“Landlords grow rich in their sleep without working, risking or economizing”, said John Stuart Mill. Sounds too good to be true? I know. But you’ve landed on this page because you have this ideal somewhere deep inside you, yet no idea where to start from.
Only the cowards flirt with real estate investing. The brave ones become landlords by “getting married” to an investment property. Now, guess what: to become a landlord, you have to WORK hard, to take RISKS, and to SAVE lots of money.
More than 10 years ago, I received a call from a friend and he invited me to attend a meeting. He couldn’t reveal to me exactly what it was going to be about. So I accepted his invitation. To my surprise, I found myself in the middle of a room full of people who were about to find some life-changing awe-inspiring secrets.
This is still a tricky wording mastered by MLM members, but then, I was hooked! They were talking about an investment scheme that would have never crossed my mind, and it had nothing to do with real estate investing. My friend didn’t get another brick in his downline at the end of the meeting, but I got stuck with one sentence in my mind: “Let the money work for you!” What do you think – is something like that even possible?
Hearts of stone for profit
In the real world, people have to work for their money. So how could you make your money work for you?
Through investments, of course. Real estate remains the asset most sought after, with a very good return on investment (ROI), for the lucky ones. According to Investopedia, the S&P 500 Index average 20-year ROI for the real estate sector is 8.6%, with residential real estate at an average of 10.6% and commercial real estate at 9.5%. But real estate is also tough and cruel. It’s not a game for the faint of heart. Let me tell you just one story.
Last year, a friend of mine, Jane (not her real name), listed her condo for sale due to financial difficulties. After more than 270 days of no payments, she would have been evicted, unless she had sold the apartment in due time. Jane had signed one of the worst mortgage contracts in history. So her monthly installments would have doubled starting with her fifth year. She has received plenty of offers, so she chose to go with a buyer from Spain in the end. When the buyer arrived, things got very complicated. The buyer took advantage of the circumstances and made her an offer so low that she couldn’t believe her ears. She ended up with half of what she had expected. She was dealing with an experienced cold-blooded real estate investor.
As Joel Greenblatt said, “the secret to investing is to figure out the value of something – and then pay a lot less.” This is so true in real estate investing! So do you have what it takes to become a real estate investor?
A million reasons to become an investor
Real estate investing is like any other business. Why would you want to invest in real estate and not in a flower shop, for example? Some of your answers could be:
- Freedom to work whenever you want, without a fixed schedule.
- To collect money without much effort and sweat.
- To make money even while you sleep (remember that your property may increase in value over time!).
- The possibility to work from the most exotic places on Earth.
- To benefit from higher profit margins. Getting to keep more of the profits, instead of sharing them with your employees.
- To achieve a certain social status.
- To carry on the business of your father.
- To let money work for you.
- …and all other 999,992 reasons.
So far, it may sound like a dream job. But actually, it is not. At least not for every real estate investor. This job can get very stressful at times. Evictions could be very tough and emotional, and sometimes followed by long periods of vacancy. Besides, an investor must always follow the stock market and interpret the signals, watch the news and educate himself – even when sipping from a cocktail on a remote exotic island. But there is no cure for fear; the fear of a market meltdown is always haunting him like a ghost. When you decide to make the step and turn yourself into an investor, you must be cautious.
Invest in a partnership
Most people are scared of the big bucks circulating in the real estate industry. They are put off by the numbers when they shouldn’t be. ‘Cause investing is not for the lone wolf. Get your family involved!
Look at the numbers and see how easy it is to play with them! You can get different meanings by just rearranging them! And even a better meaning by dividing them! The glass is half empty when you look at it alone, and it becomes half full when you present the investment opportunity to your family. It is almost impossible to invest ALONE in for example, a rental property valued at 1 million dollars in your early 20s. But this investment becomes possible when your family joins you as your partner. Let me show you the beauty of it:
When you win 9 more family members over on your side, and settle to buy a 1 million dollar property, you will have a 10% share in everything: incomes and expenses. This can be done through a family trust, for example. Make sure that the cost of maintaining a family trust does not exceed the income, though. However, since a family trust is created to reduce the credit risk, most banks and lenders require a higher down payment and interest.
An attorney should be able to give you more direction on types of partnerships suitable for a real estate investment. Nevertheless, if you trust your family and they truly understand this life-changing investment, sign a partnership agreement and abide by it at all costs.
Before we move forward, though, I have to admit that partnerships don’t always work. Finding a good business partner is harder than finding a spouse. Here are a few reasons why a partnership may fall apart:
- It is very hard to separate business matters from family matters or to separate business from friendship. Sometimes, being honest can hurt, so in the end, you may lose not only a business partner but a friend as well. Inside the family, relationships can get colder, even on the verge of divorce.
- Unequal commitment among partners is another problem that leads to failure. Not all partners are equally enthusiastic about the new venture.
- Fear of failure could make some partners give up at the first sign of peril. When one withdraws, things may not go as planned, and everyone’s investment is at risk.
- Other distractions may become more important than the partnership, and as your partners get older, their priorities may shift in a different direction.
- Clashing visions on how the business should be managed can also lead to fights and frustration. It is important to take a personality test to know your temper and do so with all your partners. Most problems stem from the fact that we do not know ourselves well enough and we do not understand others. Psychology is important!
So seeing a partner leave will feel like rubbing salt on a wound; it’s an omen of disaster.
What is an investment property?
Most businesses make money from utilizing raw material. For example, bakers use flour, florists use flowers, and butchers use meat. It just happens that real estate investors use buildings and land as their “raw material”.
They can resell them as they are at a higher price later; they can rent them, or they can make some changes and improvements before they resell them for a profit. An investment property is simply a property used for making money. To do so, it must generate a positive cash-flow. This kind of properties are hard to come by, but with some negotiation skills put to work, you should be able to find great deals.
The downside of investing is that you never know whether it will retain its value or devalue after a few years. Are lenders easy to come by or are they hard to find? An empty property does not generate income, only expenses, so how will you cope with them? The example you will find below in the article is the epitome of the American Dream – the perfect investment. You don’t have to risk so much money! But you can start with little!
Buying an investment property before first home
Is it smart to buy a rental property before your own place? Ask anyone in the real estate industry, and they will probably tell you that the best time to buy your home is 5 years ago. Same with investment properties – nobody knows the right time to buy. We are not fortune tellers, so… cross your fingers! Even experienced investors, who can read the signs from the market still have their doubts when investing.
I would say that investing is hard, especially for the younger ones. With some guidance from an adult or from an experienced investor (or a real estate agent), though, a young adult can start investing before buying his/her first home. Even better, if all the family is involved!
There are risks like in any other business. But you can SHARE them! Some risks you can control, but others are impossible to foresee: the market may crash, the price of your investment property may fall, you may experience long periods of vacancy… all these will increase your heart beat. But you will find soon that the secret is in the waiting!
Buying an investment property to rent
Real estate investing is all about buying properties that generate income and profit. You may consider investing in real estate rentals or vacation rental properties, or even in vacant land. Buying an investment property to rent can bring you much satisfaction over the years. The results of your decisions will show up later, so you must be patient. As Charlie Munger put it: “The big money is not in the buying or selling, but in the waiting.”
In a very optimistic Hollywood script, you may access a 30 year home mortgage with a low interest rate to buy a $1 million property. BUT the idea behind the family partnership we mentioned above is to have your family fully involved! A script writer would already see some interesting plots evolving by throwing so many people into a partnership, but let’s imagine that nothing bad happens. The numbers look very good on paper:
- How much would be the downpayment for a $1 million house? At 5% down payment, you have to come up with only $5,000 out of the $50,000. You can easily save this amount in 5 years with only $3/day in your piggy bank!
- How much would be the monthly payment? About $9,000 – that is only $900 per person!
- How much rent could we charge? The rule is to charge no less than 1%/month. So, for a $1 million property, you should expect at least $10,000 in rent/month. So, your monthly payment should be covered by your share of the rent every month!
- How much will you win when the house sells? Well, if the house sells for $1,000,000 (in a pessimistic scenario) your $5,000 down payment will get you $100,000 without actually working for them! That is a 95% profit! Wow! That’s huge!
So, isn’t it nice to share the burden of debt? If only we could be less selfish! Egocentrism hurts our society and our economy in ways we can hardly imagine. It is the break that we keep pushing, trying to prove that we know better.
So how to start investing in real estate? By sharing!
I know that life is not like in the movies. However, this doesn’t mean that a family partnership will never reap the fruits of a good investment. It’s challenging, but not impossible. I will go more in depth in the next section so keep scrolling down!
Three phases of real estate investing
I like to imagine investing as a three-phase process: enter, stay, exit. Planning is the key! If you fail to plan, you plan to fail goes another saying of the industry. An overlooked factor in buying an investment property to rent is the SWOT analysis. It’s not usually performed before a real estate investment, but it will bring you peace of mind.
When will you start? How long will you stay? How do you get out if things don’t go as planned? In the beginning, your decision-making skills may seem as good as a squirrel that’s crossing the street. They will get better with time, but you must learn as much as you can about real estate first. Why not start by befriending a real estate agent or broker? If (s)he is honest with you, (s)he will tell you what properties are worthy of your attention. But for now, let’s look at the three stages of real estate investing.
Now, the next sentence is very important. You become a real estate investor as soon as you start saving money for a downpayment. And yes, you can save money in order to buy an investment property before your first home!
(I) The entrance – how to start investing in real estate?
When is the right time to start building your real estate portfolio? The sooner you start, the better. The ideal real estate investor should be 20 years-old with 60 years of experience. Can you show me one who is thinking about an investment property on his/her 21st birthday! I bet you can’t. But it is never too late to learn how to start investing in real estate!
Millennials have different priorities. I wonder why their parents don’t see that their children’s pristine credit history is a great advantage for the whole family. However, schools don’t talk much about our adult phase and this is sad enough. As you enter adulthood, you become more independent but also fearless and daring, don’t you think so? Youthfulness has the power to fuel 1 million dollars in real estate investments. It can release the breaks! And who doesn’t hate speed limits?
As soon as you turn 21, legally, you become a taxpayer, too. And for the banking system, you are a potential borrower. Time for you to leave the childhood bliss and your comfort zone… As long as you understand how economy works, you will be safe! Buying an investment property to rent at this time makes a lot of sense.
Loans for real estate investors
The global economy works on debt. We borrow from our future earnings and from the future generations. We borrow money that doesn’t exist physically, so you have to put up with the idea that there is more electronic currency in circulation than paper currency (banknotes).
You will probably have a hard time understanding this, however, to make a long story short, all I want to tell you is that you are expected to become a borrower sooner or later.
This doesn’t mean that you cannot choose to stay out of debt. You can, but most investors ARE indebted. So the whole game turns into a DEBT MANAGEMENT game. No, I’m not referring to debt consolidation plans, but at your own way of organizing and planning your debts and monthly payments, your strategy of keeping things under control. If debt were not a problem, there wouldn’t be so many businesses focused on debtors such as debt collectors and specialized attorneys. To invest means to take risks, and debt is part of the game – no risk, no gain.
A man who pays his bills on time is soon forgotten, that’s sure, but you don’t want to get to that point where a debt collector will check on you daily. That’s why I will give you a few magic formulas for real estate investing below because I want you to be among the winners! The winners are the ones who are better at managing their loans, both short term, and long term. Since public education is not offering any debt management lessons, you have to learn as you go.
PRICE TO RENT RATIO
This is the report between your house value and the rent you cash in one year. For example, the price to rent ratio for a 1 million dollar investment property, leased for $10,000/month, would be 8.33.
- A price-to-rent ratio below 15 means that it is better to buy than to rent, or that the property has a good return on investment.
- A price-to-rent ratio between 16 and 20 means that it is neither good nor bad to buy the property. You can purchase it but don’t expect too much out of your investment.
- A price-to-rent ratio above 20 means that it is better to rent than to buy, or that you will recover your investment slowly and costly.
CASH ON CASH RATIO
To find this ratio, divide the before-tax cash flow to the equity invested up to that point. For a 1 million dollar home, rented for $10,000/month, and with a monthly payment of $9,000, and a downpayment of $50,000 – at the end of the first year, the cash on cash ratio will be: 120,000/ 158,000 = 0.75. For the second year, the cash on cash ratio will be 1.11 – so the property generates more incomes than expenses.
Cash on cash ratio is usually the proof that a certain company has no liquidity problems. Creditors are usually looking for cash on cash ratios of above 1 and higher.
RETURN ON EQUITY (ROE)
How many dollars do you get for every dollar invested? As you could see, your investment of $5,000 brought you $95,000 in profits, so every single dollar generated 19 more dollars! Your return on equity is 19 and so is for everyone of your partners who has 10% of that investment property.
DEBT TO EQUITY RATIO
This is determined by dividing your home equity to the money you still owe to the lender. This reveals how much of your debt has changed from a liability into an asset. For example, after 2 years of payments for the 1 million dollar home, you will still owe the bank $1,000,000 – ($216,000+$50,000 down payment) = $734,000. So the debt to equity ratio is $734,000/$266,000 = $2.75 – in other words, you still owe $2.75 for every dollar that you’ve borrowed. It can also mean that only 26.6% of that property’s value can be considered an asset.
DEBT TO INCOME RATIO
This is another simple indicator that can be calculated by dividing the monthly debt costs to monthly incomes. For your 1 million dollar house, that means $9,000/$10,000 = 0.9. As long as it is below 1, this ratio looks good and you should not be worried – your property generates enough income to pay for itself! You have made a great investment!
If you’ve never been good at math, forget about investing! You must be endowed with a certain analytical mindset. It is true though that some of the richest men in our country have dropped out of college to start a huge business. But again, they are one in a million. And they had started businesses that changed the world, not some purely speculative real estate investment adventures.
(II) Stay – How long will you keep that property?
This is the second stage of your investment. Remember the “ideal” Hollywood script? Now, as the proud manager of a 1 million dollar home, how long are you going to keep the property? As long as it brings a positive income! It is important to know when to sell your investment property. A real estate agent could give you the best advice since (s)he feels the market better.
If the property has increased in value, compare the benefits of selling it now with the financial gains of waiting for the last mortgage payment. You may want to sell it and invest in a commercial property, or in a vacation rental property. However, do not be scared and act on your emotions when something unforeseen happens. Be patient! The market is like a rollercoaster – it is speeding down only for a period, then it is up again.
Have you invested in a vacation rental property? Why not turn it into your retirement home? Use the time you have left to pass on you knowledge. Ideally, you will want your children to inherit your real estate investments. You have to teach them how to take care of your investments and how to manage them. Teach them how to SHARE the burdens and the profits, on and off the record. They may have a safe future ahead, but tell them about the risks, too.
(III) Exit – How to end your real estate investing career?
As an investor, you must keep your losses low. So, if you feel like your properties don’t get you where you wanted to, you may sell them to reduce your losses. Or, if you are part of a partnership, you may want to see if someone else wants to take over your portfolio. If you want to leave a partnership, you should take into consideration that you might have to bring someone to replace you. The best way to end a real estate investing career is by leaving your portfolio to your children and grandchildren.
But the brave ones do have the courage to admit when something is way above their heads. If things get too complex for you, don’t be ashamed to own it up. Even the best writers have a bad written chapter in their books. Turn the page and start fresh!
Good or bad, real estate investments are life lessons.
We don’t take anything with us when we leave this world… but we all hope to leave something behind. Some do… Some don’t… After all, we have to accept that’s the best they could do. If our parents don’t leave us a hotel chain, it doesn’t mean we have not been loved, or cared for. We have been loved deeply, no doubt about it. But there are those who have been sleeping in a billion-star hotel, under the moon, for years. These people will never know the thrill of real estate investing, yet no real estate tycoon seems to care about them. They turn a blind eye, boiling with greed and despair at the same time. Let yourself not become one of them!