“I Want to Create Passive Income, But I Don’t Know Where to Start” — Part II

This is Part II of the Passive Income for Beginners series. Start by reading Part I here.

How to create passive income

When I quit my 9-to-5 job, I had no concept of passive income.

Like most people, I conceptualized money in terms of time: “they pay $25 per hour” or “she makes $60,000 per year.” When I quit my job, I figured I’d live on savings for a few years and then return to the workforce.
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“I Want to Create Passive Income, But I Don’t Know Where to Start” — Part I

Imagine this:

You hop on a flight to Brazil or Costa Rica or Thailand. You spend a month reveling in the sand and surf. You taste new foods. You discover new music. You spot wildlife you’ve never imagined.

You don’t check email the entire time. Heck, you don’t even post photos to Facebook. You’re radically offline — like it’s 1972.
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I’m Upside-Down on My Home. Should I Rent It Out? Or Sell It?

A reader wants to rent out his current home he's upside-down on until the market recovers enough that he can sell it. But is this a good idea?

Should I Rent Out This House?An Afford Anything reader recently emailed me about this dilemma:

He’s upside-down on his home. He owes more than the house is worth.

But he wants to take advantage of today’s low housing prices, which will let him move his daughter into the best school district in town. He can put 10 percent down on a new house in a fantastic school district.

He’d lose money if he sold his current home. There are only two ways he can sell it: either bring cash to the closing table (i.e. pay extra to get rid of it!) or process an excruciating short sale, which would destroy his credit.

Both of those choices are off the table. He wants to rent out his current home until the market recovers enough that he can sell it. But is this a good idea?

Check out the details:

MONTHLY INCOME
Rent:
$1,600

MONTHLY EXPENSES
Mortgage + Association Payment:
$1,200
Vacancy: $100 *
Repairs, Maintenance: $50 – $100 **
Property Manager: $100

Total Expenses: $1,450

This leaves him with $100 – $150 per month in cash flow.

Hold On, Where Did You Get Those Vacancy / Maintenance Numbers?

If the house is vacant one month per year, we can average that out to a monthly vacancy cost of $100. Of course, if it sits vacant for 3-5 months, he’ll be sweating.

The “rule of thumb” is that maintenance will cost 1 percent of the purchase price of the house. Of course, that’s a long-term annualized average. It includes rare, expensive repairs like replacing the roof every 20-25 years and re-painting the siding every 5 years.

Since he has an association payment, I assume his homeowner’s association takes care of all exterior maintenance. That brings his maintenance costs down. (Well, really, it just lumps his maintenance costs into a different category).

Assuming his house is in good condition, his big maintenance costs will rare but costly events like replacing the water heater, buying a new refrigerator, etc. He won’t literally pay $100 every month. Like his vacancy costs, this maintenance cost is a long-term average over the span of many years.

He reported a property management fee of $100 per month in the email that he sent me. That seems rather cheap (it’s only 6 percent of the rent), but some property managers will charge a cheaper fee in a neighborhood with higher tenant quality, so I’ll accept that premise at face value. (Some property managers charge one month’s rent as a “placement fee” for finding a tenant, which is NOT included here.)

So What Do You Recommend?

Here’s my advice:

#1: Use your $100 – $150 monthly cash flow to build some cash reserves. Use this to cover the mortgage payments when your house sits vacant. Vacancy is your single biggest risk, because you’ll have to cough up the cash for two mortgages (your rental house and the home you live in). Strong cash reserves are the single biggest weapon you have against this risk.

#2: Add even more money to those cash reserves so that you can quickly write checks for repairs and maintenance. What if the house sits vacant for 4 months, a tenant moves in, and a week later you need to call a plumber? Cash reserves will help you sleep better at night.

#3: Don’t even think about making “extra” mortgage payments before you have huge cash reserves built.

I’d recommend a minimum cash reserve of 6 months of mortgage payments, and an optimal cash reserve of 8 to 10 months. That way, if you deal with an extended vacancy, you’ll be able to cover the mortgage.

Many landlords “shoot themselves in the foot” by panicking about a vacancy and renting out their home to the first willing tenant that comes along — even if their gut instinct says it might not be a good tenant. That always leads to disaster.

If you have cash reserves to deal with a vacancy, you can take your time and wait for the right tenant — a good tenant — instead of accepting the first person who’s willing to move in.

One of my houses has been vacant for almost three months. (It’s the $21,000 foreclosure, which is in a part of town that doesn’t always attract — um — the most qualified candidates). I’m guessing that the house might sit vacant for four or five months before I get someone in there.

But here’s the thing: Several people said they’re interested in moving in. But none of them have met my tenant criteria. It’s nice to be able to hold out and wait, so that you’ll eventually get the right tenant, not the first one.




Two Critical Things You Should Know Before You Invest in Real Estate

If you want to invest in real estate, all you need to know are these two critical things. It doesn't have to be any more complicated than that!

Note from Paula: This is a guest post from my friend Brandon Turner, a guy who shares my love for real estate, traveling and cats — not necessarily in that order.

Brandon used to write a blog called Real Estate in Your Twenties, which appealed to me for obvious reasons. These days he lurks around the corners of Bigger Pockets. He’ll introduce himself at the end of this post. Until then — take it away, Brandon!

The Only Two Things You Need To Know To Invest in Real Estate

The Only Two Things You Need To Know To Invest in Real Estate

I’m not a big fan of file cabinets right now.

Last month I bought a new file cabinet for my office. In an effort to make my office look more “home-y” I sprung for the nicer wood cabinet that resembles a dresser you might store your clothes in. Real fancy. I picked it out at my local Staples and told the associate I’d take it.

“You’re in luck! We’ve got one left. I’ll go grab it,” the associate said.

He returns a few moments later with a box.

Not a file cabinet. A box. That easily weighed over 100lbs.

“This is how we keep our prices so low! You get to put it together yourself and save! But don’t worry – there are instructions!”

I’m a fairly handy guy, so I buy the box and take it home. I know how to use a screw gun – I can handle it. After all, he said there were instructions.

The “instructions” ended up being 40 pages of pictures with no words. Just terribly drawn pictures of a cartoon man putting together a cartoon file cabinet.

Two hours later, the cabinet was put together and finally resembled a nice piece of furniture. However – several key pieces of the “guts” were missing, requiring me to fill out an online order form to get the new pieces. Two weeks later they arrived … and were the wrong kind. I’m currently waiting for order number two.

A month into this ordeal, all I have gained is a large file cabinet that cannot hold files. The only one getting any positive use of this thing is my cat, who has taken up residence on top.

Sometimes, life is just so complicated. From the box, to the manual, to the missing parts – it’s been so frickin’ complicated.

Perhaps you are wondering where I’m going with this thing. Trust me – I have a point.

In a world where everything is so complicated, there is one thing that doesn’t need to be: real estate investing.

I know – you think I’m crazy. Perhaps real estate investing seems as complicated to you as that file cabinet did for me, or maybe worse. However, the basics of real estate investing are actually so simple that even a child can understand it. This post is going to quickly break the whole industry apart for you into only two things you need to know.

A niche, and a strategy.

Allow me to explain.

Your Real Estate Niche

The first thing you need to determine for yourself when investing in real estate is your niche. Your niche is the type of property you want to invest in. There are many different kinds of property and like beer, paint, modes of transportation or clothing style – no “one niche” is right for everyone. That’s what makes real estate so fun – your personality gets to define your niche. Let me explain some of the more “popular” niches to invest in:

  • Single Family Houses
    No need to explain this one, but a single family home is the most common type of real estate investment. This could include a nice house in the ‘burbs, an inner city house, a condo, or any other type of real estate in which just one family lives.
  • Small Multifamily Housing
    This would include duplexes, triplexes, and quads (properties with 2, 3, or 4 units.) These properties are still considered “residential” in a lender’s eyes – making loans much easier to get.
  • Large Multifamily Housing
    Anything five units or larger is part of the “commercial” lending world and can range from a simple 5-plex all the way up to hundreds of units.
  • Commercial Real Estate
    Commercial real estate involves renting property to businesses. This could be an office building, warehouse, a shopping mall, a coffee shop, or any other kind of business.
  • Notes
    Perhaps you don’t want a physical piece of property at all. Investing in “notes” involved the buying and selling of loans. Although many don’t know it, notes can be invested in using the same strategies as actual properties. We’ll get to strategies in a second.
  • REITS
    Another method of investing without actually dealing with specific properties, the REIT (Real Estate Investment Trust) is like a “mutual fund” for real estate. Essentially, a multitude of investors pool their money into a fund to buy large pieces of real estate and share in the profits.

Each of these niches also have sub niches you can choose to explore as well. For example, you may want to invest in a single family home, but you can narrow down your niche even further into mobile homes or McMansions. The choice is yours!

Choosing Your Strategy

By now, perhaps you have an idea of the kind of property you want to get involved with. Maybe small multifamily properties really float your boat (it sure floats mine!) Or maybe you like the idea of investing in “notes.” Whatever choice – it’s not enough to simply buy something. How are you going to make money in this niche? This is why the second thing you need to decide on is your strategy.

Your strategy is the method you use to turn your niche into wealth. While not every niche will work with every strategy, you’ll find that most do. Investing in real estate simply comes down to picking a niche and then picking a strategy. It really is that simple. The following is a list of just a few of the more common strategies you can use:

Wholesaling

One of the more popular ways to enter the real estate investment business, wholesalers are the “scouts” of the industry, who seek to find deals for other investors and make money for finding those deals. In a typical wholesale deal, a wholesaler will find a great deal, put the property under legal contract, and then sell that contract.

For example, Bob the Wholesaler finds a small duplex that the owners are looking to sell. He signs a legal contract to buy the property for $100,000 and then finds a local landlord, Susan, who is looking for duplexes. Bob sells that contract to Susan for $10,000 and Susan closes on the duplex. In the end, the seller got what they wanted, Susan got what she wanted, and Bob made a nice profit.

Flipping

If you have cable TV, you probably know about this kind of investing. House flipper seek out great deals (often from wholesalers) and rehab the property, turning an ugly house into a beautiful home that they can sell on the open market to a family.

For example, Julie is a house flipper. She buys a property for $105,000 and hires contractors to put $35,000 worth of labor and material into beautifying the home. She pays another $20,000 in holding costs and transaction fees (insurance, mortgage, staging, seller-paid closing costs, agent commissions, loan origination fees, appraisals, etc.) She sells the home for $190,000 and profits around $30,000.

Buy and Hold

The most traditional of the bunch, a buy-and-hold strategy involves purchasing a property and simply holding onto it for many years. An ideal buy and hold property should produce both monthly cash flow (extra money after all the bills are paid) and appreciation (the value climbs over time).

For example, Jerry buys a small strip mall for $1 million and holds onto it for 30 years, making an solid return on his investment each month. Meanwhile, the loan on the property is paid off and the prices rise over time. Jerry’s retirement is fully funded by the property.

Don’t Over-Complicate Things

Like the instructions that came with my file cabinet, many people seem to complicate the real estate world with manuals, guides, and missing parts. I’m not saying real estate doesn’t have a lot of moving pieces and intricate details. However – the details will come as you get into it – you don’t need to know them all right now.

Don’t let the complications be a barrier to you when considering real estate as a source of income for you and “vehicle” for your investments. As you progress, you can learn more and dive in more deeply, switching between different strategies and niches and even combining different strategies to make even more profit. But don’t worry about that now!

This post was meant to give you a big picture framework for thinking about real estate and how people actually make money doing it. It really does come down to just knowing those two things: your niche and your strategy. Do you know yours? What is your favorite niche and your favorite strategy so far? Why?

Let me know in the comments below!

(I’ll go first: my current favorite niche is large multifamily properties and my current favorite strategy is “buy and hold.” Why? I love the cash flow I’m getting from my my large multifamily properties, which allow me to work how I want, travel when I want, and live the life of my dreams… well, my dreams without a file cabinet anyways!)

My Current Favorite Niche Is: _______________________
My Current Favorite Strategy Is: _____________________
Why? ________________________________________________

Brandon Turner is an active real estate investor and head of community at BiggerPockets.com – the real estate investing social network. He obsesses about real estate and his cats, and likes writing epic blog posts on things like the best way to screen tenants and the best way to rent a property out.




Readers Ask: What If I Can’t Hit One Percent?

rental house one percent rule

Many of my readers are rental property investors (or aspiring investors). But not all of them live in “cheap locations.”

Several readers have asked what how to invest if they live in a place where houses don’t meet the One Percent Rule.

Let’s answer this question by featuring Brian and Kristin, a couple in Arlington, Virginia, who wrote to me asking:

“My question is about your 1 percent rule for rental housing. What do you think about that rule when applied to the high-cost area where we live?

“The cost for a tear down where we would like to own rental properties is $400,000 – $500,000. Rents are all over the board and vary widely by proximity to metro/restaurants/schools. Generally you find $2,500 – $4,500 for a 3-4 bedroom house. The low end is suitable for college kids/roommate living and the high end is for families with kids.

“We … are currently in the hunt for (rental) houses in the $400,000 – $550,000 range. All of the houses will need work, (ranging) from … new cabinets to full-on additions.

“(We expect) to have a 3-4 bedroom house that’s worth $650,000 – $750,000 (after renovations) that we rent for $3,200 – $4,000. We may not make much on rental income, but we would be growing a nest egg in the value of the resale of the house down the road — be it 5-10 years down the road.

“We’re curious on your thoughts.”

Dear Brian and Kristin —

I crunched the numbers at the low end of the range — $3,200/mo gross income on a house valued at $650,000. I assume you net 70 percent of the monthly income after expenses (although that’s a generous assumption — the industry rule-of-thumb is that you’d net 50 percent).

You’ll net $2,240/mo, or $26,880 a year. Your cap rate is 26,880/650,000 = 0.041, or 4.1 percent. So right off the bat, I’d say that you should make sure your interest rate on the loan is lower than 4 percent.

(Ideally you want a big spread between your interest rate and your cap rate, because you’re taking on a risk. Investors call this spread a “risk premium,” a fancy way of saying that they get paid for the risk they carry).

Historically, homes nationwide have appreciated at a long-term annualized average of about 6-7 percent, which makes them a comparable (though slightly worse) choice than stocks for the long-run.

But Arlington, VA has appreciated at an annual rate of 3.9 percent since 1990, according to Neighborhood Scout.

So, again, you want to make sure your interest rate is substantially lower than the returns you’ll be getting. It looks like the return you’ll get is about 4 percent, based on historic long-term appreciation in your area. That means your interest rate should be around 2 percent.

What if you can’t get a teeny-tiny interest rate? Here are two options:

#1: Dedicate a significant amount of time scouting out the best deals. You just need one super-undervalued property to make your personal numbers substantially better than the general average. You can beat the average in rental properties if you buy the right house.

#2: Look outside of Arlington. Imagine a bunch of concentric circles on a map, with your hometown as the epicenter. If there’s nothing that meets the One Percent Rule in your hometown, expand your search to the next ring. Then the next one. And then the next one.

I lived in Boulder, Colorado for 8 years. I never found anything in Boulder that meets the One Percent Rule. But when I expand outward to a small city called Broomfield, Colo., I can find plenty of rentals that meet the One Percent Rule.

Also: Many people who read Afford Anything (mistakenly) think that Atlanta is an awesome place to invest. But you must realize that when I talk about “metro Atlanta,” I’m referring to a place that has a population of 5.2 million people. That’s eight times more populous than Vermont. It’s a bigger population than the entire state of Colorado.

Atlanta isn’t a one-size-fits-all market. I can’t paint such a massive metro area with one giant brush.

Sure, there are some pockets of metro Atlanta — like east of Panthersville, Georgia — where I can buy a foreclosed home for $21,000. But there are other areas in Atlanta where a 1000-sq.-ft. condo sells for $450,000. Location, location, location.

If I only looked at my own backyard, my quest to meet the One Percent Rule would be a lot harder. I put that in bold because this is a crucial lesson. Almost everyone who emails me, looking for permission to be the “exception” to the One Percent Rule, cites the reasoning that there’s nothing in their backyard that meets that requirement. Well, guess what: There’s nothing in my own backyard that fits the One Percent Rule, either. That’s why I expanded my search outward, in bigger and bigger concentric rings, until I found neighborhoods that have properties that fit this rule.

(It took me a year of fruitless searches to figure this out. Here’s the ah-ha story that I wrote when I did. Learn from my mistake; you’ll save time.)

By expanding outward, I can find better deals — and so can you. Keep looking. Don’t give up.

Good luck.

Cheers,
Paula




Investing 100 Percent of My Income: May Edition

investing 100 percent of my incomeTime for the next edition of Investing 100 Percent of My Income, and I have just one question:

How is it June already?!

For those of you who are new readers: Will and I are a couple who have pledged to live on one income and invest the other. He gets a steady paycheck, while my income fluctuates because I’m self-employed. So we’ve decided that in 2012, we’ll live on his income and invest 100 percent of mine. (This makes financial planning a heckuva lot easier!)

By the end of last month’s update, I maxed out my Roth IRA, renovated a rental house with a 14.8 percent cap rate, and paid quarterly taxes.

That was the easy part. Those were no-brainer moves.

Now comes the hard part. It’s time to make strategic decisions about how to invest the rest of my income for the next 7 months of the year. Here are a few lessons I’ve gathered:
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