What’s In It For Me?
Real estate investing can be an effective way to grow your wealth and can be particularly valuable if you are interested in pursuing financial independence. The potential for returns are higher in real estate investing compared to investing the stock market because of the use of leverage (or borrowed funds) that you use to buy real estate. Additionally, real estate receives favorable tax advantages and the income the properties generate can be used to help fund an early retirement. Real estate investing can be a great “side hustle” since it can be a nice supplement to a full time job and is not incredibly time consuming. Buy it, Rent it, Profit! Was written by an experienced real estate investor and helps provide a solid foundation of knowledge for those looking to get into real estate investing.
The Big Idea
One of the key mantras from the book is “buildings don’t pay rent, people do!” Therefore, it is imperative to understand what the demographics and psychographics show the renters in your target area want, and then find a building that fits their needs. Unlike other real estate books that preach “fix and flip” or get rich quick schemes, the author firmly believes in a buy and hold approach to reduce risk and slowly build wealth over time. The author also preaches the importance of using systems to achieve success in real estate investing, whether it is a move-in checklist or a process for evaluating a potential investment.
Key Concept #1
How to Be a Successful Landlord
Get educated
The more knowledgeable you become about real estate investing, the greater the chances you will succeed. Continue to read and educate yourself because all the wisdom you need already exists, you just need to expose yourself to it.
Always be professional
Real estate is a team sport because you are interacting with lenders, tenants, contractors, and real estate agents. Being professional will improve your ability to lease units and access deals.
Develop effective systems
Systems allow things to be done consistently, correctly, and in less time, increasing profitability and decreasing the likelihood of mistakes.
Build a team
You will need experts in various fields to help you invest and manage profitably. A team that works together wins together.
Manage your time
Organize your time by prioritizing, with cash flow activities coming first and actions to minimize expenses coming a close second.
Maximize income, minimize expenses
This mantra is the key to success. Learning how to set proper rental rates, reduce turnover, and implement preventive maintenance to avoid repairs is critical.
Set goals and achieve them
In property management, goals can provide benchmarks for achievement, such as 97% occupancy or 90 percent on time rent collection. Goals should be specific and measurable.
In addition to following the steps above to be a successful landlord, the book offers some advice on how to get a good deal. It is important to understand the net operating income (NOI) of the property, which is the amount of revenue it will generate. Knowing what the present NOI is, what you can do to increase it, and projecting what that number will begin the future is essential to being a successful landlord.
Targeting added-value properties is a proven method to getting a good deal. Added-value properties are those in which value can be increased through renovations. Sometimes it could be as simple as new paint and carpet, or it may be adding an additional bedroom or bathroom.
Those new to real estate may think it is less risky to own one or two units. However, nothing could be further from the truth, as a portfolio of only a few units puts you at a high risk of vacancy should one of your tenants leave. Building economies of scale is the key to being successful in real estate. Not only will owning more units reduce your vacancy risk, but it will minimize expenses as well. To thoughtfully build economies of scale, consider targeting duplexes or multi-unit properties that will be easier to manage.
Key Concept #2
The SEOTA Method of Evaluating Properties
“Doing your research on an area before you start looking at specific properties serves as protection against getting sidetracked into looking at every “great deal” someone wants to pitch you.” Buy it, Rent it, Profit! P. 50
SEOTA stands for the Strategic Evaluation of a Target Area, which is a step-by step process for evaluating a property and determining if it’s a good investment for you.
The first goal of the SEOTA process is to identify areas that are good rental markets to invest in. The book offers eight key indicators to analyze a target area, and evaluating them will identify the areas with the strongest rental markets:
- Building permits
Looking at building permits helps track growth.
- Employment
Strong employment increases demand for housing, which can positively impact your occupancy rates and ability to increase rent over time.
- Average household size
This is important to determine the proper unit mix. If you learn the average household size is 3.8 persons per household, then pursing a mix of studio or one bedroom apartments won’t work.
- Demographics
Gives you the age, gender, and income level to help determine who your prospective tenant will be.
- Psychographics
Determines why someone will rent from you, or why they will not. While demographics tells you who they are, psychographics tells you what they want.
- Mortgage interest rates
These help determine market cycles. If rates are at all-time lows, more people will be qualifying for mortgages and are therefore less likely to be in the rental market. However, if rates are low and lending standards are tight for the middle to moderate income demographic, this demographic will likely be forced to rent.
- Rental market rates
Looking at the rental rate history in an area helps in determining where rents are currently and where they will be in the future.
- Occupancy rates
This is the percentage of currently rented units and helps you forecast how many vacant units to average in your numbers so your financial calculations are based on accurate vacancy estimates.
If a property passes your initial SEOTA check, the next thing to look for is if the property generates cash flow (i.e. does it produce enough income to cover expenses). Key Concept #3 will go into some more detail on key metrics to use when evaluating a potential property.
Key Concept #3
Understand Real Estate Metrics
There are some basic metrics that are important to understand as a real estate investor, and fortunately the math is very straightforward. Below are some of the key terms and formulas you should use to help evaluate your real estate investment:
Gross Potential Income (GPI): Your main source of income is the rents you take in. The GPI is the maximum possible rental income you can collect if all the units are being rented and is calculated on an annual basis. For example, if you have a duplex with each side renting for $1,000 per month, your gross potential income would be $24,000 per year ($2,000 x 12 months).
Vacancy Loss (VAC): In a perfect situation, all your units would be rented 100% of the time, but that is rarely the case, so it is important to allow for some vacancies when putting together a financial forecast for the property, which is known as vacancy loss. The average vacancy rate used by most investors is 5 percent, but it is more advisable to use the average vacancy rate in your area. Another term to understand is collection loss, which is the fact that not everyone will pay all the rent all the time.
VAC = GPI X estimated vacancy rate
If we continue with the duplex example and assume a 5 percent vacancy rate, the VAC would be $1,200 ($24,000 GPI x 5% vacancy).
Effective Gross Income (EGI): Effective gross income is defined as your total income from possible rents minus VAC and collection loss.
EGI = GPI – VAC
Capitalization Rate (Cap Rate): Cap rates are primarily used to help estimate the value of income properties and is a measure of the absolute return on dollars invested. For example, if a property has an NOI of $50,000 and the price of the property is $500,000, then the cap rate is 10 percent. When you think about cap rates, keep in mind that NOI is verifiable, but value is debatable, since everyone can have an opinion on the value of a property, ranging from the bank to the seller, to the appraiser, and finally to you as an investor.
Cap Rate = NOI/Value
Cash-on-Cash Return: The cash-on-cash return is the ratio of annual before-tax cash flow divided by the total amount of cash invested, expressed as a percentage. Unlike the cap rate, which does not factor in leverage (i.e. financing), the cash-on-cash return factors in the use of leverage. The cash-on-cash return highlights why real estate investing can be so powerful: because it allows the investor to increase returns through using leverage (other people’s money).
Key Concept #4
How Do I Pay For It?
Financing can make or break the profitability of a deal. Before selecting your financing, however, it is important to understand your exit strategy. Investors planning to purchase below-value properties, rehab it, and then quickly place the property back on the market will typically want to use a variable rate mortgage. A short-term investor may find variable rate mortgages are more attractive as the interest rates on these loans are often initially lower and the investor plans to sell the property before the loan resets to higher payments.
A long term buy and hold investor may want to look at a fixed rate mortgage or an ARM (adjustable rate mortgage) for the first five years to help maximize cash flow. If you anticipate interest rate increases, having the piece of mind of a fixed rate mortgage can be invaluable.
The author gives several keys to securing financing in a difficult lending environment :
1). Pick wise investments: Use the SEOTA method mentioned earlier to help find the right property. The property should have positive cash flow.
2). Have a resume: In cautious financial times, credibility can help you get a loan. The more you do to assure lenders you are educated, trained, and prepared to manage rental property, the more you are reducing your risk.
3). Be prepared to put more money down. If lending is tight, this will help reduce risk and increase your chances of getting the loan approved.
4). Safeguard your credit: Take steps to improve your credit score and keep it in good standing.
5). Develop professional relationships: Work with mortgage brokers who understand investment property.
When the real estate market crashed in 2008, a lot of people were over-leveraged on their properties and they couldn’t refinance. Real estate courses preaching “zero money down” left a lot of people on the hook for their investments. Had investors put 30 percent or some other amount down, their mortgage would have been a little lower. The author is not making the case that leverage is always wrong, but knowing when to use leverage and how much to use is critical. The type of rental property and well as its demographics can play a major role in the ability for a real estate investor to survive a crisis and stabilize a property.
Key Concept #5
Legal Protection
Every real estate investor should have a working knowledge of the different types of legal entities out there. There book suggests real estate investors should consider either a corporation or a limited liability corporation (LLC).
A corporation is popular type of legal entity due to its flexibility. It provides the ability to protect your personal assets from claims against the business, and you can elect two different tax structures for the business: subchapter S or C corp.
A LLC is probably the most popular legal entity to do business because it offers maximum creditor protection and maximum tax flexibility. The LLC provides protection from claims of creditors of the business, and also has some additional protections that when used effectively can make it preferable over a regular corporation. If there are investors other than you in the LLC, most state laws provide that they are protected from any claims related to the LLC. Investors know that the only risk they will have is the actual capital they invested. Additionally, the LLC provides that if a creditor tries to take ownership of an LLC, that creditor cannot seize the ownership. This protection makes the LLC preferable to a regular corporation in any situation where there is more than one owner.
If you have a single owner LLC or single owner corporation, the protection is approximately the same. However, an LLC is generally more flexible from a tax perspective because you have four ways to tax it as opposed to two ways to tax a regular corporation. Below are the four ways:
As a sub-S you elect to treat your business as a small business under the tax code. All profits and losses are directly passed through to the owner.
As a C corporation your business will be taxed twice: once on the income it earns, then again when the business makes distributions to its owners. This is referred to as “double taxation.” A C Corporation has the ability to accumulate capital inside of it (called retained earnings) and is capital that the business may use for acquisitions or investments. Additionally, the C Corporation has the ability to take a greater tax deduction.
As a partnership tax status you are taxed on a “pass through” basis as well. Companies taxed as partnerships have quite a few flexible tax benefits in the right situation.
A disregarded entity is ignored for tax purposes. If the owners tell the IRS to ignore the business and just tax the owners as if the business was not there, it’s “disregarded.”
If the above is confusing, just remember a corporation can be taxed either as a sub-S or a C corp. The LLC may be taxes as a sub-S, C corp, partnership, or disregarded entity. The protection benefits and greater tax flexibility make the LLC the entity of choice for most investors, but it is worth consulting with an attorney for your individual situation.
The book recommends that investors create a brand name around a management LLC, which is an LLC taxed as a sub-S corporation. This will not be an entity you own property in, but it’s a “storefront” you do business through. One of the biggest mistakes investors make is pile all of the real estate assets they own into one corporate basket. If there is one lawsuit against that corporation, all of their investment assets are impacted or at risk. The recommendation would be to have one brand name under a corporation entity, but own separate properties under separate corporation entities. This limits the liability of each property but allows you one “brand” to operate under.
Apply It
Preform a SEOTA analysis on a property. Even if you do not have the funds currently to be making any offers, analyzing properties in your target area will make you more prepared for when you are ready to make an offer.
Many amateur landlords own one or two properties, typically prior properties they lived in. While there is nothing wrong with this approach, the book makes a strong case for why scaling is important in real estate. Consider looking at duplexes or triplexes as a way to gradually build your real estate business since it will be more effective to manage and decrease the vacancy risk.
Analyze a prospective investment property by making assumptions and calculating some of the important metrics such as cash-on-cash return, GPI and cap rate.