Today I’m excited to bring you a guest post written by James Lowery at RethinkTheRatRace.com about rental property investing. This is an area of investing that I’ve been interested in for a long time, but I haven’t pursued just yet. James has a lot of experience in this area, and this post provides significant value on the topic.
Guest Post by James Lowery:
I’m not ashamed to admit that when Jared reached out to me and asked me to write an introduction article on real estate investing, I got pretty hyped. My wife and I went from one to nine units in a year and recently just closed on our 10th rental unit, so you could say we are pretty passionate about real estate investing and the freedom it can bring. Today I’ll essentially go over Rental Property 101 and give you a broad overview of real estate to help you prepare to get started.
Types of Real Estate Investing
One of, if not the most, important parts of real estate investing is deciding the type of investing you want to do. There are tons of options that will depend on your preference, your time, and your goals. A few different types for real estate investing are:
- Residential long term rentals
- Short term rentals (AirBnB)
- Commercial real estate investing
- REIT (real estate investment trusts, which are the index funds of the real estate world)
As you can see, there are lots of different types of real estate investing, and there are also many subsets of each of these categories. But today, we are only going to focus on our bread & butter: residential long term rentals. Long term rentals can provide sufficient cash-flow when purchased correctly; they are much more passive than flipping or short term rentals; there are millions of properties available; they provide plenty of tax benefits; and they are easy to leverage. So let’s go over the ins and outs of long term rental property investing.
The 1% Rule
When you’re starting to look for properties to buy, “the 1% rule” is a guideline you can follow to help determine if the property is going to be a good long term rental. The 1% “rule” is a common rule of thumb thrown around in the long term residential rental property world.
The way it works is: the monthly rental income should meet or exceed 1% of the purchase price.
For instance, a $100,000 house should rent for $1,000 a month. Essentially, it’s an easy way to filter through properties to determine if they are worth looking at closer.
It won’t take you long to realize a few things about this rule of thumb. First, people quickly notice that certain areas will never meet the 1% rule. San Francisco, New York, Miami, and other high cost of living areas have home prices in the $1 million+ range, but you’re crazy if you think they’ll rent for $10,000 a month. Even in low cost of living areas, there’s going to be an upper limit to what people will pay to rent. You’d never be able to rent a $350,000 luxury home in our area in Alabama for $3,500.
It’s important to mention that the 1% rule is mainly for ‘back of the envelope’ calculations and that just because a property doesn’t meet the 1% rule doesn’t mean it won’t cash flow. And, just because it’s over 1% doesn’t necessarily make it a good buy either. A $20k slum that rents for $300 will quickly cost you more money on vacancies, evictions, and repairs than it’s worth. So the 1% rule is more of just a guideline to get you started, it’s not a hard and fast rule.
Location, Location, Location
Live where you want, and invest where the numbers make sense. You don’t have to invest where you live, especially if you can get much better returns in other markets. There are a couple of concerns that people have when thinking about investing outside of their immediate area. The main one is that they can’t go to the property if there is an issue. But, how many people are handy enough to fix things anyway? If a tenant reached out to us and told us they were having an electrical issue, we would call an electrician and have them do the repairs, because the last thing I want is to get fried to a crisp. Being close to our property doesn’t necessarily help us in this situation, because we wouldn’t be able to resolve anything ourselves anyway. It’s just as easy to call an electrician in another state as it is one down the street.
So, now the question becomes, where do you invest? You’ll want to look for a few things:
- Investor friendly states and cities. It’ll take months longer to evict someone from an apartment in Los Angeles compared to Houston.
- Population growth. More growth equals more potential tenants, which would hopefully lead to more qualified tenants.
- Stable or growing economy with diverse industries. If you invest in a single industry town, and that industry busts, you’ll be stuck with a property in an area with no qualified tenants and no one left to sell to. Think Detroit during & after the recession: 25% population loss, and they still have double the average unemployment rate today.
Become an Expert
Once you have an area in mind, you should start researching. Run the numbers and make sure that area can meet, or at least come close to, the 1% rule. It’s nice if you have some familiarity with the city, but not a requirement. That’ll just mean you might need to do a little more research on the specific areas you should be targeting to make sure they’re good rental markets. Some cities can vary street by street, while others will be consistent through multiple zip codes.
I wouldn’t suggest jumping in head-first just yet though. You’ll want to become very familiar with the market, not only with the properties, but also by getting a potential team in place. Interview multiple real estate agents, property managers, inspectors, and contractors. These people can make your life much easier when you are purchasing, renting, rehabbing, or selling.
You should know your individual criteria, the market rents, and the bargain listing prices like the back of your hand. Want a 3 bed, 2 bath house? You should know how much it should rent for in each neighborhood, and how much they typically sell for. Once you calculate the numbers on enough properties, you should be able to spot a good deal as soon as it comes on the market. When you find a good deal, be sure to do your due diligence and make sure it’ll cash flow, which is where your team comes in. But, ultimately, the decision is on you. Trust the process, be confident in your research, and pull the trigger when you find the property that fits your criteria. Sitting on the sidelines isn’t going to make you any richer.
Rake in Cold Hard Cash
We are going to skip over the closing process. It’s boring, and there are plenty of different iterations that could grow into an article all on its own. So we are going to assume you’ve closed on the property with some decent financing. You’ve screened and found good tenants, and here comes the fun part. The tenants are paying your mortgage every month, and if you ran your numbers right, you should be getting to pocket a couple hundo’s a month after setting money aside for vacancies and repairs. This is the beauty of financing.
Let’s run through a quick scenario to see the benefits of financing with rental properties:
- You have $100k to invest in real estate. You can either buy one house for $100k, or you can buy 5 houses with $20k down on each. All the houses are identical and all rent for $1,200 a month.
- With one house, after deducting 10% for vacancies, 10% for repairs, and $300 a month for taxes and insurance, you’re left with $660 per month. Not a small sum of money, but let’s see how it compares to the other scenario.
- Now let’s say you buy 5 houses, all with 30 year mortgages at a 5% interest rate. After taking out the same 20% of rent for vacancies and repairs, the same $300 for taxes and insurance, and an additional $429 mortgage, you’re left with $231 x 5 = $1,155 per month. The benefit here is threefold.
- In addition to more cashflow, you also have these benefits:
- Your mortgage is being paid by the tenant, so you are also gaining equity every month.
- You are more diversified, so one vacancy is only 20% of your portfolio vs 100%.
- You are lowering your tax burden because you can claim the interest on the mortgage on your taxes. You can also depreciate the properties, and since you have five, that’s $18,181 per year you can claim as a “loss” compared to the $3,636 you could claim by buying one house with cash.
Ultimately, real estate grants you more control over your investments, which we thoroughly enjoy. Painting some cabinets won’t increase our return in our Vanguard account, but it will increase our return on a rental property. Real estate is also a great way to speed up the process of reaching financial independence or retirement with the ability to leverage. Not everyone is cut out to manage their own properties, but we strongly believe that everyone is suited to invest in some form of real estate and give themselves some diversification and peace of mind in the future.
About the author: James & his wife Emily have been on the path to financial independence for a little over two years. James, a medical administrator, and Emily, a systems engineer, enjoy writing about real estate investing, frugality, fitness, travel, and personal finance on their blog “Rethink the Rat Race”. Their goal is to “retire” from their jobs in 2019 to travel domestically and abroad.
We hope that this information has been helpful to you in understanding rental property investing! If you have any questions, please reach out to either James at Rethink the Rat Race or contact us here at Fifth Wheel PT!