So you want to start in real estate? True, a lot of money can be made but how do you avoid the common traps? In this article I will explain the beginner steps to real estate investing. First you need to know a safe strategy for real estate investing, nobody wants to end up poor and even more in dept than he or she started with. After this I will also show you the math.
Real estate requires a few personal characteristics: a keen eye, financial intelligence and patience. It also requires you to have money. Unlike most start-ups, real estate investing requires capital to make it work for you. This increases the threshold for the amount of people that can be in real estate and is one of the reasons why it is so profitable. Of course anyone can go into real estate without money, then again most people are broke. So either there is a catch, people are lazy or both.
Most people are just lazy and don’t want to spend the time learning and investing. There is also a catch that comes in the form of impatience and a financial crisis. Perhaps you remember the crisis of 2008, housing prices plunged with around 30% at that time. The first thing that comes to mind then: is real estate investing not risky? The short answer is yes and no. Yes it can be risky but it depends on your strategy.
I prefer to teach safe ways of getting rich even if it is a bit slower. The key focus point of any safe investing strategy is patience or the more common: buy and hold. Yes a lot of money can be made with short term stock trading and flipping houses, a lot of money can also be lost when the crisis strikes. Keeping in mind that the crisis is around the corner, let’s not follow the masses into hell. So what to do then? Buy and hold.
Why? Because or focus is on cash flow, not quick cash. We want an asset, not an inflation stricken currency. Real estate can be rented out that produces a steady cash flow. It also allows for diversification by scaling the amount of real estate you have over several regions and forms of estate. But even in real estate there are safer choices. Offices are cycle dependent which means they earn well in a growing economy but are dead weight in a crisis. Houses or homes are safer. Everyone needs a roof over their head. In a crisis people lose their jobs, sometimes they can’t afford their home anymore and have to move to a smaller house or a rental: your rental. Also, rental prices are a lot more stable than housing prices. They generally increase with inflation and sometimes more. Only if the population in an area is shrinking, houses become empty and thus rental prices fall. This doesn’t really happen in most developed countries and cities therefore rent prices go up quite consistently unlike housing prices.
Now we know why we buy a house and what we are going to do with it, how do we buy a house? This requires the before mentioned keen eye and financial intelligence. You need to develop a keen eye for houses. When you start in real estate investing you are unlikely to be able to afford a big mansion but are more likely to afford a small apartment for one or two people, often people who study or just started working. That means you need to find an area that attracts those people. Think about cities with universities or places were a lot of single elderly people live, they often want to live smaller. Also consider the price of the rent you are going to ask and the budget of people in the area. People near the financial district often have more money than people living in a village.
Once you have found some places that fit the criteria, find houses that need a renovation. That requires a keen eye. Find the houses that few people buy because they don’t see the opportunity. Remember that we don’t flip the houses, we renovate them so we can rent them out to generate cash flow. A sale is a one-time event to get your money back but a rented house can generate cash flow for years. You are thus much more likely to get the investment for the renovation back. Also don’t forget the common advice that is mostly used for flipping houses but also works for us: save costs by doing most of the work yourself.
So why do you need the financial intelligence? Because you need to know if the investment will be worth it! We need to do some market research and figure out how much we can invest in the house and how long it would take to earn that money back. We also need to consider the costs of the insurance on a house, the mortgage, taxes and some general maintenance costs. A good rule of thumb is to save up 1% of the value of the house for maintenance costs each year. For insurance it is important to cover the fire, water, storm and break-in damage. Also an insurance for the furniture inside the house might be smart if you want to rent out the house with furniture included. Also find out how much taxes (rental tax, tax on capital) and municipality fees (garbage, sewer etc.) you pay for owning a house. Now that we know all these costs we need to talk about the mortgage.
Again it is unlikely that you will buy you real estate without a mortgage. If you can, great! You need to decide for yourself if you want to spend it all on one house or if you prefer to diversify and take a mortgage on multiple houses. Now I know that a mortgage is a debt and we prefer not to have debt. However, there is a reason why most businesses have debt and are still very profitable. Loans allow a company to leverage the wealth of others to make profit for themselves and that is exactly what we are doing. A mortgage on our own house when we have a salary only is a liability to the bank. If you lose your job, you will find it more difficult to pay of your mortgage. Indeed, you are a slave to your debt. However, if we buy a house to rent out we have an asset not a liability. The house itself creates the cash flow to sustain the mortgage. Of course if you don’t have someone who rents your house you still have a problem. That is why the location is so important.
There is also another factor in play. A good mortgage for investing has a fixed payment plan. As long as you make the monthly payments, the bank won’t just ask for its money back all at once. That means you can save part of the profit from the rent for when there is not person renting your house. Some real estate investors save several years for each real estate piece for when a property doesn’t produce cash flow. Also, in the worst case scenario you can also still sell the property. Again this is a last resort, the idea is really to buy and hold. Often when you are required to sell due to financial constrains the market prices are on the lowest point. To make it easier to get a mortgage and to not be influenced that much by market shocks like the housing bubble it is wise to have a down-payment on each house of at least 20%. In a crisis housing prices drop, in the last crisis around 30%, with this downpayment you insure yourself again accumulating debt. With the 20% down payment you ensure you generally still break-even when the crisis hits and housing prices fall and for some reason you have to sell. With this strategy you can at least be sure that you invest, for as far as that is possible, quite safe.
Now that we know we need a 20% down payment at least we also know how much mortgage we need. The last thing to figure out is the length of the mortgage and the rent price. The rent is generally dependent on the renting price in the area. Analyze how much is reasonable, for example by looking up prices online or by asking the neighbors of your property (if they rent the house). Once we know the average rent price for the house we need to subtract the maintenance cost (10% of the housing price / 12), taxes and municipality fees (per month) and the insurance cost per month. What is left is profit and mortgage. Choose the timeline in which you can pay of the mortgage but also ensure you keep a bit of monthly profit. The higher the mortgage the faster you will pay of the mortgage but the less profit you make. If you pay of slower you will make more profit. This is really a personal choice but it is generally safer to take a couple years longer to pay off and save on the side. The saved money could come in handy to keep paying the mortgage in case the renter doesn’t pay on time or you can’t find a person to rent the house from you. It also allows you to use the profit to get another piece of real estate to diversify your portfolio and mitigate the risk that way. There is also not really a hurry to pay the mortgage off because the house pays for itself. Perhaps its best to start illustrating this story with some numbers.
The Math of Real Estate Investing
Let’s start with a small appartement for a price of $100,000. It’s a small house in the city center of consisting of one bedroom, a kitchen and bathroom. We fix it up for $1.000 that we pay out of our savings. You can rent this house for around $900 a month. A reasonable insurance is around $1.200 a year, or $100 a month and taxes and municipality fees for the house are (inc tax breaks) around 2% of the home value per year, so around $166. You need to save 1% of the value of the house for maintenance which adds up to $1.000 a year or 83 a month. This means your total costs are $349 a month. We make a down payment of 20% so we have a linear mortgage with 3% interest of $80.000 that we will pay off in 20 years, the first payment then costs us (80,000*0,03)/12+80,000/20/12= $467. The total amount we pay each month is then $816 each month.
Now be aware that I state: “the amount we pay” not “the costs”. For outsiders it might seem that you only make 900-816=$84 profit. But you should know better. Because that mortgage payment of $467 consists of interest (a cost) and payback on the loan (which is a saving). We pay 80,000*0,03=$2,400 of interest each year or $200 per month. However we also pay off the loan with $267 each month. Now why did I call this a saving? Because when we sell the house we get this money back if we sell it for the same $100.000 we bought it for. So if we have a debt of 80,000 and pay of 267 each month, at the end of the year we would have a debt of 80,000-267*12= $76,796. If we were to sell the house again for $100.000 and then pay off the outstanding loan of $76,796 we would have $23,204 leftover. This consists of the 20% downpayment of 20.000 but the 3,204 on top of that comes from our repayments of the loan and is our capital! We essentially saved $3,204 and of course we also received a profit of $84 a month, totalling $1008. That means after one year we are $4,212 richer than we were before, not bad!
Another thing you might have notices is that I mentioned a linear mortgage and that I was talking about the first payment being $467. In the left graph below you will see a linear mortgage model. We pay off the same amount each month but because the outstanding balance decreases, so does the interest rate. This means that, over time, our costs decrease as well. The first payment is $467 but the first payment of the second year is (80,000-3,204*0,03)/12+80,000/20/12= $459, or $8 less. Of course that also means you earned $92 instead of the $84 each month.
An alternative mortgage is an annuity model. In this case you pay the same amount each month but the composition changes. So we would pay off $467 each month for 20 years, but the repayment in the beginning is very slow and the interest is high and as time passes the interest becomes less and the repayment more. Depending on the state and country you live in, the annuity model can have tax advantages. Another benefit is that the amount is always the same so it is easy to calculate with and the payments in the beginning are lower compared to the linear model. However, that also means that the payments at the end are higher compared to the linear model. It really depends on the strategy you want to use for investing.
So why is it so important to buy and hold? Let us dive a little bit deeper into the “what happens if I sell scenario”. When I explained how you save money with paying off the loan, I assumed you would get the full $100,000 back. Of course in a growing economy it is unlikely I would get less for my house than what I paid for. However, in a recession this is not that easy. If housing prices drop with 20% during the recession that means our house is suddenly only worth $80,000. Because of our down payment of 20% we can still sell the house without accumulating debt but of course we would lose the $20.000 down-payment if we sell. But there is not really a reason to sell as long as there is a renter in the house because we can still make the mortgage payments and other costs. The house is still generating a cash flow and we can just wait out until the prices rise again. So if the house is worth $80.000 or $100.000 is meaningless to us as long as we keep receiving our $900 rent. We will also still receive our $84 free profit each month. So why would we sell?
The only reason why we would sell is when the house isn’t being rented out. Of course this can happen. People lose their jobs and might not be able to afford the house anymore. However, we have two advantages. First of all, we currently have one of the smallest houses there is, it is a one room apartment. If everyone needs to downsize that means our house is the smallest and thus becomes higher in demand. People who own a house move to renting a house and people who rent a house are stuck. People who rent a big house can downsize to a middle sized house and people who have a middle sized house go to a small house. But the people already living in a small house are stuck. So the demand grows for the small rental houses, our house! This means the chance that nobody will rent our house is very small. Especially in a recession. The changes of renting prices falling with rising demand becomes then an unlikely scenario too. To be on the safe side: try to save the immediate profit from your house to a couple of months (or even better years!) worth of rent. So for half a year save 900*6 = $5,400. Even if you can’t find a renter for a while you will still be able to keep paying your mortgage so you don’t have to sell the house. So our little venture is a very safe adventure. We don’t need to sell the house because we will have renters and as long as we don’t sell the house we can make payments to our mortgage and thus keep increasing our wealth.
So why isn’t everybody doing this? It helps to know that 80% of U.S citizens has less than $10.000 in savings according to a GOBankingRates survey in 2018. This means that most people can’t afford the investment to fix up the house and pay the down-payment of 20%. Sometimes people are stupid enough to still try to invest in real estate but people without savings are generally people who cannot save. So they get into trouble when a renter pays too late or when they don’t have a renter in their house for a couple of months. Of course this always happens when they just lost their primary source of income, their job. So they have to sell the house at the worst possible time, a recession, see 20% of the value of their house disappear, which was all borrowed money. That means they suddenly have to pay back a little less than the full $100.000, for which they bought the house, but the house is only worth $80,000. That means they accumulated a debt of $20,000 and all because they didn’t save and had to force-sell their house. So stay on the safe side: Save to invest. Don’t invest to start saving.
Of course once you saved up some money, you can start scaling. Buy another house and repeat the same steps. Eventually, you will be able to live off the cash flow from your houses and gain financial independence. How you get to the first $20.000 is a topic for another time but a job could certainly help you on your way ;-). Be a saver and become a real estate investor!