or less of market value is an AMAZING deal that will get them very excited.
Luckily, I had mastered the art of finding cheap real estate in my area (FAR below 70% of market value) so when I told them about this property, I had their attention very quickly. I gave them a general overview of the property (“a 2 bedroom, 1 bathroom house on the southeast side of town, a 1.5 stall garage close to the local public school, etc.”). I also prepared a Rental Property Analysis to show them exactly what kind of ROI they could expect from this property as a rental unit (more details on that below).
After seeing my property prospectus report, my buyers said they were ready to gowith cash in hand, contingent on an acceptable home inspection and verification of all of all my assumptions.
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Running The Numbers
One of the most important things you MUST do as you're evaluating a new property are your projections.
“Projections” are basically just a series of highly informed guesses about how profitable a property may (or may not) be in the future. In order to figure this out, you'll have to do a little bit of homework and develop a thorough understanding of what the income and expenses are likely to be from this property in the future.
It's not difficult, but as with any real estate transaction, there are a number of things you need to pay close attention to. As you research a property and learn more about what you're getting into – certain things matter greatly, and other things matter very little. My hope is that as we're walking through this process, I can give you a good idea on what to look out for.
Many, MANY of the deals you'll see on a regular basis won't have positive cash flow (in fact, that's almost exclusively what I saw in my first year as a real estate investor) – and there are a lot of things that can sabotage the profitability of a rental property. Things like:
- Paying too high a price for the property
- Excessive Property Taxes
- Excessive Interest Expense
- Insurance Costs
- Maintenance, Utilities and Upkeep
- Unforeseen Disasters
- Home Owner's Association (HOA) Fees
If a deal doesn't cash flow, don't buy it. PERIOD. This is why it's crucial for you to nail down your projections and get an accurate depiction of its profitability – because frankly, your “GO” or “NO GO” decision usually boils down to the answers you get after going through these motions.
Dealing With Imperfections
Are your projections going to be perfect? Not likely.We aren't fortune tellers after all, so it's impossible to know EXACTLY how things will pan out in the coming months and years.
Projections rarely come to fruition exactly as we plan, but when they're done correctly, using realistic data and assumptions, they will almost always set you up with reasonably accurate expectations that won't lead you astray. The numbers may turn out better or worse than you estimated, but they should at least come out somewhat similar to what you had originally predicted.
Challenge Your Assumptions
- So you think rent will be $750 per month? Says who?? Is this a reliable and unbiased source of information?
- You think the vacancy rate will be 10%? What makes you think so? Do you have any actual experience or market data to back this up?
- What kinds of maintenance and repairs will you have to take care of? How certain are you about what the costs will be?
- What if one or more of your assumptions turns out to be wrong? Does the property still perform to an acceptable standard?
In order to come up with your “best possible guess” at what the future is going to look like, you need to be armed with the right information. Your inputs will literally determine everything here, so remember the theory of “garbage in, garbage out”. If you start with bad information (or if you just guess at the numbers without really getting them from a credible source), you're not going to have a very reliable number in the end.
The last thing we want is to invest our life savings into a property that loses money hand-over-fist.
One of the best rental property evaluation tools I've ever found is called the PropertyREI Rental Property Calculator. It's an easy-to-use excel spreadsheet that allows you to plug-in a few basic inputs, and (assuming your numbers are reasonably accurate) will show you some very clear results that will help you determine if/when you're looking at a worthwhile real estate investment.
In the example below, I'll show you how I used this calculator to go through the motions of plugging in the numbers so I could understand whether I was looking at a solid deal for an investor to pursue.
(Note: If you want to get a copy of this calculator for yourself, be sure to use Promo Code: RETIPSTER1 at checkout for an instant 10% discount).
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Step 1: Determine Your Rent Revenue
It all starts with having a solid understanding of the revenue your property is likely to generate every month. We're talking gross income – before any/all expenses.
Now – in my first conversation with this seller, he told me that he was generating $750 per month in revenue from this house.
Can we trust him? There are a couple of ways to find out.
I started by asking him to send me Schedule E of his past two years of tax returns (a Schedule E is basically an income statement, showing the amount of revenue and expenses he reported to the IRS for this particular rental property). After reviewing his information, it turned out that he did make approximately $750/mo for the past two years.
I also ran the numbers on Rentometer – which gave me a quick look at what similar properties were renting for in the immediate vicinity. I found that $750 was a little on the high-end for the area, but not a completely unreasonable expectation.
I also gave my property manager a call to see if he thought this was a realistic expectation given the property and neighborhood. He expressed some hesitancy and mentioned that in his opinion, a more realistic number (in THIS neighborhood, for THIS kind of house) would be around $700.
In the end, since I had proof that $750 was attainable based on the seller's tax returns (and since the property was being sold with the same tenant who had been paying that amount for the past 2 years), I decided to use this number in my calculation… but I would likely re-run the numbers again later with this $700 number, just to make sure the deal still produced adequate cash flow.
I also assumed the property would have no other sources of income (i.e. – no vending machines or coin laundry), a vacancy rate of 10% (i.e. – the property will be vacant and/or between tenants for 5 weeks out of the year… a pretty conservative estimate in this market) with the plan for increasing rent revenue each year by 3% on average.
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Step 2: Purchase Price and Financing
Depending on whether the property is being purchased with some form of financing, or whether it's being purchased outright as an all cash deal – the financing picture will usually have a big effect on the outcome of your calculation.
In my example, the property was being purchased with cash – which greatly simplified this portion of the calculator.
Why was this property being purchased with cash instead of financing? A few reasons…
- The property was relatively inexpensive.
- The investor had the cash available.
- The investor was more concerned about generating more cash flow than about making their cash work harder for them (which we'll get to in a minute).
For this deal, the closing costs came out to approximately $1,500 (which is actually closer to 5.5% – but not a huge variation from the 5% shown above) and the deferred maintenance costs we planned for were $2,500 (the furnace was in rough shape. It was apparent the previous owners had no idea how to replace furnace filters, so we assumed it would need to be replaced shortly after closing).
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Step 3: Factoring in All Expenses
Understanding a property's expenses can be a painful dose of reality.
These are the items that most sellers tend to downplay (or just fail to mention altogether)… but these numbers are CRUCIAL to understand.
These numbers are very real and will play a major role in the profitability (or lack thereof) of your rental property. You’ll have to do your homework in this section, and it’s important that you do this part of the process well because if you use the wrong numbers, you'll only be fooling yourself and hurting your (or your buyer's) future.
Property Taxes: Property taxes have always been a depressing subject for me. Why? Because regardless of whether you purchase a property with financing or you buy it free and clear, you will always have to pay property taxes. Since this expense is permanently attached to the property, it’s important that you find the correct number and factor it into your calculation. I found this number by checking the seller's Schedule E and by checking the City Treasurer's website for the total annual property taxes over the past two years. In the previous year, this property owner paid $1,464 in property taxes, so that was the number I used here.
Insurance: This one is pretty easy. You can call any property insurance agent (I recommend trying at least a couple to compare prices) and they will be more than happy to tell you what the annual cost will be. I called my property insurance agent and gave him the rundown, and he indicated an annual cost of $550 – $600 for this type of property. Given that the seller had paid $553 – I decided to use that number for this part of the calculation.
Utilities: For most residential rental properties in my town, utilities are set up in such a way that the landlord pays the water bill, but everything else is covered by the tenant. The utilities can be set up in a number of different ways, but whatever your arrangement is, you need to get a good idea on what this number will be on an annual basis.
In this situation, the seller also had the utilities arranged so that he paid ONLY the water bill. By looking at his Schedule E, I was able to see that he had paid an average of $900 per year for the past two years. Based on my own experience with my other rental properties in the area (and based on my property manager's opinion), I knew this was a solid, legitimate number to work with.
Advertising: I use a great property management company for all of my rental properties (and I recommend all my buyers do the same). Most property managers will handle the placement and eviction of all tenants as part of their service, so we'll get to this cost in the .
HOA Fees: This property is not part of a home owner's association, so this step is easy. ZERO.
Property Management: Even if you’re not going to hire a property manager like I do (most property managers will charge around 10% of your gross rent revenue), you still need to pay yourself for your trouble. The fact is – somebody, in some way, will ALWAYS have to manage this property, so regardless of who is doing the job, this is a very real expense that ought to be accounted for.
Maintenance & Repairs: Another absolute must that you need to include in your expense column is a reserve for maintenance and repairs. I always plan to set aside at least 10% of my gross rent revenue to cover the issues that willcome up when my properties start falling apart (because sooner or later, it's going to happen). Even if you have a year or two where no extraordinary expenses come up, you need to let these funds accumulate. All it takes is one roof replacement, or one pipe to burst in the basement and ALL of this money will be needed immediately – so let this money build up and don’t drain this account.
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Step 4: Taxes and Depreciation
This next step is pretty simple. If you know what effective tax rate you're working with (this will depend on the investor's situation), you can plug it in and the calculator will factor this in to the final calculations of what your annual cash flow will be after taxes. I used 20% in my example.
The calculator will also do a calculation to show what the TOTAL cost will be to purchase the property (in this case, it's taking the purchase price of $27,500 + closing costs of $1,375 + deferred maintenance of $2,500 = $31,375 cash required to purchase property).
This simply shows us what the full acquisition cost will be, so there is no confusion about this deal is going to cost the investor.
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Step 5: Executive Summary
This is usually a very revealing part of the calculation process, because it gives us a good look at what kind of net revenue the property can actually be expected to generate (both before and after taxes).
In the example below, the calculator is telling me that after all expenses, the investor would be adding another $3,563 to their annual income, and then the amount they would actually keep in their pocket (after their taxes are paid) would be $3,030. This is if the investor chooses to buy this property and pay all cash for it.
In a very real way, this information is your final, decision-making data, and depending on whether the property is being bought with cash or with financing – the end results can vary widely.
Some of the numbers I always watch very closely are the Annual Cash Flow, the Cash Required to Buy and the Cash on Cash Return.
For example, let's go back to the Dashboard and change our financing strategy to buy this property with a mortgage. If we put down 20% and get a 30 year mortgage at an interest rate of 4.00% – we now have to add monthly loan payments of $105 into the mix.
What does this do to our numbers? Check out the differences…
When we use financing for a property like this, it comes with some tradeoffs. Let's look at the pros and cons of using financing to buy this property.
- If we utilize financing, this property (and the source of income that comes with it) will require significantly LESS cash to buy upfront.
- The Cash on Cash Return is over 2x higher when we use the power of “OPM” (Other People's Money). In other words, every dollar we put into this property from our own pocket is going to work MUCH harder than if we had to cover the full purchase price without financing.
- Since we'll have to make monthly loan payments for the next 30 years, the annual cash flow is going to see a significant negative impact. Although the property will cost us less cash upfront, it's also going to produce less cash flow after the debt service is paid each month.
- If you're scared to death of debt or if you have a personal philosophy of avoiding debt at all costs – this approach will obviously conflict with that mindset.
The great thing about financing is that it has the potential to supercharge the growth of your real estate portfolio. When you can purchase properties quickly without tying up your own finite source of cash, you might be shocked at how quickly you can build up a MASSIVE source of wealth and income for years to come.
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Deal or No Deal?
The bottom line is this…
If we purchase this property and pay all cash for it, we can reasonably expect to be $3,030 richer at the end of each year after taxes… and it will cost us $31,375.
If we purchase this property with financing, assuming 20% down and 4.00% interest over 30 years, we can reasonably expect to be $1,945 richer at the end of each year after taxes… and it will cost us $9,375.
If you want a closer look at how I plugged all of these numbers into the PropertyREI calculator – I'll walk you through the entire process in this video below…
Want to use the PropertyREI Rental Property Calculator?
You can get it at PropertyREI.com. And remember – be sure to use Promo Code: RETIPSTER1 at checkout for an instant 10% discount.
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Making The Offer
When you know a deal makes sense on paper, it's time to make an offer.
On December 15, I prepared a very simple, one page written offer for $27,500.
A couple of days after I emailed this offer to the seller – he called me and we spent some time haggling over the price on the phone. He obviously wanted as much as possible – but $27,500 was literally my ceiling (if the price went any higher, I wouldn't have had a buyer on the other end – and I made this very clear to the seller).
On December 18 – I received the seller's acceptance via fax.
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The Necessity of Due Diligence
Whenever you're making an offer – you have to make some assumptions. There's no practical way around this.
It's okay to assume some things (if your purchase agreement gives you the necessary wiggle room to get out of the deal) – but once your offer is accepted, you need to go through the motions of verifying that those assumptions were actually correct.
As you conduct your due diligence, there will be almost always be some “findings” that come up in your research process (i.e. – things you weren't aware of when you made your offer). The key is to know when these findings are acceptable and when these findings are a deal breaker.
Once we had this seller's official “go ahead”, I ordered a home inspection report from a company called House Master (for a grand total of $385 – which my buyer agreed to reimburse me for). House Master is one of many home inspection companies that operates in my area.
There are a lot of home inspectors out there who do similar work… but if you happen to have a House Master in YOUR area, I can give you my official “thumbs up” recommendation. The team that handles my inspections does a great job – and the information they provide almost always results in me negotiating a lower price.
While the inspector was there, I dropped in to do a quick visual inspection of my own.
I don't always do this (in most cases, I can trust my inspector and property manager to give me an accurate assessment), but since I live just on the other side of town, I figured it would be prudent to swing by.
Here are a few pictures I snapped of the interior and exterior with my iphone:
As you can see – it was a pretty simple, small house. Not enough for anyone to retire off of, but not a bad property for a newbie investor to get their feet wet with.
A couple of days after the inspection, the folks at House Master emailed me their full, 51-page report, giving a VERY thorough overview of every observable issue that could come up with this property (honestly, it was more than I even wanted to know – and considering their job, this was a sign of a job well done).
Their report brought some pretty important issues to light – all things the seller didn't tell me about, and things that would likely impact the cash flow of this property within the first couple of years after acquisition.
The most pressing issues were as follows:
- The furnace was still functional, but was near the end of its life (it was over 20 years old). Replacing it would definitely be a necessity in the near future, and it wouldn't be cheap.
- The bathroom shower was leaking and needed some attention to fix the issue.
- The roof needed some patch work.
- Some of the siding had some holes in it and needed to be replaced.
- The kitchen faucet was leaking and the counter top had some chips in it.
Altogether, we figured these repairs would cost approximately $5,000 to fix.
Now obviously, I don't expect any property to be 100% free of problems, but what I do expect is to understand what those problems are BEFORE anybody goes through with buying it (whether I'm buying it myself, or assigning the deal to another investor).
This was a tricky case, because I knew the seller had already come down quite a bit with his asking price, and he had no intention of going any further.
In most cases – I would keep pressing the seller to move further down (depending on their level of motivation), but rather than continuing to push this guy, I decided to adjust the “Deferred Maintenance Costs” in the PropertyREI calculator from $2,500 up to $5,000 to see what the deal would look like after accounting for these extra costs.
Fundamentally speaking, if this property was financed conventionally – it would still cash flow, it would simply reduce the cash on cash return from 20.7% to 16.4% and if the property was purchased with all cash, the cash on cash return would be reduced from 9.7% to 8.9%. The annual cash flow and net operating income would stay the same.
On both accounts, it was still a good deal… the numbers would just take a slight move in the wrong direction (though not enough to be a deal-killer). Given this, we decided to take the hit and move forward (something I don't do often, but the deal was good enough that it warranted this kind of concession from our standpoint).
The benefit we had in this case was awareness. When these problems need to be addressed – we DON'T want to be surprised or “stabbed in the back” by the seller.
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Once I knew our $27,500 was still acceptable after our property inspection, I emailed our fully executed purchase agreement to the title company and they began their title search on our behalf.
Now – when I'm REALLY pinching pennies, I do have the option of doing my own title search – but considering that my buyer was going to pay a significant amount of money for this property AND it involved an assignment of contract AND we needed someone to facilitate the signing of the closing documents, handing this job over to a title company was an easy decision.
With this particular property, my intent was to “assign the contract” to a third-party buyer.
In other words, my plan was to take my purchase agreement and sell the paper to another investor (a process that some refer to as “wholesaling”).
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How Does Wholesaling Work?
When I signed this contract with this seller, they gave me the legal right to purchase this property for $27,500within a specified period of time.
Well – if for any reason, it's not convenient for me to buy this property for $27,500 (e.g. – if I don't have this kind of cash in my pocket at any given moment), but I know another investor who would LOVE to get this deal, I am literally allowed to sell this contract to them.
This is allowed because the seller gave me their written permission to do this (it is stated very clearly as an “assignment clause” in our contract).
This kind of transaction is completed with a 1-page form called an “Assignment Agreement”. This document is signed by ME (the “Assignor”) and the end buyer (the “Assignee”). The end buyer pays me a set amount of cash for the contract and in exchange, they can jump into my shoes and take my place as the Buyer in the original purchase agreement.
When Does Wholesaling Work Best?
This type of transaction tends to work best when a property is being purchased in an all-cash transaction(i.e. – the buyer doesn't need a bank loan to purchase the property).
Why? Because whenever a bank gets involved with a real estate transaction, they have a tendency to add a lot of restrictions and rules that make it very difficult (if not impossible) for the wholesaler (i.e. – ME) to get paid.
Luckily, I was dealing with a cash buyer in this situation – which is part of what made the whole project possible.
The Assignment Fee
There are a couple of different ways that I charge assignment fees.
Method 1: If I have a property under contract for a ridiculously low price (say, 20% of market value) – I generally feel comfortable charging a sizable fee, simply because there is a HUGE profit margin available that I can pull from. If the deal makes sense, the seller will gladly pay it because even with the cost of my fee, they are still getting an awesome deal that they wouldn't have found without my help.
Method 2: If I have a property under contract for a respectably low price (say, 50% of market value) – I will charge a 6% – 10% assignment fee (similar to a realtor commission).
Now to clarify… I am NOT a real estate agent (nor do I ever intend to become one). There is a distinct difference between what an agent does, and what I (as a wholesaler) do.
When I structure a deal like this, there is literally a purchase agreement signed between ME and the seller. Once this contract is signed, I have an marketable interest in the property.
A realtor doesn't have this kind of arrangement. Instead, they are signing an agreement whereby the seller authorizes them to market the property on their behalf in exchange for a commission if/when the property sells.
Selling property on behalf of a property owner without a license isn't legal. However, if you're selling your marketable interest in the property (via your executed purchase agreement), this is a completely different scenario. This is a very important, key difference between these two types of business arrangements.
At The Closing Table
The closing process went very smoothly. The seller met at the office of our title agency in the morning, and my buyer met at the same office later that afternoon. During this process, the following things were transferred from the seller to my buyer:
- Current building inspection certificate
- Copy of the Current Tenant lease
- Tenant Unit Condition Checklist
- Original Tenant Application
- Tenant Security Deposit
- Keys to the House
My buyer then had to complete the following items with their new property manager:
- Execute a Management Agreement
- Execute a W-9 (IRS form)
- Sign Up for Direct Deposit (easiest way to get paid by their property manager)
- Hand Over the Keys to the House
- Hand Over the Security Deposit
The transaction was seamless and there were no major hiccups along the way.
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What to Expect
During their first month of operations – my buyer earned a whopping $10 of rental income from this property (yippee).
There were a few reasons for the lackluster start:
- The tenant only paid $600 of their $750 rent to the previous owner
- There were some small, but immediate repairs that needed to be done
- The property management company had to recoup their initial start-up costs
This is the reality of owning rental properties. It would be very atypical for an investor to come blasting out of the gate with their best possible outcome on the first month. It just doesn't work that way.
It's not unusual for the first month of operations to be disappointing, but there are a few things to keep in mind.
- Often times, rental properties suck wind in the beginning. When you're acquiring an older property with an existing tenant… be patient. Dealing with deadbeat tenants, repairing things that should have been fixed years ago, paying for sins of the previous property owner are ALL very real possibilities immediately after you buy. For this reason, ALWAYS be conservative when you're creating your projections on a rental property. Not all sellers are “liars” – but as a general rule of thumb, don't ever assume they're telling you everything you need to know. I've dealt with a lot of reasonable, respectable sellers – but they still didn't tell me 100% of the details. Allow some room for error when you're evaluating the deal.
- Maintenance is something you'll always have to save for. If you're purchasing a property over 50 years old (which accounts for almost every property I look at), maintenance will be an even bigger issue to factor into your cash flow. This is okay IF you are buying the property for a low enough price. Just remember – when you buy an older property, you need to allow some room in your cash flow for some “question marks”. Be conservative and allow for some small, bad things to happen without putting you in the red.
- Build up a 6 month reserve and maintain it. You should always have a reserve of cash available to cover the costs of your property when it doesn't cash flow. For example, if the tenant in this property decides to stop paying his rent altogether – he's going to get evicted, no questions asked. If this happens, the property will be without revenue for at least 2 – 3 months, best case scenario(maybe even longer).
When I bought my first rental property, my property manager was very upfront with me and said:
“Plan for a net loss your first year.”
Even though I was getting a great deal and the projections looked awesome – he was still right.
When you're dealing with some of the issues listed above, there are a lot of unknowns and things inevitably don't go as planned. Be prepared for this.
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A Look Back (One Year Later)
In this case study, we analyzed this property using the same process that has been proven by a lot of highly successful real estate investors. Our evaluation was thorough, we verified our assumptions and we took every feasible issue into account.
My buyer did end up having a lot of costs during their first year (judging by the age and known issues in the house) and they did eventually lose their tenant. However, in the months and years since, the rent price was adjusted upward to account for the stronger market for rentals that followed with the rebound of the real estate market.
Some of the known issues did take a toll on the property's profitability during their first few months of ownership – but once the repairs were made and the right tenant was in place – they were able to consistently generate the monthly cash flow that was projected in our initial evaluation. They were also able to benefit from the additional tax write-offs that came with owning rental real estate like this.
Again – this is not (nor will it ever be) a property that throws off massive cash flow, but for someone's first experience with a rental property, it's an ideal way to get started in the business.
It generates some small supplemental income for the new owners and will be relatively easy to sell whenever they decide to liquidate the property (because this is a very generic, affordable property in a densely populated part of town). These are great attributes to have in a property when it comes time to sell.
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As with any real estate investment – buying rental properties takes a lot of homework. Rental properties don't necessarily come with the glamour and huge paychecks that “flipping houses” is known for – but it is a proven method of building multiple streams of permanent income.
If you're looking to supplement your retirement income with something that comes with significant opportunities for appreciation, passive cash flow and tax benefits – buying properties (the right way) it a great way to make do it.