The ABC’s of Buying Rental Properties — A Hands-On Approach To Success

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I love real estate.  However, I respect it at the same time, meaning you must treat this type of investment with care, love and lots of attention to be successful with it.  In my 15 years of experience with investing in real estate, I have learned much. But, perhaps the most important lesson I have learned is that it is not a get rich quick investment, and it is HANDS ON.

If you follow some basic rules, you will do very well with real estate.  If you don’t, then you’re better off investing elsewhere.  In my case, the vast majority of my portfolio is invested in real estate.  However, this is NOT TO SAY that real estate is a better investment than stocks or bonds, in fact, to the contrary.  Stocks have actually outperformed real estate over the past 100 years.  However, I happen to understand and enjoy real estate, and believe real estate is an important diversification strategy in a portfolio. Accordingly, I have gravitated more towards this investment strategy.

Below, I have compiled another list, (I love making lists), related to rules on buying rental properties.  As mentioned above, understand that investing in real estate is typically a hands on, non-liquid investment.  But for the right person, following these rules, it can be very rewarding. This will be the first of a series on investing in real estate.

The rules listed below are not necessarily listed in order of importance:

  • Your First Real Estate Investment Should Be Your Personal Residence.  Why should you even begin to buy a rental property if you are in fact renting yourself?  Buying a house opens up many tax advantages, builds equity over time, gets your feet wet with a real estate closing, and gives you some basic experience in the rewards and headaches of owning rather than renting;
  • Your Second Real Estate Purchase Should Be For Your College Aged Child (If Applicable).  In general, buying real estate for your children has numerous financial advantages.  For example, if you buy your child in college a small 2 or 3 bedroom home near their school: (1) You will probably save money over the dormitory cost because your child can rent the other bedrooms which may cover the entire cost of owning the property (mortgage, taxes, insurance, repairs); (2) Instead of giving your child spending money which is absolutely non-tax deductible, you now pay your child for managing your property.  Your child pays taxes on this money at their rate, which on the first $4,800 is ZERO, and the rest will probably be taxed in the 15% bracket, (3) Your property will probably appreciate; (4) You probably will not pay any taxes on the rental income received from the other tenants due to depreciation write off; and (5) You have given your child perhaps the best learning experience with a business transaction that they have had up to this point in their lives;
  • Your Third (or Maybe Second) Real Estate Purchase Should Be Your Office or Business Location.  Again, why pay rent when you can own your own real estate and build equity over time? You will have the flexibility to do what you want with your space without having to get Landlord approval.  Typically, you will not incur any additional cost in owning your own office space or business location.  In fact, if you rent out the additional space, you can many times occupy your space rent-free.  What easier way is there to get involved with real estate and experience the management involved with real estate then to do it with the property you will be at everyday? Buying my own office building was one of the best real estate investments that I have ever made;
  • Don’t Believe Real Estate Is An Easy Get Rich Quick Program With No Money Down.  Let me make this very, very clear.  If you are going to invest in real estate, you will need to have at least 25% of the purchase price available in liquid funds.  Maybe, and I mean maybe, you will eventually get lucky and find some owner financing deals.  But they are rare. Also, you more than likely will have to be hands on in managing your property. For example, advertising coordination, showing the property to tenants, drafting leases, handling maintenance and repair calls, collections, evictions, accounting related work inclusive of tenant statements, and becoming familiar with specialized tax issues related to real estate are but a few of the management tasks associated with directly owning real estate.  After some point, you may have enough properties where you can afford to have some of these tasks done for you by professionals.  But early on, you better be prepared to handle these things on your own because more than likely, the economics of your first few deals will not allow for payments to outsiders for these services.  With that said, don’t get scared — I just want you to know what your getting into.  I REPEAT, I ABOSLUTELY LOVE REAL ESTATE, AND WITH THE HARD WORK COMES LONG-TERM REWARDS THAT ARE POTENTIALLY ENORMOUS;
  • Develop a Relationship With A Good CPA and Attorney With Real Estate Experience.   I know I just stated that you probably will have to handle at least the accounting on your own in your first few deals, but an attorney must do the legal work.  Make sure you get a closing attorney that has good E&O insurance, can ABOLUTELY assure you of clean title by issuing you title insurance at closing, and can advise you of the best way to structure the contract.  Believe me, I have seen good and bad professionals in both of these categories;
  • Only Buy Real Estate In Your Local Area (No More Than 1 ½ Hour Drive From Where You Live). Trust me on this one.  I have in the past violated this rule and regretted it.  I found myself ignoring this property just because I didn’t want to make the drive. Also, there is no way you can become an expert in a far away area.  You need to know the area inside and out.  You should be familiar with the area’s demographics, rental rates, property values, as well as knowledge of the average length of time to sell properties in the area, etc.  Knowing your area well will be of vital importance for properly making your analysis and running numbers and projections;
  • Don’t Ever Buy Real Estate Solely For The Tax Benefits.  I have seen this error occur over and over again.  Many people jump into a poor real estate investment because they were excited that their taxes would be lower.  Of course, they end up never making money on the deal, inclusive of any tax savings.  In other words, the tax benefits of real estate are secondary to the economics of the deal.  Yes, there are significant tax benefits to investing in real estate but they rarely, if ever, can overcome the loss from a bad deal;
  • Use a Professional Inspector.  The cost for having a professional inspector look at your property is usually nominal compared to the potential problems they can help you avoid.  Unless you have significant experience in construction, you will never locate all the problems that they will find.  Make sure they are licensed and members of their related professional associations. They should look at basements, foundations, structural members, roofs, roof supports, equipment on the property, alarm systems, elevators, boilers, heating and air units, etc.  Their written reports will identify deficiencies and recommend the type of repair and perhaps the estimated cost.  This could assist you in your negotiations to get a reduced price.  You may also want to consider purchasing extended warranties for appliances;
  • Buy Residential, Commercial and Maybe Industrial, But Never Office (Unless It Is Office Space For Your Own Use).  When times are bad, office is the first to lose value and have high vacancy rates.  There is too much office space in this country, end of story.  Your best bet is to start with residential and then slowly venture into perhaps a small commercial investment;
  • Don’t Buy Class “A” Property.  Class “A” properties are the premier properties in your area.  For example, if we were in New York City, Trump Tower would be a Class “A” property.  Guys like Donald Trump have the deep enough pockets to buy and operate this type of space.  I own no Class “A” properties — I actually prefer Class “C” and even Class “D” properties (which usually require fix up).  The opportunity in real estate is to create value where others don’t have the time, energy or resources to create it.  Furthermore, you will typically see that the Class “A” and Class “B” properties have the highest vacancy rates during tough economic times.  You would be amazed how much a paint job, new carpet and wallpaper can do to a Class “C” and Class “D” property that has good structural integrity.  Creating your own value with inexpensive cosmetic changes has worked successfully for me time and time again.  I recently purchased, with some long-time partners, a Class “D” retail strip center.  The owner was widowed and did not have the time or inclination to run the property.  We bought it for a song and currently are in the process of improving the property.  The purchase price of the property was $240,000 and we will spend around $15,000 improving the property.  Tenants are already knocking on our door and we expect gross rents to be in the range of $5000 to $6000 per month.  You will see from point #14 below that these are the type of deals where your returns can really shine;
  • Don’t Buy Raw Land.  I know the great American dream has always been to own raw land.  But here is the reality.  Typically, an individual will invest in raw land, do nothing with it for eight to ten years, sell it for twice the purchase price and mistakenly think that a lot of money has been made.  BIG MISTAKE!  With vacant land there is no income to offset any expense (the average annual cost of owing a piece of raw land is 15% to 20% of what you paid for it). Also, it is difficult to get conventional financing on raw land. Accordingly, if you don not sell the property for twice what you paid for it within three to five years, you are not going to make any real money.  Maybe, and I mean maybe, after many other real estate investments in income producing property should you consider raw land.  Obviously, if you were going to develop the land, this could influence your raw land purchase decision.  However, as discussed below in point #12 development is not for the faint of heart;
  • Development Projects Are Not For The Faint of Heart.  I have been involved with numerous residential and a couple of commercial development projects.  First, I must state that if you are considering such a project, run your numbers at least three times.  Then have somebody who has actually done such a project review your numbers.  Second, if you are not going to be the general contractor on your project, your risk of making money is greatly increased.  Third, if you are going to use an independent general contractor, you better be ready for litigation expenses.  Have an attorney carefully review the contract and make sure it is written on an AIA (American Institute of Architects) contract.  General contractors (GC) love change orders, and believe me, you will have them.  In other words, any changes you make to the original proposed architect plans will incur a hefty cost by the GC once the project has started.  Fourth, have a good architect who can serve as your construction supervisor who will examine the project during various phases of construction, and ultimately be responsible for approving draw requests.  Finally, in your projections, include at least a 15% cushion over and above your projected cost of
    construction.  I’ve never come in under budget, but I’m happy to say I’ve always made money with development projects by measuring three times, and cutting once.  This is an area for the very experienced and if you are going to take a crack at development, perhaps try it with a small project in your own home (like finishing your basement);
  • Buying Real Estate With a Partner (or Partners) Can Be A Bonus and/or A Detriment.  Both the best and the worst thing I have ever done in real estate are having partners.  Most of the times, it’s been great.  Occasionally, I have truly regretted it.  My advice is to be very, very careful in choosing your partners.  Try to pick a partner that compliments your skill sets.  In other words, if you are good at accounting, then pick a partner who has the repair and maintenance skills.  Perhaps you will be the working partner, handling all aspects of the property that will actually structure the deal and provide management services, and you are looking for a money partner who will up the down payment and working capital. I have found the more partners, the more headaches.  Have everything drafted in writing by an attorney up front so you can limit the misunderstandings down the road.  Typically, when things are going well in terms of money flow, the partner problems seem to be minimal.  But once a deal begins to go “south”, requiring additional capital from the partners, you will quickly find your partners to be your adversaries.  MAKE SURE ALL PARTNERS HAVE SOMETHING TO LOSE IF THE DEAL GOES BAD. Finally, it helps if you have a clear delegation of responsibilities among the partners.  In my case, being a CPA, I tend to partner with a person who is excellent at the day to day running of the property, taking care of renovations, repair and maintenance, and I handle the accounting, leasing and tax aspects of the property.  It has and continues to work well.  But we tested the waters by starting slowly with a small project and then gradually did more and more together.  Be careful.  Remember, the test of a good partnership is not when things are going well, it’s when things are going bad;
  • Form A Legal Entity To Hold Your Real Estate.  I recommend that each property you own be in a separate legal entity.  This shelters each property from one another’s liability.  I have found an LLC to be best for tax and legal purposes.  They give your basis for debt (important for tax purposes) and have no net worth tax in Georgia;
  • Run Numbers Before Buying (1% to 1.5% Rule).  There are many categories of expenses that could be associated with owing real estate. Additionally, you should expect vacancies.  In general, in determining your projected cash flows, take 93% of your projected gross rents plus any other income sources, such as vending or laundry, and subtract your estimated expenses.  Estimated expense categories include: principal and interest, taxes, insurance, advertising, lease commissions, management fees, repairs and maintenance (estimate between $50 to $60 per month per unit for multi-family residential), water/sewer, garbage, electricity, licenses, advertising, supplies, pest control, accounting, legal, misc. (5% of gross rents).  Obviously, your goal is to end up with a positive cash flow at the end of this analysis.  A QUICK AND DIRTY RULE IS THAT YOUR MONTHLY RENTS SHOULD BE AT LEAST 1% TO 1.5% OF YOUR TOTAL PURCHASE PRICE.  Example:  If you buy an apartment building for $500,000, your monthly gross rents should be at least ($500,000 X 1%) = $5,000.  If you pass this test, then the property is worth a further detailed analysis;
  • Figure Your Returns Based Upon Cash On Cash Return Basis (Don’t Use CAP RATE or IRR Analysis).  I don’t know about you, but I like to keep things simple.  In this regard, when I calculate my cash flow as discussed in point 14 above, I simply figure the annual return based upon my cash outlay.  For example, if I purchase a property for $500,000 and have to put 25% down ($125,000), then I take my yearly cash flow, after debt service, and divide it by the total cash outlay.  Example, if I project my monthly cash flow to be $1,000 per month, then my yearly return is $12,000/125,000 = 9.6%.  Not too shabby.  Also, remember that you should have additional return from yearly principal reduction and property appreciation, which I consider to be gravy.  Also, much of this cash flow should be sheltered from taxation due to yearly depreciation write off.  The “cap rate” of a property is the yearly net operating income (before debt service) divided by purchase price.  I like to see at least a 9-cap rate before I further investigate a property. IRR is a complex calculation beyond the scope of this article which factors time value of money into your returns;
  • Don’t Use A Management Company.  It comes down to this: no one cares more about your assets than you do.  I assure you from my own experiences that they will not maximize revenues, care for the property, screen tenants, handle the accounting, and properly keep you informed unless you are a very large client.  In other words, it doesn’t pay to use one unless you are huge.  Count on at least 6% to 10% of your gross revenue as their fee if you must use a management company;
  • Property Management Tips:  (1) Don’t let tenants move in until the agreed date, money has been paid in full, and the check has cleared; (2) Complete a “Move In/Move Out” form prior to move in and move out (I have one upon request); (3) Inform tenants in writing that your insurance does not cover their stuff (maybe in lease); (4) Make rents due on first of month, and late by the 5th; (5) Don’t provide drapes or curtains; (6) Provide incentive for early payment (prior to 5th, reduce by $25 – remember you artificially mark up); (7) Only show units ready for move in; (8) Consider longer than 12-month leases and lower rent (never go month to month or less than 12 months); (9) Get rid of bad paying tenants (more than 30 days late) – I use CSS Services – inexpensive and good.  By the way, Georgia courts are very pro Landlord and you will almost always get a judgment in your favor; (10) Use an approved realtors board lease for commercial property (I have a good sample residential lease and a copy of a Georgia commercial lease available upon request); (11) Use QuickBooks to do your accounting.  Set each tenant up as a customer to create separate accounting for each tenant using “statement charges” (I can help you with this upon request at $150 per hour consulting – it is well worth it a couple of hours of your time if you have no experience with this); and (12) Until you are large, manage property yourself;
  • BRIEF Real Estate Tax Highlights  (Remember This Topic Could Be a Seminar All To Itself):  (1) Allocation of purchase price will impact your taxes greatly – land is not depreciable, FF&E is 7 year life, residential building is 27.5 year life, nonresidential building is 39 year life; (2) Sale of real estate subject to depreciation recapture is taxed at 25% (assuming long term capital gains apply); (3) Hold your property for more than 1 year to receive long term capital gain tax rate on sale (generally 20%); (4) If you actively participate in real estate, up to $25,000 in passive losses from rental real estate can be deducted each year against other income (phased out by 50% of amount AGI exceeds $100,000) ; (5) If you are a real estate professional, all losses from real estate can offset other income (more than 50% of individuals personal services and you spend more than 750 hours of service per year); (6)  If you have more than 1 real estate property, you must make a special election on your tax return to treat them as oneactivity pursuant to section 469©(7)(A) – may need to do this to reach the 50% rule discussed in #5; (7) No tax on gain for like kind exchanges – there are 6 qualification rules:  First, both the property sold and bought must be for business or investment; Second, the property must not be held for sale to customers, like inventory; Third, must be like kind property like real estate for real estate; Fourth, a discussion on intangible property which is not relevant for this article; Fifth, the property to be received in an exchange must be identified in a written agreement within 45 days after the sold property is transferred; and Sixth, the property in the exchange must be received on or before the earlier of:  180 days after the transfer of the property given up, or the due date including extensions) for the tax return in which the transfer of the property given up occurs. You should use a like kind exchange company to handle these types of transactions for you;(8) Deduct all miles for visiting your property;
  • Real Estate Should Be Viewed As A Long Term Investment. Like most investments, I find real estate to perform best if you hold it for at least 5 years.  Most of my properties have seen there greatest appreciation at the 5 year point and beyond;
  • After 5 Years, Refinancing Usually Will Yield Tax-Free Proceeds.  In other words, your property will have likely appreciated after 5 years and hopefully so has the property’s income stream. Therefore, you can pull equity out of your property tax free by refinancing;
  • Keep Your Credit Clean.  If you are going to be successful in real estate, you will need to be able to borrow money.  Don’t bog your credit down with credit card debt, auto debt, and especially don’t have late payments.  Typically, a BEACON score of 675 and above will be needed to obtain conventional debt financing for investment real estate;
  • Insurance. You will have to have property insurance on your real estate. I have found State Farm to give the best rates on investment real estate;
  • Making An Offer.  Always do it in writing, perhaps first with a letter of intent. Don’t be shy or afraid to make a low-ball offer.  I would start at 20% below asking price.  You can always go up, but it’s almost impossible to go down.  You have nothing to lose. Remember, if you are using a real estate agent, they must, by law, present all your offers.  Also, don’t let the agent, who may be motivated by a higher commission, talk you out of making a low offer.  I have saved tens of thousands of dollars by being patient and low-balling the offer.  Once the letter of intent has been agreed upon, convert it to a contract.  It is best use a standardized contract that you should be able to obtain from a realtors office;
  • Be Creative With Your Offer.  Use a standardized Georgia Association of Realtors contract  (I have them available upon request).  Structure the offer creatively.  For example, perhaps you want to become more familiar with the property before purchasing it.  Therefore, try to get a lease on the property with an option to buy after a certain period of time.  Explain to the Seller that it is to their advantage to give you an option because they will get a higher price for property, option may be forfeited if rent not paid timely (assures Seller of timely rents), gives tenant a sense of pride of ownership which is an incentive to take better care of property, and rent may be higher than fair market value because of the option. Be sure your option language is drafted by an experienced real estate attorney for assurance that your option is enforceable.  The Seller may change their mind and a court of law will examine the language closely. First Rights of Refusal are very powerful tools in tying up a leased property.  This could protect you from losing your business, especially if it is location sensitive. Also, attempt to get owner financing if you can’t get conventional financing.  Finally, try to use win/win negotiation techniques.  Try to figure out the needs of the Seller and structure your offer to meet both the Seller’s needs and yours;
  • Don’t Get Emotionally Attached To A Property.  In other words, don’t buy it just because it’s pretty.  Make sure the economics make sense;
  • Liquidity – Remember, Real Estate is Not Liquid By Nature.  Make sure you can afford the property, and IT won’t cause your a hardship because you may not see the down payment money for at least 5 years. Can you imagine how well investors would do if there stock investments were not liquid?  In other words, if they could not sell based upon emotion, but were forced to hold long-term. Real estate by nature really forces investors to analyze buy and sell decisions carefully partially because of its non-liquid characteristic;
  • Never, Ever Buy a Property With Environmental Problems.  I know this may seem obvious, but you will be tempted because the purchase price will be very attractive.  Make sure you have at least a Phase I Environmental Study done on all your purchases.  Your liability exposure in this area is enormous, so if environmental issues show up, walk from the deal.  There are plenty more out there.  It has pained me to leave behind some very sweet deals due to environmental problems;
  • Zoning.  Make sure your property is zoned for your intended use.  At least early on, don’t even think about going for a zoning change.  It’s easier to get an act of congress passed than it is to re-zone a property, and zoning attorneys are very expensive;
  • Use The Newspapers’ Classified Ads To Find Deals.  Some of the best deals I have ever seen have been out of the newspaper.  You can’t believe the gems hidden in the classifieds.  It’s time consuming, but worth the effort;
  • SBA Loans. Great for your first big commercial purchase.  Many banks specialize in SBA financing.  You can usually only use an SBA loan once, so do so wisely — perhaps use it on a deal where you don’t have enough money to put more than 10% down.  SBA loans are great for those deals where you want to put down a low down payment;
  • Appeal Your Property Tax Assessments.  Every single year, I appeal.  Usually, I get a reduction.  It’s a bit of a pain to appear in front of the tax board, but after I calculate the hourly rate from the savings, I realize it’s well worth the effort.  There are professionals that will do this for you on a contingency fee basis, usually 25% of the savings.  I have information on this for Georgia upon request;
  • Did I Mention I Love Real Estate?  I will conclude by stating that in my humble opinion, no other investment can provide you with current cash income (most of it sheltered from tax), growth of your assets, leverage (using other peoples’ money to generate wealth for you), and instant equity. Real estate has gone up in value on an almost uninterrupted basis since the early 1800s.  Until the late 1970s, real estate went up at a rate of almost twice the Consumer Price Index.  Over the last 20 years, real estate has gone up at an average rate of approximately 5% compounded annually.  Keep in mind, since we are buying property using leverage, this can represent up to a 50% to 100% cash on cash return on investment (especially with cash flow factored in) over 5 year periods.  It’s hands on and requires work, but can be very rewarding.  Remember, real estate is not meant to replace equities or bonds, just another category for your portfolio.

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