The House is Ready to Go on the Market!

I’m coming off another jam-packed weekend of 12-hour days fixing up our foreclosure house. Between our weekend warrior efforts and the nearly $5,000 we’ve paid towards labor costs, this fixer-upper is ready to go on the rental market!

Want proof? You’ve seen the “before” video (if you haven’t, click here.) Check out these “after” pictures:
rental property investing for cashflow
cashflow positive rental property
foreclosure home investing
rental property
foreclosure property investing
real estate home investing

Haha - There's me taking pics of the house.


(Click “display images” to see the photos if you’re reading this by email.)

So how much did it cost us to convert an ugly duckling into a beautiful swan?

House: $21,000 *
Labor: $4,661.73 **
Materials: $3,576.98
Total Repairs (Labor + Material) = $8,238.71

Total = $29,238.71

* we also paid a couple hundred bucks for closing costs

** carpet and garage door (material + labor ) included in “labor” figure

This is enough to get it show-ready. We still need to replace the gutters and water heater and tune the HVAC, which will add roughly another $1,000 to the total.

This means that my gut feeling that the “total purchase price” (purchase + repairs) would come to $30,000 was spot-on.

Two important caveats, though:

#1: Count Your Time

Will and I spent every weekend and many evenings working on the house, and I spent many mornings and afternoons collecting quotes from contractors and checking up on the work. I didn’t track the total time we invested, but I’d guess that we roughly spent 100 hours combined on this project.

The value of our time should be added to this equation, especially since that time represents “missed opportunity” to earn money elsewhere. Time is money: Every hour we spend doing X is one fewer hour that we can spend doing Y.

It’s hard to make a precise calculation about how much our time is worth. At $50/hr, those 100 hours represent $5,000. At $25/hr, those 100 hours represent $2,500.

What metric do we use? I have no idea. That answer hinges on “what else would we do with that time?,” which is hypothetical. I just think its important to acknowledge that the time we invested translates into some financial worth.

#2: The One-Third Rule

Sooner rather than later, we’ll need to replace the windows, siding, bathtubs and roof. These aren’t urgent tasks, but they should get done in the next 3-5 years.

Why am I mentioning this? There’s the tough question of how people should allocate the cash-flow rental income that comes in. My favorite book on real estate investing, From 0 to 130 Properties in 3.5 Years, recommends the 1/3 approach:

  • 1/3 on improving the house and/or extra mortgage payments
  • 1/3 on buying more positive-cashflow real estate
  • 1/3 on chasing capital gains (stocks, ETFs, etc.)

It’s a great suggestion, but I’m going to tweak it a bit:

  • 1/3 on improving the house
  • 1/3 on buying more positive-cashflow real estate
  • 1/3 on building a thicker emergency fund

In 3-5 years, when I can switch from “fix-it” mode to “maintenance” mode, I’ll re-evaluate. But for the moment, this is my general strategy.

Update: The house is rented! What’s the return on investment? Find out here.



Is This House a Good Investment?

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income propertyForget fancy-pants calculus.

The most important math is the stuff you learned in fourth grade.

How do you know if an income property (rental property) is a good investment?

Start with The One Percent Rule: Does the monthly rent equal one percent of the purchase price or more?

Example:
Purchase Price: $100,000

$100,000 x 0.01 = $1,000

Is the monthly rent greater than, or less than, $1,000? If the monthly rent is greater than $1,000, this property merits further consideration. Otherwise, ignore the property and move on.

In other words: for every $100,000 in price, I look for $1,000 in rental income. If a house costs $225,000 – as mine does – it needs to rent for $2,250 per month or more.

One percent is the bare minimum level of return I’d accept.

Note: Whenever I say “purchase price,” I’m referring to total acquisition cost — which includes property price, closing costs, and any upfront repairs to get the unit rent-ready. It wouldn’t make sense to just count the “sticker price” of the home, because you might buy a $10,000 home that needs $80,000 in upfront repairs. Run calculations based on total acquisition price.

Just FYI, there are some investors who believe that One Percent is too lenient. These investors shoot for the “2 Percent Rule,” which means they collect $2,000 per month in gross rent for every $100,000 of house. However, I don’t (necessarily) advocate for those types of properties, since those tend to exist in high-risk neighborhoods. Keep in mind, there’s usually a tradeoff between risk and reward.

Example:
Midtown, Atlanta is a stable neighborhood with high rental demand. Tenants are likely to be college-educated, and many will hold graduate degrees. Tenants are likely to have perfect credit. Many are saving for their own home.

The tenant risk is lower, so your returns will also be lower. One percent is probably the best you’ll find in an area like this. (I got lucky.)

Hypothetical Town, in contrast, is an area with a high crime rate. Tenants are likely to have bad credit and bankruptcies. The tenant risk is higher, so your returns should also be higher. I’d demand at least 2 percent in a place like this.

The Cap Rate

If a house passes the One Percent Test, I look at a measure called the capitalization rate.

The capitalization rate, or “cap rate,” measures the return on the property value. Cap rate equals annual net operating income divided by the acquisition price.

“Uh, what?” – Don’t worry, that sounds like gibberish to me, too (and I wrote it!) Let’s walk through an example.

  • Rent = $1,200 per month
  • Insurance, Taxes, Water, Trash, Repairs, etc. = $700 per month
  • “Net operating income” (also known as “NOI”) = $1,200 – $700 = $500 per month.

Multiply by 12 to find your Annual NOI: $500 * 12 = $6,000
does this property produce good income ?
To find the cap rate, divide $6,000 (Annual NOI) by the total acquisition price of the house. Let’s assume your house cost $200,000.

$6,000 / $200,000 = 0.03

Multiply your answer by 100 to convert it into a percentage. The $6,000 in cash flow you’re receiving translates to a 3 percent return on your property value.

Meh. Yawn.

I’m not excited about that.

Let’s change one variable: Let’s assume you bought the house for only $100,000.

$6,000/$100,000 = 0.06, or 6 percent.

Much better! At that rate, it will take you 16 years to “pocket” the price of the house (100/6).

(Notice that if you bought the house for $200,000 and rented it for $1,200 per month, it wouldn’t meet the One Percent Rule. But if you bought it for $100,000 and rented it for $1,200 per month, it totally hits the One Percent Rule.)

**Important Note: Notice that we’re calculating “net operating income,” not “net revenue.” This sounds like an inconsequential distinction, but it carries one important implication: We subtract operating expenses, but not debt servicing or equity-building expenses.

What does that mean? Mortgages consist of four parts: Principal, Interest, Taxes and Insurance. These are collectively called PITI. When you calculate NOI, you subtract the cost of TI (taxes and insurance), because they’re part of your operating overhead. You don’t subtract the cost of PI (principal and interest), because these build equity and service debt, respectively. They’re not an operating expense.

“Okay, I understand not subtracting for principal repayments. But why wouldn’t you subtract the interest?”

We’re trying to evaluate the asset itself — the property — not the attractiveness of the loan. Let’s exaggerate this for the sake of illustration: ALL properties will look terrible with a 99% interest rate, and MANY properties will look awesome with a 0% interest rate. That doesn’t necessarily make those properties inherently good or bad rental candidates. We want to remove the financing arrangement from clouding our judgment about the property itself.

In other words: First, evaluate the property. If you like it, THEN find good financing. Don’t mix the two.

Cash-on-Cash Return

Finally, I scope out my cash-on-cash return: An equation that shows how far my cash will carry me.

The formula for this is annual NOI divided by down payment.
is this income property a good investment?
Using the same example as above:

I buy a house for $100,000. I put 20 percent down, or $20,000. The annual NOI is $3,000.

$3,000 / $20,000 = 0.15, or 15 percent! Holy moly!

This illustrates why real estate is so powerful: it’s probably the safest way to leverage your dollars.

Let me be clear: Real estate is still risky. But leveraging your money for other investments – like buying stocks “on margin” (with borrowed money) – is much riskier.

Gigantic Freakin’ Disclaimer:
The cash-on-cash return needs to be taken with a grain of salt. (Actually, take it with a whole damn salt shaker.) This equation rewards people who take out the biggest possible mortgage. (This shrinks the denominator, which makes the formula spit out a higher number.) Frankly, that gives this the potential to be a dangerous equation. You don’t want to get led into thinking that more leverage is always the better option.

The bigger your mortgage, the bigger your risk. Be cautious about using the cash-on-cash formula.

Here’s a safe way to use this formula: Try using this equation ONLY to compare the performance of properties you’d buy in cash. That way, you’re looking at “pure cash return,” absent of leverage risk.

If you can’t literally buy a property in cash, run the numbers through this equation anyway. You’ll at least gain an understanding of what type of return this property will create once the mortgage is paid in full. In other words, you’ll develop stronger knowledge about the strength of the property itself — absent any financing considerations.

Final Thoughts

Of all these formulas, the One Percent Rule is the easiest and most intuitive.

Cap rate is the most comprehensive.

Cash-on-cash is a nice finishing touch.

Use them all. Your success (or failure) as a real estate investor happens before you buy.

Note: This article was updated in February 2015 to clarify FAQ’s around this topic.

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Thanks to Jeremy Levine Design and Images of Money for today’s photos.

My Rotting Home: Weird and Freakish Adventures in Buying Real Estate

Note from Paula: In my last post  — Part 1 – I described how I searched for a rental house. In today’s post, I’ll spill the details of how I put the deal together.
buying some weird real estate no one else wants
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To say that the house is a “fixer upper” is too polite.

The house is –- well, it’s safe for human habitation. I think.

Cable television seems to think that a ‘fixer upper’ simply needs a makeover. Rip out the peeling yellow laminate. Toss in some granite and hardwood. Poof – instant fix.

Haha. If only.

This house has crazy core problems. There are no gutters, rotted doorjams, awful fascia, and the floors feel like mush near the doorways.

Water damage? Check.

Rot? Check.

Mold? Check.

Leaking pipes? Check.

Wonky foundation? Check.

Electrical issues? Check.

Real estate investors are used to dealing with these problems. After all, the house is 101+ years old (and it’s been neglected for at least two dozen years by absentee owners). What do you expect?

But one issue scared every other investor away: the sinking foundation.

Imagine a concave object, like a cereal bowl – high on the sides but low in the center. That’s what the house looks like; it droops several inches in the middle.

Some of the “support beams” are nothing more than thin planks of wood propped up on cinder blocks.

You feel a little like you’re in an amusement park fun house.

Real estate investors are fond of fixer-uppers, but many get scared by a bad foundation.
my adventures buying real estate
When others are fearful, I see opportunity.

Two experts separately evaluated the basement. A third-party certified inspector spent the better part of an afternoon documenting every flaw. And my partner Will, who paid tuition for his engineering degree by rehabbing houses, spent a day crawling underneath the house.

After lots of scrutinizing, every inspector declared the same opinion: The foundation is “fixable” (although I believe one of them described it as a “sponge on toothpicks.” Yikes!)

Okay, we’ll tackle the foundation. Next question: Would it appeal to tenants?

W.W.T.W. – What Would Tenants Want?

The house has nice “bones” – high ceilings, huge windows, lots of light. Those traits impress tenants.

More importantly, the house is divided into two single-bedroom units and one three-bedroom unit.

Single bedrooms are ideal. It’s easy to find one person – just one person – who wants to live there.

Three-bedrooms are tougher to rent. Heck, it’s hard enough getting three people to pick a restaurant for dinner. “Let’s get Italian! No, let’s get sushi!”

Imagine how hard it is to find three roommates who agree to rent your home.

Typically, families with children will rent 3-bed, 2-bath homes, while single young professionals opt for 1-bed or 2-bed units. This neighborhood tends to attract young professionals who want an urban lifestyle (rather than families looking for good schools), and this gave me a bit of pause about taking on a 3-bedroom unit.

Fortunately —

The 3-bedroom unit is the most beautiful space in the building, with huge windows, high ceilings, hardwood floors and Craftsman-style turn-of-the-century character. If three people are going to agree on any space, this would be a great one. I gave it a thumbs-up for marketability.

Now all we needed was money.

Show Me the Money!

The first banker said no.

Will and I had just returned from backpacking around the globe. I think that’s awesome. But as it turns out, bankers don’t look kindly on unconventional lives. 

Their conversation went something like this:

Banker: So you’ve been unemployed for … how long, exactly?

Will: Several years. I was overseas.

Banker: Were you working overseas?

Will: No.

Banker: So you were unemployed.

Will: By choice.

Banker: Did you look for a job overseas?

Will: I didn’t want one.

Banker: Tell me about your current job. How long have you been with your employer?

Will: Three months.

Yeah, you can imagine how well THAT interview went.

Rejection!!

But we kept trying. Here’s my little secret: keep trying until someone says yes.

Even if you want to claw your eyeballs out in the process.

Eventually it becomes a numbers game. Ask enough people and eventually someone will say yes.

They’ll demand a higher down payment. They’ll charge a sky-high interest rate. They’ll make you sign over your soul, your kidneys, and your firstborn child. But someone will ultimately say yes.

We got smacked with a higher interest rate: 5.375 percent at a time when everyone else was getting approved at less than 3 percent. That’s the punishment for living unconventionally, I suppose.

The other trade-off was that we were only approved for a $200,000 loan. Would that be enough?

The house was priced at $420,000 in 2008. An investor went under contract at $380,000, but pulled out after inspection.

A second investor went under contract at $325,000, but pulled out.

A third investor went under contract at $285,000, but pulled out.

By the time I spotted it, the house had sat on the market for 16 months. The owner was heading into foreclosure. He was desperate to sell.

We offered $225,000. Most of that money came from our loan, with $25,000 plus closing costs out-of-pocket (about 12 percent). The homeowner agreed.

The Rotting Building …

But the homeowner owed $325,000 on it. His bank would lose the $100,000 difference. Were they willing to do that?

I wrote – I’m not joking – a 24-page letter detailing all the structural deficiencies of the house, pleading a case for why a home in such bad condition should sell for a $100,000 discount. We argued that no one else would buy a house with foundational problems, and noted that the bank would lose even more money if they sold the house at a foreclosure auction.

And I included pictures. Lots and lots of pictures.

All unflattering.

The bank said yes. I’m now the proud owner of a rotting building.

But I took a risk — and a six-figure debt. Would it pay off? Tune in to Part 3 to learn how it’s doing, one year later.

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