Are you ready to learn The Nitty-Gritty DETAILS of How to Buy, Renovate, and Manage Rental Property… to Generate Passive Income and Cash Flow Your Way to Freedom? The “buying” is literally the most fun part of the process. Later you will discover the emotional rewards of providing quality homes for families.
The 3 most important factors which separate the winners from the losers in the rental business are:
- Buying at the right Price
- Selecting the right Tenants
- Finding the right Contractors
Today we will focus on Price.
For inspiration and introduction to real estate, Rich Dad Poor Dad is a good start to understanding some key concepts including the value of building income streams. However, like many books, the specific details of exactly how to do it are lacking.
Start Small and Stay Close
It’s important to start small, buying your first single family home, duplex, or triplex. Once you learn all the ins-and-outs of buying, renovating, and renting the property, simply rinse-and-repeat for the 2nd, 3rd, 4th, etc.
I do not advise trying to fast-track by buying houses #1 and #2 at the same time. It’s recommended to learn the full process for house #1 so you don’t get in over your head. There will be plenty of time to accelerate your rental property empire later. I once had 3 accepted offers at the same time.
If you have desires to become the next real estate tycoon, then similar to Monopoly, you can advance from 4 green houses to 1 red hotel (or apartment building). I thought that was the path I was going to take, but surprisingly, upon comparing the numbers, single family homes in my area still offered much better rate of return.
Some big-time professional real estate promoters will try selling the idea that you can buy rentals anywhere, that you’re not limited to your local area. I couldn’t disagree more!
As you gain experience, you might investigate out of town opportunities, but for your first several properties, it is wise to buy in close proximity to your residence. The closer the better as you will be making frequent trips to the property. Roughly a 30-minute drive or less is preferred, but that’s dependent on your personal tolerance for the inconvenience of being further away. All my houses are 10-15 minute drive from my primary residence.
Target Class C for Highest Cash Yield
What does Class C mean? Property locations and buildings are categorized as Class A, B, C, and D. There is no governing body or institution which determines this designation, so it is somewhat subjective among real estate investors.
Generally speaking:
- Class A is analogous to Monopoly’s Boardwalk and Park Place, the best and most expensive properties in high cost of living cities. Prime real estate and often newer construction.
- Class B is typically 10-40 years old, but well-maintained and occupied by both blue collar and white collar folks representative of the middle-class.
- Class C properties are usually occupied by low-to-middle income workers, many are government subsidized, and most are rentals.
- Class D areas are to be avoided as they have high crime and dilapidated buildings. You will see many boarded-up windows, vacant properties, and the area is likely contaminated with high drug use.
Just like school grades, sometimes investors will get more specific with A-, B+, B-, etc.
The strategy is to buy property significantly below market value in Class C locations, renovate to Class B quality, and rent to Class B caliber tenants. This provides the highest rate of return.
For example, I currently have a resident doctor, a registered nurse, and a high school guidance counselor all living in Class C locations. It’s amazing what a fresh coat of paint and new floors can do for a house’s appeal, even if the house is 50-100 years old.
All my tenants are non-subsidized or what landlords call “market tenants” which means they pay the prevailing market rates without any government subsidies.
For a real-world comparison to illustrate how the Cash-on-Cash Return is much better with Class C:
- A nicely renovated house in Class C area can bring $700-950/month rent. Purchase price + renovation costs = total investment of $50,000 or less
- Vs. A house in a Class B- area with a total investment of $100,000-120,000 will only provide an extra $100-300/month rent.
So the numbers are not as lucrative — would you rather buy 2 houses at $50,000 each providing gross rent of $900 each = $1800 OR buy 1 house at $100,000 which provides gross rent of $1100?
Assembling Your Team
I personally value the security and simplicity of staying small enough such that I can manage the entire business myself. When I contemplated hiring a property manager after buying my first rental, I thought “How am I going to know if they are doing a good job if I don’t know how to do it myself?”
Property management fees are typically 10% of gross rents. Some charge an additional fee for finding a tenant which may be first month’s rent. This is a huge chunk of profits!
Therefore, I am going to prepare you for managing properties yourself. The nitty, gritty details of how to buy and manage rental property are not taught in any traditional schools or accredited colleges.
If you have an 8th grade education and possess basic math skills; addition, subtraction, multiplication, and division, and understand concepts like percentages and rates of return, then those are all the traditional academic skills you need to successfully own and manage rental property.
That is not to say that’s all the skills you need. Managerial, organizational, and negotiation skills; communication, problem solving, and resourcefulness are all equally important. These are referred to as soft skills which we acquire through working our jobs, maintaining our house, raising a family, and living life.
Step #1 — Find a Real Estate Agent
Not just any agent, but an agent who owns rental property themselves. That is key as they will essentially be your mentor. Find someone older and established late in their career, preferably the owner of the branch. My mentors were my agent and a former boss who owns many rentals.
Agent-landlords are best for knowing the neighborhoods and fielding your endless questions. They are also good for advising on rent rates for a given house and location. After a couple years, you will become an expert on rent rates. This is the beginning of the assessment process which I will get to later.
Step #2 — Find a Lending Institution
For those with substantial investment capital, well… it’s good to be you! The ability to make cash offers goes a long way and enables the best deals. I once had my lower cash offer accepted over another bidder who needed financing. Sometimes sellers prefer the hassle-free cash buyer.
If you plan to use financing, find a bank that specializes in rentals and setup a meeting. Your local mentors are good resources for that. These institutions will have you complete a financial statement, a listing of all your assets and liabilities, income and expenses.
The typical down payment required for rental property is 25%, and the interest rate is roughly 1% higher than what could be achieved if obtaining a mortgage for a personal residence.
The down payment required will vary based on your personal credit and the current economic housing and lending climate. If the economy is in recession, then lenders have more stringent requirements. Whereas during periods like 2003-2006, banks became reckless and the practice of providing “no money down” loans was prevalent.
Finding Opportunities and Making Offers
Step #3 — Search for Prospective Properties
Once you find a good agent, start looking at houses right away. Looking and making offers is the fun part! Here are my preferred sources in order of value:
- Start looking on Realtor.com at all homes under $60,000. I live in Ohio, so all figures discussed will be most applicable to the midwest/heartland and Southern states down to Georgia. Adjust accordingly for your location. Some localities enable online access to the MLS (Multiple Listing Service), but Realtor.com has served me well.
- Hudhomestore.com is the site for all HUD listed homes. HUD homes are foreclosure properties owned by the Department of Housing and Urban Development (HUD). These are homes that were originally financed using FHA loans (Federal Housing Administration), but went into foreclosure because the mortgage defaulted.
- Drive neighborhoods looking for vacant houses with signs in the front window or atypical signs in the yard. Sometimes properties are owned by out of state institutions, the marketing is lackluster, and properties may not even be listed in the MLS.
- Estate or other auctions — these are not common, but you may see auction signs while driving neighborhoods or your agent should be aware of them.
- Google “sheriff auction your county state” — many beginners erroneously believe these foreclosure auctions are a good source. The reality is the starting bid for most counties is 70% of assessed value. So that’s the lowest price you can acquire the property. If the property is desirable “as is”, then there will either be stiff competition or the holding bank itself will outbid you. Best to skip these auctions and wait for the properties to hit the MLS. I have never found these auctions useful, but that’s not to say they aren’t in some areas.
Note on HUD homes: when properties are first listed, bidding is only open to owner occupants, nonprofits, and government agencies (teachers, police, and firefighters).
So unfortunately for investors, we have to wait (typically 7-14 days) for any of the above mentioned folks to bid on the property. Once there are no accepted offers, the property will be open for investor bidding.
What qualifies as an “owner occupant”? You must live in the house as your primary residence for a year before renting or selling it. So if you are the type who does not object to buying a house, living in it while you renovate, and then renting, this can be a really good opportunity.
Be careful about falsely claiming to be an “owner occupant” as there may be consequences that put an end to your real estate investing career.
Step #4 — Viewing and Assessing Properties
While reviewing the houses on Realtor.com, make a list of the ones that meet your criteria and look appealing. Select 3-5 houses and make an appointment with your agent to view them. Figure roughly 30 minutes per house.
In an effort to be more efficient and not waste your agent’s time, you can include the additional step of driving by the houses in advance to weed out locations you don’t like. It will take a year or two to become familiar with good and bad areas.
Any good agent will provide you with an MLS printout for each property they are showing. As you walk through each house, make notes right on the MLS sheet. Be as detailed as you like, but I focus mostly on what the house “needs”. If something is exceptional, I will note that as well. For example:
- Needs new carpet 2nd floor — $1200
- Paint entire first floor — $1500
- All old windows; need 10 new 2nd floor (water damage) — $3000
- Garage painting — $800
- Main drain line corrosion/leaking in basement — $1000
- Remove overgrown evergreens in front — $500
- Roof looks nearly new!
- Closing costs — $600
- Misc. — $500
- Total — $7900
- Estimated monthly rent — $850
The costs are quick estimates based on experience, so with each additional house renovation, you become an increasingly skilled estimator. Remember, you will be looking at lots of houses, and therefore, need to make quick 20-30 minute assessments to determine initial offer price.
The houses which will provide the greatest rate of return are generally the cheapest ones that are a disaster cosmetically, yet have mostly solid infrastructure.
What does that mean? It means many novices lack vision, and they are scared off by damaged walls, badly stained carpet, and a generally dirty house. Cosmetics are the least expensive item to “make like new”. So if the infrastructure is solid and in good condition, then repairing wall damage, a fresh coat of paint, and installing all new flooring will really make the house “pop” and attract higher caliber tenants.
The following are the top infrastructure items to assess:
- Foundation — walk through the house and verify floors are level and sturdy. Your assessment skills will improve over time, but generally it’s not too difficult to determine if the house was well-built or not. Review the basement, looking for severe cracks in walls and evidence of water intrusion. Noticing the basement has been water-proofed is a huge plus.
- Roof — review as much of the roof you can from the ground. You can quickly assess the condition of the roof. e.g. We had a hail storm a couple years before I started buying houses, so many of the older homes had newer roofs, less than 5 years old! Read more about CapEx in the Glossary.
- Furnace and A/C — Most furnace installers post notes documenting dates of installation and service right on the unit. Less than 10 years old is a plus. Note: low percentage of Class C houses have central air (20% of mine) — window A/C units are more common.
- Windows — check for single or double pane windows and condition; even older double pane are good.
- Kitchen Cabinets — most can be cleaned up and made acceptable, but if they are in really bad shape, you will likely have to acquire the house super cheap to be able to replace.
- Hot Water Tank — check for date of installation as well. Over 20 years old with rusty appearance and it’s probably on it’s last leg.
Step #5 — Analyzing Deals and Making Offers
The #1 mistake first-time rental investors make is overpaying for property.
Overpaying for property is an unrecoverable mistake which puts investors in the category of those who failed in the rental business. Those are the folks who have disastrous experiences and swear off rentals forever. Don’t allow others’ failures to influence your ability to succeed.
True story: I know someone who bought a triplex near the peak of the housing bubble in 2005 for $120,000. 10 years later they were trying to sell it for $89,000. (I knew the market well as I previously bid on a newly renovated triplex which sold for $58,000.) I looked at it and would not have paid a dime over $40,000 as it needed a lot of work. I didn’t even make an offer. They ultimately sold it in 2017 for $67,000, and I believe that buyer overpaid as well.
With that in mind, have you ever heard general statistics like 90% of all businesses fail? Well, that is not to be interpreted as each individual has a 90% chance of failing.
In other words, if that statistic were broken down further, it would likely reveal something like 95% of people fail 94% of the time, and 5% of people fail 14% of the time (95 x 0.06 + 5 x 0.86 = 10 successes out of 100).
To put it another way, Mark Cuban certainly has a much higher success rate than the average business starter. Likewise, we want to educate and prepare ourselves so we are in the percentage of successes!
Just as there are competent and incompetent people in all professions, there are competent and incompetent landlords. It’s all about how educated and knowledgeable we are at what we are doing.
What is a “Good” deal?
How do I know how much I should pay for a property?
Before going any further, it is imperative to review and understand the terms in the Glossary down to and including Cash-on-Cash Return Targets.
Now that you understand how to calculate key components like Net Operating Income (NOI) and Cash-on-Cash Return, let’s continue…
An offer is simply an invitation to negotiate, and our initial offer in most cases will be far below asking price. If the seller responds with a counter-offer, then we know they are interested in negotiating. If the seller is offended and does not counter, then we do not need to perform detailed price analysis, and we moved on to the next property.
The 2% Rule: this is a quick method used by rental investors to determine preliminary purchase price. Using our above MLS sheet notes as an example, simply take the projected monthly rent and divide by 0.02 ($850/0.02=$42,500).
The 2% Rule is actually a Rule of Thumb or Guideline and should not be used to determine final offer price.
The 2% Rule says $42,500 is the ballpark total investment amount, purchase price plus renovations. Therefore, the preliminary purchase price is $34,600 ($42,500 less $7900). This is the initial offer we might make during a seller’s market.
A word about real estate market climate: how low of an offer we can make is largely dependent on whether it’s a buyer’s market or a seller’s market at any point in time.
A seller’s market means housing prices are high and there is a lot of buyer competition. This is bad for investors.
A buyer’s market occurs during recessions or downturns like the 2008/2009 housing crisis. From 2008-2016, we could easily make 50% offers. (The market transitioned to a seller’s market in early 2017.)
In the above hypothetical example, suppose the seller is asking $50,000:
- For a buyer’s market, our initial offer is $25,000 (50%)
- For a seller’s market, our initial offer is no more than $34,600
Do not be apprehensive about making low-ball offers. This is business! And we have no idea how eager or distressed the seller may be to sell. If they are insulted and don’t counter, then review other prospects and come back to that one in a month. I prefer to have the perspective that the buyer always has the power. We don’t need the property. We have no emotional attachment to it.
All but one of my rental purchases was either bank-owned or part of an estate. An estate property typically means the owner of the house passed away, and the house is now part of an estate controlled by the inheriting family member.
My point is the sale of an estate property is basically “free money” for the inheriting party. They have no monetary investment they need to recoup. And a bank definitely has no emotional attachment to the property. They just want to unload the property to recover as much of their loss of possible.
Once the seller responds with a counter offer, the negotiation begins, and it’s important to perform a detailed analysis using a tool like my Free Deal Analyzer to determine the purchase price which results in our target rate of return. This is how we predetermine that the property generates income and meets our rate of return requirements.
For All Cash Deals, Cash-on-Cash Return Targets are:
Minimum > 10%
Preferred > 15%
Stretch > 20%
For Financed Deals, Cash-on-Cash Return Targets are:
Minimum > 25%
Preferred > 35%
Stretch = Infinite ($0 Invested)
Completing the Purchase Agreement
Your agent should already know this, but upon completing and signing the purchase contract, write “or assigns” after your name. This enables you to change the buying entity to an LLC or other entity later in the purchasing process.
If you are obtaining financing, then just as when buying a primary residence, make the offer contingent upon obtaining financing.
Tip: Every offer I make I include the following: “Contingent upon verification that the house is not located in a flood plain.”
In most cases, it is not advisable to buy property in a flood plain as your mortgage lender may require flood insurance which is very expensive, and the property will be difficult to sell later for the same reason.
Verify the Purchase Agreement allows at least 10 days to inspect the property.
Step #6 — Property Inspection
Once we have an accepted offer, we need to perform detailed inspection of the property to confirm there are no major issues we missed during our prior viewing. For your first rental, I recommend hiring a qualified home inspector.
Meet the inspector at the property so he/she can show you issues, and you can ask questions, learning as much as possible about the important things to inspect. They will typically email you a detailed report of the results.
Believe it or not, for my second rental, I successfully used that report as leverage to negotiate a purchase price reduction from $30,000 to less than $21,000!
After my first two houses, I became knowledgeable enough that I began performing inspections myself, saving about $300 on each subsequent purchase.
Anatomy of a Deal
The following is an actual account of buying my first rental property:
- As stated above, I looked on Realtor.com at all houses under $60,000 of which there were about 85 in my small city of population 30,000.
- I wrote down about 25 of them with preference for 3 bedroom; some 2 bedroom.
- I sent the list to my agent, and she scheduled for us to view 4 or 5 of them.
- I made approximately 50% offers on 4 houses at the same time, one of which was $25,000 for a house listed at $45,000, recently reduced from $55,000 after having been on the market for 6 months.
- The seller countered at $35,000.
- I estimated about $8000-9000 in renovations to make the house “rent ready”
- Eager to buy my first rental, and worried the seller may reject another counter offer and I would lose the house, I contemplated just accepting the $35,000. Instead I stuck to my numbers and countered at $30,000.
- The seller accepted, and I bought my first rental!
- I hired a home inspector for $300 and discovered some mold in the basement. After overcoming my first instinct to back out of the deal, I instead asked the seller for $4000 for mold remediation.
- The seller agreed to pay $2000.
- We closed 3-4 weeks later at a final price of $28,000.
- The whole process from first contacting my agent to closing was 7 weeks.
- Renovation costs were around $9000 and the house rented 3 months after closing for $750/month plus tenant paid all utilities.
Follow a similar script and you too can cash flow your way to freedom.
There is no such thing as a perfect deal.
Stay tuned for my next article, “How to select the best tenants”, including free marketing tips and the easiest way to show houses.
Take Action and Follow Your Dreams!!!
— Your brother Mike
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