Today, we have an article from Mark Ferguson who is an experienced real estate investor. He’ll help us figure out how to make money with rental properties. If you are thinking about investing in rental properties, you’ve come to the right place today.
Investing in the stock market is the traditional way to build up money for retirement. However, rental properties are another avenue to retire early and for me a better avenue. I have been a Realtor since 2001, own 11 long-term rental properties and I complete 10-15 fix and flips a year. That gives me an advantage when buying rental properties that cash flow, but investing in real estate is not limited to only those in the industry. If you take some time to educate yourself, find the right people to help you and look for a great deal almost anyone can invest in real estate. It does take some money, but if you are willing to make some sacrifices it may take much less money that you think.
I like to invest in rental properties because they provide long-term cash flow that never eats away at my principal investment. If I am able to create a significant amount of cash flow, that allows me to generate a mostly passive income that will last as long as I own the rental properties. My 11 rental properties provide about $60,000 in cash flow a year and that will continue to grow even if I do not buy anymore properties (I plan to buy a lot more!). With the stock market I don’t like the fact my money could eventually run out if I do something silly like live longer than I expect.
What are the basics of investing in rental properties?
Getting great returns on rental properties is not easy, but great things in life rarely come without a price. To make money on rental properties I like to follow these guidelines:
- Buy rental properties below market value
- Buy rental properties that cash flow
- Do not count on appreciation, unless you have a solid plan in place to deal with market down turns
- Find a great lender that will help you leverage your money
- Have a great team in place that can help you buy rental properties: real estate agent, lender, contractor and attorney if needed
- Stay on top of your tenants and maintenance
- Have an emergency fund set up for unexpected costs
Why should you buy rental properties below market value?
I am sure most people have heard stories about how rental properties nearly ruined someone financially. Usually those stories involve a rental property that was bought for retail value that had no cash flow or someone turned their personal residence into a rental that did not cash flow. If you educate yourself about the market you invest in and buy properties below market value you will eliminates most problems that come up with rental properties. In the worst case scenario a rental property bought below market value can usually be sold without taking a loss. When you buy properties below market value you gain equity as soon as you close and increase the chances of creating cash flow.
It is not easy to buy real estate below market value, but certainly possible. With the stock market you cannot buy below market value. You can buy under valued companies in the stock market, but you are betting the millions of other investors out there have undervalued the company for some reason and you are still paying market value. To buy real estate below market, you need to have a great real estate agent who will act fast, because deals do not last long. Some great places to find properties below market value:
- Estate sales: 2 of my 11 rentals have been estate sales and many more of my flips.
- REOs: REOs are bank owned homes that have gone through foreclosure and are often prices low to sell quickly.
- Short sales: Short sales are still owned by the home owner, but the bank must take less than they are owed on the mortgage for the home to sell. Short sales are prices low, because it can take months for the bank to approve the short payoff.
- Auctions: Many homes are sold at auction and those auctions are not always advertised well (that means less competition).
- Traditional sales: Some houses are under priced by agents or the sellers just want out quickly.
- Off market: These properties are not for sale, but bought by investors marketing to targeted homeowners. Letters are sent to distressed looking properties, absentee owners or people who have inherited properties.
I have used all of these techniques to buy properties for my rentals and fix and flips. It takes a lot of time to research your market to make sure you are getting a great deal, but it is well worth it. Many times a house will be under priced because it needs work. Be prepared to make some repairs on properties to get the best deals.
Why should you buy rental properties that cash flow?
Cash flow is the money you make on a rental property every month. If your rent is $1,500 a month and all your expenses are $1,000 a month, your cash flow is $500 a month. It is not easy to buy houses below market and it is not always easy to buy houses that cash flow either. Most people do not have the cash to buy rental properties out-right so we will assume we are getting a loan. When you buy properties that cash flow, the tenants rent will pay all your expenses for you, including the mortgage and leave you money left over. The reason I love cash flow is that money will keep coming in every month as long as you own the properties, in fact it will increase over time. Rents will eventually go up with inflation just like the stock market always eventually goes up. Your mortgage payment will stay the same (unless you refinance or get an adjustable rate mortgage) while the rent goes up increasing your returns. Given enough time your mortgage will be paid off by the tenants and your cash flow will really increase.
Buying one rental property will not give you enough money to retire; you need multiple properties providing cash flow every month to provide enough to retire on. When you figure cash flow you need to make sure you are considering all the expenses including vacancies and maintenance. Here is an example of the rents and expenses on one of my rentals.
Mortgage payment: -$400
maintenance – $195
Vacancies – $130
Total cash flow $470
The tricky part with calculating cash flow is that many investors do not consider maintenance and vacancy expenses. You don’t know how much maintenance a property will need or how many months it will be vacant, but you have to assume these costs will occur. I like to assume I will need between 10% and 25% of the monthly rents as maintenance expense, depending on how old and what condition a property is in. I like to assume 10% of the monthly rents will be used for vacancies. Some houses will have great tenants that rent for years, while others will need the tenants evicted with huge expenses in less than a year. To make things easier my cash flow calculator can help investors determine the cash flow on rental properties.
Some other costs to consider with cash flow are HOA fees, utilities (if landlord is paying) and management fees if you use a property manager.
How to use leverage to buy rental properties
When I buy a rental property I always get a loan, which allows me to increase my returns. Here is a quick example of how leverage can increase returns on rental proprieties.
Purchase price $100,000
Monthly rent $1,300
cash flow without a loan $870
To make things simple we will say the investor had to pay out $110,000 after closing costs and repairs to get this property ready to rent. The return on his money would be 9.5%. (870*12/110,000). If you would get a loan on this property with 20% down at 4.5% the payment would be a little over $400. That would leave $470 in cash flow each month, which would equal a return of 17.6% (470*12/32,000). To get the $30,000 cash needed with the loan I added the $10,000 we used for the cash deal for repairs and closing costs and then added another $2,000 for the costs associated with getting the loan, plus the 20% down payment.
Not only does leveraging your money with rental properties provide a better return, but it has many other benefits as well.
- Every month you are paying down your mortgage a certain amount and increasing your equity.
- Rent appreciation and property value appreciation will increase your returns significantly, because you used less cash.
- By only spending $32,000 instead of $110,000 you can buy three properties instead of just one. This amplifies the other benefits of rentals; tax advantages, mortgage pay down, rent appreciation and property value appreciation.
How can you buy rental properties with less money down?
I can buy rental properties with about $30,000 cash in my market using financing. Some people are in markets with higher prices or they don’t have $30,000 to invest. Even if you do have $30,000 to invest you do not want to spend all of it buying and repairing a property. Expenses will come up or it may take longer than you expect to rent and you need money set aside to make repairs or handle vacancies.
There is a simple way to buy with less money down, but it takes some sacrifice. Buy as an owner occupant, live in the home one year, then rent out the home. When you buy as an owner occupant you can put as little as 3.5% down with FHA or $0 down with a USDA or VA loan. The payment will be higher than the 20% down loan, because of the higher loan amount and because these loans will require mortgage insurance in most cases. That mortgage insurance can add $200 or more per month.
Once you buy a house, live in it one year and then rent it out,. You can repeat the process over and over again as long as you keep qualifying for new loans. As long as you live in a house for a year or whatever the owner occupant requirement is for your lender, you can legally rent out the home.
What are the tax advantages of rental properties?
Another huge bonus with rental properties is they get very favorable treatment from the IRS regarding taxation laws. The IRS lets you depreciate the structure of rental properties, which means you can deduct a certain amount of money from your taxes every year. The IRS lets you depreciate the structure over 26.5 years. If we value the structure on our $100,000 purchase at 80,000 you can deduct $3018 a year from your taxes ($80,000/26.5). Even though you may make $5,600 a year from your rental property, it will only show as a $2,582 gain on your taxes. Since rental properties are a business, most expenses including your mortgage interest are deductible as well.
What if you can’t find cash flowing properties?
I am lucky that in Northern Colorado houses are relatively cheap and rents relatively high. It still takes me a long time to find great deals that cash flow well. Some people are in areas of the country with much higher proprieties values and rents are not high enough to create any cash flow. One strategy is to buy rentals and hope for appreciation based on the local economy and housing demand. If you buy for appreciation, you have to prepare for the worst because prices could go down. When you buy with negative cash flow it gets really old putting money into a house every month that is supposed to be going up in value, but is actually losing value. Most investors also do not calculate their cash flow correctly and actually lose much more than they anticipated. Follow these tips if you are dead set on buying for appreciation.
- Calculate the cash flow correctly.
- Make sure you have a large emergency fund just for that rental property. The emergency fund will be losing money over time thanks to the negative cash flow.
- Be prepared to hold the home longer than you expect too. Many investors in the last housing crisis went bankrupt because they could not carry the negative cash flow long enough.
- Buy below market value so you start ahead of the game and are not betting only on appreciation!
What do you do if you are in an area that does not have much cash flow but you still want to buy cash flowing rental properties? The first step is to research your market area and make sure you did not miss any neighborhoods that may produce cash flow. Then check surrounding towns or suburbs for lower prices compared to the rents. Finally there is the option of buying out-of-state rental properties. It is not easy to find properties, find real estate agents, find property managers and buy a great rental out-of-state, but it is possible. You can also look at turn-key rental properties which are already rented, repaired and have property managers in place. These properties usually cash flow, but are not bought below market, because the turn-key companies likes to take a nice profit for their work.
What is the downside to investing in rental properties?
If everyone made 20% with little effort or time on rental properties, we would all be doing it. The truth is it takes a lot of time and education to figure out the best markets to invest in and where you can make money. You also have to have a large amount of money to invest with in most cases. It may cost me $30,000 to buy and repair a rental property, but I need more than $30,000 before I can invest. I need to have an emergency fund for that property in case it needs repairs or the tenant has to be evicted. I would advise saving at least $10,000 more than you need to cover costs on a rental property; more if you are buying higher priced properties.
It also takes time to manage your properties. I am lucky that my real estate team can manage my proprieties for me, but you must have the time to manage them or hire a property manager. A property manager will typically cost 8-10 percent of the monthly rents and some will charge a leasing fee as well. A property manager will make your rental properties a mostly passive investment with little work needed from you. If you manage the properties and you only have one single family rental property it will not be too hard to manage. Once you get a few properties it will take some time to find good tenants, make sure they are paying on time and keep track of the maintenance.
Just like any business or job, it takes time to learn the business and experience to become an expert.
There is a lot involved with buying great rental properties that cash flow. However the returns make it a very worthwhile venture for me. Not only am I making over $60,000 a year from cash flow on my rentals, but they increased my net worth by $600,000 over the last 3.5 years. That net worth increase came from buying below market, adding value with repairs and appreciation. I am going to keep buying rental properties, but it is nice to know if something happened with my business I have that $60,000 a year to fall back on.
About Mark Ferguson
Mark has been a licensed real estate agent since 2001 and specializes in REO and HUD listings. He currently runs a team of ten, which includes 7 licensed agents. Mark own 11 long-term rental properties and fix and flips 10-15 homes a year. Mark also runs InvestFourMore.com, a blog dedicated to discussing his rental properties, fix and flips and becoming a real estate agent.
If you are interested in real estate investing, but you don’t want to be a landlord, check out Realty Shares. This is a way to invest in real estate through crowdfunding. Investors pool their money to fund a project which is managed by a local company. Realty Shares vetted the projects, but you can do your own research and invest in the areas that you like. Each investment is different and the minimum investment is from $2,000 to $25,000. This is a new way to invest in real estate and I’m going to invest $10,000 in 2017 and see if it will be a good passive income stream.
Passive income is the key to early retirement. This year, Joe is increasing his investment in real estate with CrowdStreet. He can invest in projects across the U.S. and diversify his real estate portfolio. There are many interesting projects available so sign up and check them out.
Joe also highly recommends Personal Capital for DIY investors. He logs on to Personal Capital almost daily to check his cash flow and net worth. They have many useful tools that will help DIY investors analyze their portfolio and plan for retirement.