We Bought House #4! Check it Out!

We just bought rental house #4! Check out all the numbers - of course, it meets the 1% rule. Find out why that's critical when buying a rental property.

Guess what? We did it again. We bought House #4, which represents our 6th rental unit in total!

“Whoa, Paula, this is getting ridiculous.”

Yeah, I know. Let’s meet the new rental, shall we?

The Rental House

First, the stats: It’s a 3-bedroom, 2-bath single-family house. Sound familiar? Every single-family residence we’ve purchased has matched that description (except for this one, which is a 3 bed, 1.5 bath).

Why? 3/2’s hold wide appeal, since they meet the needs of so many people. Couples, roommates, and small families are all eligible renters. Even single people sometimes rent 3/2’s if the price is right.**

The house barely needs any immediate repairs. It only needs about $3,000 worth of upfront work, which makes it the most turnkey property we’ve ever bought. Eventually (within the next 5 years) we’ll need to replace the roof and upgrade the kitchen. But for the moment, the house is move-in ready.

Wanna see? Check out the pictures:
(If you’re reading by email, click “display images” to see the photos)

Rental Property

Tools scattered everywhere. This is what we call “Friday night!”

Rental Property

Neutral paint, beige carpet, white trim. It’s cookie-cutter, which sells better.

Hanging window treatments. Ah, isn't real estate glamorous?

Hanging window treatments. Ah, isn’t real estate glamorous?

How do you take an interesting photo of an empty room, anyway?

How do you take an interesting photo of an empty room, anyway?

Old vanity; new topper, faucet and hinges. It's a cheap facelift!

Old vanity; new topper, faucet and hinges. It’s a cheap facelift!

Completely irrelevant photo of my new kitten. Isn't she awesome?!

Completely irrelevant photo of my new kitten. Isn’t she awesome?!

Location

The house is located in an up-and-coming neighborhood. It’s the type of place where ramshackle, boarded-up vacant homes sit next door to posh new construction.

Ah, real estate is endlessly fascinating, isn’t it? In the established suburbs where I was raised, there were “good neighborhoods” and “bad neighborhoods,” with plenty of space in between. But in an emerging neighborhood, “good” and “bad” is literally a house-by-house matter.

The neighborhood features old Fords propped up on cinder blocks, next to vegan raw food cafes. Go figure.

Costs

First of all, before I get into the price, let me take a moment to emphasize how tough it was to find this deal. Remember the last house that I didn’t buy? That whole incident took place back in – what, early April? Ever since then, searching for houses has felt like a demanding second job.

If any of you are serious about real estate investing (in a major way), know this: Searching for properties is a job onto itself. You’ll reject hundreds before you find the right one. (In that regard, I guess it’s like swiping through faces on Tinder?)

Okay, here are the figures:

“Real” Purchase Price: $120,000 (purchase plus initial repairs)
Rent: $1,300 per month

(UPDATE July 2015 — We’ve raised the rent to $1,500 per month.)

Right away, what do you see in those numbers? This house meets the One Percent Rule, meaning that its monthly rent is at least 1 percent of its purchase price. (For this house, the monthly rent is 1.1 percent of the purchase price).

As long-time Afford Anything readers know, I won’t look at a house that doesn’t meet the One Percent Rule.

Bear with me while I veer onto a tangent about that rule for a moment …

One Percent Rule

Why is the One Percent Rule so critical?

If the monthly rent is 1 percent of the purchase price, then the yearly rent is 12 percent of the purchase price. Your GROSS return is 12 percent annually.

But vacancies, maintenance, repairs, taxes, insurance, and management will take a huge bite out of your gross profits. Let’s assume two scenarios:

#1: You live in a state with massive property taxes. You have pricey insurance. You get overloaded with repairs, maintenance and vacancies. These costs consume 50 percent of your gross rent.

You’re left with a 6 percent cash flow return. Plus, the house appreciates at the rate of inflation, 3 percent.

Total return = 9 percent annually.

#2: You live in a state with a low property tax rate and cheap insurance deals. Repairs, maintenance and management are cheap. Vacancy is low. The tenant pays for all utilities and yard care. Your expenses consume only 33 percent of your gross rent.

You collect 8 percent cash flow (that’s like buying a dividend stock with an 8 percent payout!) The house appreciates at the rate of inflation.

Total return = 11 percent annually.

Not bad, eh? That’s the magic of the One Percent Rule.

Note: I’ve laid out this math assuming that you paid cash for the deal. Why? Because you should evaluate investments separate from its financing terms. This way, you can compare two houses with different financing terms and make an apples-to-apples comparison.

Furthermore, you can see how well the house will perform when the mortgage is paid off, which is the ultimate goal.

Real Costs of This House

How does the math change when financing gets added in? Let’s check out this house:

Yearly Income:
$15,600 (at $1,300/month rent)

Yearly Expenses:
$1,248 Vacancy (Assuming an 8 percent vacancy rate)
$1,560 Management (Assuming a 10 percent property management fee)
$1,200 Maintenance/Repairs (Assuming 1 percent of the purchase price per year)
$7,416 Mortgage (Fixed, 30-year loan on $90,000 @ 4.25 percent, including property taxes and insurance)

Total Expenses: $11,424
Passive Income: $4,176 per year!! Wahoo!!

We’re ecstatic about this house purchase, as you can guess. We already have a tenant living there, and – knock on wood – he seems like an ideal tenant (great job, etc).

UPDATE July 2015: We still have the same tenant! In fact, he just renewed his lease for another year (at a $200/month price increase), bringing him to a 3+ year tenancy and counting.

It’s clear that these deals are getting tougher to find. Two years ago, you could throw a dart at a real estate listing and score an awesome deal. These days, you’ll devote hundreds of hours to combing for a needle in a haystack.

We’re very happy with the six rental units that we’ve accumulated during the Great Recession (one triplex and three single-family homes). But the Great Recovery is now rearing its ugly head. That’s bad news for buyers. Our focus is going to shift to mortgage pay-down rather than property accumulation … maybe.

Although I might search for just one more. :-)

“OMG, Paula, you’re getting out of control.”

What do you mean?

“’Just one more’” is what addicts say.

I know, I know. :-)




**Note: In my experience, a 3-bed/2-bath home is the most awesome type of single-family house. If you’re renting out a multi-unit building, like a 3-plex or 4-plex or 100-plex, then buy a building in which each unit has only 1-2 bedrooms. Here’s why.

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.




How One House Throws $5,000 a Year at Me

Want to know how we generate $5,000 per month in passive income from a rental property? This post is all about rental House #3.

Remember when we bought House #3? It’s now rented! Let’s see if this deal is hot or not.

Excuse Me, Did You Say House #3?

As long-time Afford Anything readers know, Will and I bought our third rental property in May. It’s a 3-bed, 1.5-bath single-family home in a good school district in Atlanta. The asking price was $125,000, and we snagged it for $94,000.

This needed the fewest repairs of any of our houses. Here are the “before” pictures. As you can see, the scope of work was small. Knock out a wall or two; bust up some concrete steps; install a skylight. Voila – instant awesome!

Check out the “after” photos, below.

Rental Property - Nice Living Room

We’ve painted the walls, refinished the floors, and spruced up the entryway.

 

Rental Property - Kitchen Photo

The former owners remodeled the kitchen, so these new cabinets and countertop were included. Score!

 

Rental House - kitchen skylight

Remember that skylight we were installing in the kitchen? Here it is!

 

Rental Property - Kitchen

Here’s the dining area. It’s a little narrow, but it works.

 

Rental house - new paint and refinished floors

You’d be amazed at how a few plants can help with staging.

The total cost of the renovations came to $6,000, which means our “total purchase price” (purchase plus upfront repairs) was a solid $100,000.

It now rents for $1,295 per month. Passive cash, baby! Right away, we see that this passes the One Percent Rule with flying colors.

(The One Percent Rule states that the monthly rent should be at least one percent of the purchase price. Move the decimal point two spaces left. If the monthly rent isn’t at least that high, buy a different rental.)

But let’s dig down deeper. How do those numbers check out?

What’s the Cap Rate?

First, let’s find the “capitalization rate,” or cap rate. This measures the net return that the house provides, excluding your financing arrangement.

Why examine this? Because it shows you the strength/weakness of the deal itself, in a vacuum. Remember, ANYTHING can be cash-flow positive if you buy it with cash. That doesn’t mean it’s a good deal.

The “cap rate” helps you examine the quality of the underlying deal. Once you decide whether or not the investment is worth pursuing, you can calculate how different cash/financing scenarios will affect your passive income.

How do you find the cap rate? It’s easy: Just divide the house’s price by its net income.

Gross Income: $15,540 per year

Expenses:
Management – 10 percent of rent – $1,554/year
Taxes – $1,100/year (includes trash service)
General Repair/Maintenance Fund – 1 percent of purchase price – $940/year
Utilities – The tenant pays everything! That’s one huge benefit of renting out a single-family home, as opposed to a multi-unit building. (In contrast, we pay $300+ per month to cover the tenants’ water bills in our three-unit building.)
Yard Work – The tenant handles it!

Total Expenses: $3,594 per year

NET Income (Income after Expenses): $11,946 per year. Yeah baby!

Right off the bat, I can see that this is a sweet deal. I’m netting almost $12,000 a year for a $100,000 house. That’s roughly 12 percent.

Crunch the numbers, and the cap rate is $11,946/$100,000 = 0.1194, or 11.94 percent.

I don’t know about you, but I think a near-12 percent return is pretty stellar. It’s not as sweet as the 17.8 percent return I’m getting on House #2, but hey, you can’t strike gold every time. ☺

So How Much Cash Goes In Your Pocket Each Month?

Okay, now we know the cap rate. How much passive income are we collecting?

We have a private loan in which we’re making interest-only payments at 7 percent. (Hold your horses! I know this might create chaos in the comments section. I’ll explain why we choose this below.)

Let’s look again at the numbers.

Net Income: $11,946 per year
Financing Payments: $7,000 per year
CASH FLOW after debt service: $4,946 per year! Wahoo!!

We’re getting $5,000 in passive income each year from this house! That’s one huge step closer to financial freedom.

Why did we get the financing that we did? Look again at the numbers. Look carefully. How much money did we pay out-of-pocket for this investment?

Zero. Zip. Zilch. Nada.

Without spending a dime of our own money, we set up a deal in which we receive about $5,000 in passive income per year. That’s AFTER paying a property manager to do the actual work, plus setting aside a “rainy day” fund for long-term maintenance and repairs.

In other words, we borrowed at 7 percent and used the money to snag an investment that pays 12 percent. This practice is called “arbitrage,” which might be my favorite word in the English language. ☺

“Why get interest-only financing?”
It gives us the most flexibility. We’re earning $5,000 a year in passive income, with no money down.

We can choose – CHOOSE – to use that $5,000 to pay down the principal on the house. (There is no pre-payment penalty). We can use the money to buy another house. Heck, we can blow it on champagne and strippers, if we wanted. It’s our choice.

“What are you doing with that money?
First we’ll buy a few more rental units. Then we’ll start paying down the loans. In other words, we’re reinvesting the profits back into the business.

“Are you disciplined enough to re-invest that money?”
DUH!! If you’re not, get out of the game!

“Why not just borrow from a bank?”
I’d love to. But banks are sick of us.

“Are you worried that you’re over-leveraged?”
Nope. We use cash frequently, and we have kick-ass equity. We bought House #2 in cash. We paid for repairs on House #1, Unit B with cash. Relative to many real estate investors, we’re quite conservative.

“You allot $1,554 for paying a property manager. Why not manage it yourself?”
I do.

“Then why do you include a ‘management’ line-item?”
Because I pay myself for my time.

The management fee is active income I pay myself for the time I spend managing the property. It’s a radically different beast than the passive income I earn from the investment.

Rookie real estate investors conflate ‘paying themselves’ with ‘profit.’ You can’t pay yourself $0, pay someone else a a fair wage, and make an apples-to-apples comparison.

Every investment must allow me to make a profit after paying myself. That way, I can remove myself from the equation and the numbers will stay the same. Remember, the goal is financial freedom, not a lifetime job.

“Are you talking to yourself, in the form of italicized questions?”
Uh, yeah.

“In public? On a blog?”
Uh, yeah.

“You’re a dork.”
That’s not a question.

“You just proved my point.”
Whatever.




We Bought a Third Rental House!

I can’t believe I’m saying this: Dear Readers, I’d like to introduce you to Rental House #3.

“But Paula, didn’t you just buy a house? A couple months ago?”

Yep, it feels fast to me, too.

Check out the pics, and meet me below the photos to hear the details.
(If you’re reading by email, click “display images” to see the photos.)

bought rental house - making repairs

We removed the 1970’s wood paneling from this room …

bought rental house - repair wall

We removed a closet to add more space to a bedroom …

bought rental house - repair kitchen

The kitchen is decent, but not amazing …

bought rental house - repair man

… so we’re adding a skylight to the kitchen. Hooray for natural light!

bought rental house - repair stairs

These used to be the steps to the front porch.

bought rental house - repair porch steps

These are the new steps to the front porch! Much better!

The LowDown

The basic stats are normal: 3 bedrooms, 1.5 baths, built in 1965, neglected and needs repair. Up to this point, the description sounds remarkably similar to House #2.
repairing the home
Its location sets it apart. Will and I have “stuck to our core competence” by only buying rental properties that cash-flow. We’ve diversified pretty heavily, though, when it comes to location.

As background: the Atlanta metropolitan area is encircled by a highway, 285, which we call “the Perimeter.” City lovers look for homes “inside the Perimeter,” while suburban-dwellers live “outside the Perimeter.”

Generally speaking (there are many exceptions), the suburbs north of Atlanta are more educated and moneyed; the suburbs south of Atlanta are less.

House #1, the triplex, is in the urban heart of the city, with a view of the skyline. House #2, a single-family home, is “outside the Perimeter” in the faraway suburbs to the south of Atlanta. (That’s why it only cost $21,000.)

House #3 is in a location that Atlantans would call “AT the Perimeter” — in that grey zone where urban meets suburban, within a mile of the 285 highway. It borders the suburbs to the north of Atlanta, in an area with good school districts.

Sorry if I’ve bored you with too much detail, but location is the most important aspect of this project. Many real estate investors decide to specialize in ONE location — sometimes limiting their search to only a few blocks — and there’s a ton of merit to that strategy. If I start flipping houses, I’ll most likely follow that approach.

Will and I are taking the opposite tactic for our rentals, because we’re buying-and-holding for the long run. Neighborhoods will fluctuate in unpredictable ways over the span of the next 40 years. By diversifying our buy-and-hold locations, we’ll defray the risk of holding a bunch of houses in an area that might experience a collapse. (Of course, if ALL of metropolitan Atlanta plummets, we’re screwed.)

C’mon, Get Talkin’ Numbers, Already

rental property - repairThis house went on the market in August 2011 with an asking price of $175,000. If that sounds like a lot of money for a home in disrepair — in a city where you can pick up houses for $21,000 — you can thank the location. This property sits on one acre of land, which is a rarity inside the Perimeter.

The asking price was a little high. The next-door neighbor’s house is currently on the market with an asking price of $155,000, and it doesn’t need repair.

So one month later, in September 2011, the owners dropped the asking price to $148,000. That’s in line with homes on that street that are in good condition, but this place needed a deeper discount to compensate for the work that needs to be put into it.

So in October 2011, the owners dropped the price again, down to $125,000, and that’s where the price remained when we stumbled upon the house in February 2012.

Negotiation Time

We toyed with our offer for a long time. We had a very strong sense that the owners would accept $115,000, and we were ready to pay that. But we wanted to make a smaller offer, so that we could “negotiate up.”
bathroom renovation
Will wanted to offer $105,000. I argued that we should offer $95,000. We volleyed the idea back and forth. We both worried that the “reverse sticker shock” of a less-than-six-figure-offer would cause the seller to dismiss us.

We consulted Mom and Dad. My dad, a tough negotiator, liked Will’s idea. My mom, an even tougher negotiator, agreed with mine.

Mom knows best: we submitted an offer of $95,000 and waited for the seller to retort with a counter-offer. To our amazement, the seller accepted it!

You know, real estate just blows my mind. You can “save” $10,000 just by asking for it. I don’t know any other area of life in which that’s possible, unless you’re running a major business.

We bought the house for $94,000, after getting another $1,000 concession when the inspector found mold in the basement. (It’ll cost $1,000 to treat the mold, so we’ll “break even.”)

The “REAL purchase price” is the purchase PLUS initial repairs. Our repairs are going to cost about $6,000, so the “actual cost” of the house is $100,000.

According to the One Percent Rule of Thumb, this house would be a good deal if we collect $1,000 per month in gross rent. ($100,000 x .01 = $1,000).

I estimate that this house can rent for $1,000 – $1,200 per month, thanks mostly to its zoning and its school district. The return on investment isn’t as hot as the $21,000 house, but the quality of tenant is likely to be much higher.

What’s Next?

rental house team sportThank goodness we’ve started delegating out the repair work: instead of sanding cabinets and hammering nails in House #2, we outsourced that work and used the extra time to search for House #3.

Plus, we forged great relationships with the contractors who worked on House #2, so we knew exactly who to call for quotes on House #3. This streamlined the process immensely, allowing us to coordinate the repairs much faster.

If there’s one lesson that Houses #2 and #3 have taught me, it’s that you’re only as strong as the team around you. Business is a team sport. My focus from this point forward is to build that team.

UPDATE, NOV. 2012: We rented out the house! Check out the final numbers.


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.



Your Money Should Make Buckets of Excess Money

Your money should earn money

Want to learn how to double … triple … even 10x your money?

Read on.

If you’re like most people, your only money-making asset is your ability to work. Take that away, and you’re sunk.

But here’s a little-known truth: our ability to work is limited by our time, energy, and desire. Our money’s ability to work is unlimited.

Send your money to work on your behalf, and you’ll never need to commute to the office or punch a clock again.
[Read more…]