Investing Architect

Category: Long Term Rental Properties

Should I sell my house or turn it into a rental property?

You’ve made the decision to move. Maybe it’s because you were bursting at the seams and your family needed more space. Or you wanted to get the kids into that excellent school district. Or perhaps it’s time to enjoy the good things in life and you really wanted a backyard paradise with a great swimming pool. Whatever your reasons for moving, now you face a critical decision that could have important repercussions for your financial future.

Should you sell your current house, unlock your equity and take any capital gains that might have accumulated off the table tax-free? Or, should you turn your existing home into a rental property and use it as a building block for your real estate portfolio?

It’s a very good (and common) question that like most good questions doesn’t have a one-size-fits-all answer. But, I’d like to offer you a mental framework to help you think through this important decision.

Eliminate bad options

A decision is only difficult if it’s a choice between two very good options. If one of your options at your disposal isn’t particularly attractive, the decision makes itself, doesn’t it? So the first thing you should consider carefully is the validity of your options.

Is selling your house even an attractive outcome? For instance, if you were upside down on your mortgage as many homeowners were coming out of the Great Recession of 2008, selling your property isn’t a great option on its own, regardless of the alternatives. So that option will eliminate itself and make your decision more obvious.

Alternatively, would your property make a good investment property? There could be physical aspects of the property that would make it unsuitable for investment. For instance, the property could be very old and it would require significant capital expenditures or it could be too large. Or, the numbers on the property don’t work to generate a fair return on investment for the risk you’re taking in turning it into a rental property.

This is the point where you get out your pencil and run some simple numbers: Rent minus Operating Expenses minus Mortgage Payment equal Cash Flow. Are you looking at a positive return or will you need to “feed” the property from your pocket each month? While considering the validity of turning your house into a rental property, you may eliminate this option from contention and make your decision easier.

Side-by-Side Comparison

I assume that if you’re asking this question, you’re most likely facing a decision between two equally attractive options. If that’s the case, let’s move to the next level of the mental framework: the side-by-side comparison.

First, let’s look at the selling option. Let’s say you’ve built up nice equity over the years courtesy of your initial down payment, value appreciation and paying down the mortgage.

The first thing you want to do is determine the exact value of the equity you could unlock by selling. This isn’t a simple problem where you take your estimate of value and subtract the mortgage balance because that’s not what you’d get if you sold. You have to account for closing costs, selling costs, prorations and make ready. Closing costs are fees you pay at closing for things like title insurance, title company fees, recording fees, HOA statements etc. Selling costs are fees you pay to real estate brokers for facilitating the sale and any incentives you might offer the Buyer (i.e. closing costs contributions) to entice them to buy the house. Prorations are your share of property taxes, insurance costs and HOA dues for the portion of the year you owned the property. And finally, make ready costs are what you’d spend to get the house ready for sale (i.e paint, carpet, landscaping). Once you’ve accounted for all these costs, you can determine your net proceeds at closing otherwise known as the amount on your check after closing.

Next, you want to consider what you would do with this money if you sold. Would some (or all) of it make up the down payment of your new house? If you have that covered with other funds, where would you invest that money and what is your expected rate of return? You could purchase a different investment property or invest the proceeds in the stock market.

Now, let’s consider the option of turning your house into a rental property. Earlier we ran numbers to determine your annual cash flow. Divide the annual cash flow into the net proceeds you’d receive if you sold. That’s your return on equity – the return you’re earning on your equity by turning the property into a rental. How does that figure compare to the return you could earn by selling the property and investing the proceeds into an alternative investment? Beyond the side-by-side return comparison, it’s critical to make a judgment call on how your house is likely to perform over the long term. Do you feel that the property will see more value appreciation, solid tenant, and buyer demand or is the area in decline and things are about to get worse? If the long-term fundamentals don’t look promising, it’s time to sell and deploy that capital into an area that is poised for solid growth.

Another way to ask the question is this: If you were to sell your house, would you buy it again as an investment if given the chance or would you purchase a different investment? This focusing question removes the confirmation bias fog that tends to skew our judgment to confirm decisions we’ve already made. If you wouldn’t buy the property again if given the chance, then the only reason you’re considering keeping it is that you already own it.

In Conclusion

The decision between selling your house and turning into a rental property can be complicated. Sometimes, the right decision is obvious because one of the two options at your disposal is not feasible or favorable. But when presented with a choice between two good options, you should use a mental framework that walks you through the benefits and drawbacks of each option and compares them side-by-side in a long-term outlook context. This way you will see the empirical differences and make the smarter decision for your financial future.

June 15, 2018
Real Estate Investing Rules of Thumb are Dumb

You can’t escape it. Everywhere you look – in online forums, blog posts even books – you will run into real estate investing rules of thumb that promise you an escape from doing boring, old-fashioned analysis.

There’s the “world famous” 2% rule: The monthly rent on a good investment property should be at least 2% of the purchase price. As long as the rent is 2% of the purchase price, your analysis is done. You set out on your quest to find these unicorn properties that abide by this golden rule. Single-family properties that sell for $150,000 and rent for $3,000 a month? Got it. Small multifamily properties that sell for $380,000 and bring in $7,600 per month in rent? Sure. I have some good news and some bad news about the 2% rule. The good news is that should you find such a deal you should jump on it because it is an absolute steal! The bad news is that such deals are at best, fossilized remnants of decades past and at worst, pure fantasy.

Then we have the reformed 1% rule: The monthly rent on a property should be at least 1% of the purchase price. Not as radical to be sure but you keep looking for properties that fit into that box and you find yourself being pushed to lower and lower quality neighborhoods. Properties in these neighborhoods attract more problematic tenants that lead to evictions and turnover and expenses. In the end, you have a terrible investment experience and your actual returns aren’t that good when it’s time to face your accountant and year-end.

Last but not least, the 50% rule: You can safely assume that operating expenses on your property will be 50% of your gross rent. No need to figure out actual expenses or put boots on the ground. The magical 50% has you covered. Then you realize that it’s much more complicated than that. Are you managing the property yourself or do you have a property management company? Is it an older property that requires lots of capital expenditures or a newer property that needs very little? Is the owner responsible for any utilities or are they all covered by the Tenants?

Look, I get it. There’s an allure to the simplicity of these shortcut rules. They offer an escape from the boring analysis, the mind-numbing figures, and the time-consuming due diligence. Furthermore, they can provide a template lens through which to view potential investment opportunities.

But in the end, real estate investing rules of thumb are the realm of amateurs and they’re a poor replacement for solid analysis. There’s no shortcut to actually looking at operating expenses and estimating vacancy and repairs. There’s no getting around learning the market and figuring out what price to rent ratios it offers for each type of property at this point in time.

Even worse yet, rules of thumb can provide an arbitrary filter that can keep you out of the investing game when the opposite is the preferred course of action. Rules of thumb can establish rigid anchors in your thinking and ultimately prevent you from achieving your goals.

If you don’t know how to do due diligence on a prospective property that should be the first thing on your agenda to learn. Skip the analysis and due diligence at the peril of your investing results.

April 23, 2018
The Freedom Formula: How to turn $244,000 into $1.4M in 14 years

Today’s post is exciting for me to write primarily because of what it can do for investors that actually heed the advice.

Since the beginning of Investing Architect, I’ve argued that quality real estate purchased in the context of and according to a sound overarching long term strategy can alter an investor’s life in fundamental ways. Surely, it can have an impact in that investors financial life – namely her passive income and net worth. But that’s only part of the magic. Most importantly, through their financial impact they can offer what I believe most of us are truly after: The freedom and independence to craft a life well lived.

I have a Freedom Formula that I’d like to share with you:

(Quality real estate + Strategy+ Discipline + Execution)^ Time = Freedom

The case study I’ll go over with you today is the “proof” of the validity of this formula. Let’s dive in the numbers.

Case Study

Suppose you were presented with an opportunity to invest in brand new small multifamily (4 units) properties in a new development in an established Texas market with impressive population growth and solid tenant demand with strong median household incomes to support your rents.

Annual Income: $55,200 (4 units leased at $1,150 per month)

Total Operating Expenses: $22,563 (property taxes, insurance, management and repair reserves, vacancy provision)

Net Operating Income: $32,638 per year

Debt Service and Leasing Fees: $23,485 per year

Positive Cashflow: $9,152.64

Purchase price: $460,000

Cash to close: $122,000 (25% down payment plus closing costs)

Why Strategy matters

This is usually the point where first time readers get a puzzled look on their faces. “Wait a minute – how do we go from a potential investment property that throws off $9,200 a year in positive cashflow to turning $244,000 into 1.4 Million?”.

In one word: Strategy.

There’s a reason why strategy is the second ingredient of the formula. Quality real estate comes first because in it’s absence none of the remaining factors matter. You could have the most sophisticated strategy in the world, the discipline of a buddhist monk, and Jason Bourne’s execution skills and none of it matters. But once you’ve purchased quality real estate your strategy makes the difference between magic and meh. Every month I meet with investors that through sheer gut feel have acquired a couple of quality properties. But only minutes into our conversation it becomes abundantly clear that their investing efforts lack a general direction, an overarching strategy. Therefore, they do okay with their investment but they leave massive potential on the table.

Let’s get back to the numbers to illustrate the opportunity cost of a solid strategy. If you were to purchase this same exact property but lacked a long term strategy, what would happen? Well, you would be earning 7-8% on your money (conservatively) and would take advantage of leverage as the property appreciated over time. That’s not a bad investment but it doesn’t exactly change your life.

Here’s a better option. For the investor with available capital resources, I’d recommend the purchase of two fourplexes (8 rental units in total). The completion of these two transactions requires $244k in capital (+- 1%). Upon the completion of acquisition, I would have this investor utilize the positive cashflow from both properties to aggressively pay off the mortgage on the first property while making regular payments on the second. To add more “wood to the fire”, I would recommend that the investor contribute an additional $500 from her income to accelerate debt retirement even faster. Think of this as a 401(K) contribution that actually works.

What’s the effect of this strategy? The mortgage on the first property is completely paid off in 112 months (just over 9 years). After the first property is free and clear, the positive cashflow from that property is no longer $9200 but rather the entire Net Operating Income of $32.6k since there no more debt to service. Now I’d recommend that the investor continue the same process with the second property. The only difference is now we’re attacking that mortgage with a LOT more money every month. Therefore the mortgage on the second property is paid off in 57 months (just under 5 years.

Final Results

Let’s look at the only thing that ultimately matters: Results. If you heed my advice, you invest $244,000 of your hard earned capital and after applying a Domino Strategy you end up with two free and clear properties in 14 years that assuming an appreciation rate of 3% (inflation) would be worth $1.395M at that time. Also at that time, these two properties would produce $65,000/year in investment income. That’s the difference between just buying a couple of good properties and buying a couple of good properties according to a solid strategy mixed with discipline and laser focused execution raised to the power of time.

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Important Note: A project with 11 new construction 4plex and 4 new construction 6plex multi family properties in a growing Texas market is about to break ground in 2-3 weeks. We have partnered with the Developer to offer first shot on these properties to our clients during the construction phase. Over the next few weeks, we will be holding one-on-one conference calls with our clients to discuss the opportunity. Typically we sell out projects of this magnitude in 2-4 weeks.

If you are interested and would like to receive an information packet containing detailed cashflow analyses, location map, site map, demographic and psychographic data about the location, contact us or if you’re reading this from your email, just hit reply.

September 10, 2016
The most amazing real estate deal of all time

Imagine for a moment that you just orchestrated the most amazing real estate deal of all time. This deal is so impressive Scorsese will make a movie about it with Di Caprio playing your part. People who aspire to become successful real estate investors will hold week-long case studies of this deal for years to come.

All the elements are present. Through world-class negotiating skills during purchase, you locked in so much equity it should be illegal. Price to rent ratio is in the low single digits so your property throws off cash like an ATM machine. And finally, the return on investment might make people think you’ve entered the loan shark business. A thing of beauty, a work of art.

And yet, I’ve got news for you. The most amazing real estate deal of all time, will NOT change your life.

Let’s run through the numbers of one such hypothetical scenario.

Suppose you were able to purchase a $250,000 property for $150,000 and secured six figures of built-in equity. No repairs are needed. The first week on the market you find a great Tenant willing to pay $2200 per month for a two-year lease on the property. Total operating expenses plus mortgage payments add up to $1400 per month leaving you with positive cash flow of $800 per month. Assuming a 35,000 capital investment that’s a 27% cash on cash return with an internal rate of return in the triple digits.

If you zero in on the numbers of such an amazing real estate deal, it’s pretty impressive. But when you open up your focus and look at the big picture, things come into perspective a little clearer.

Let’s look at the end result. With all the amazing equity, cash flow and returns, at the end of the day, even the most amazing real estate deal produces just $800 per month in passive income. That’s a fantastic return on the capital invested but from the perspective of your complete financial picture, that cash flow will not change your life. It will not allow you to retire early or do the work you want to do instead of the one you have to do.

The main point I want you to take away is this: Real estate investing isn’t some form of Olympic sport where investors compete for the highest return or the largest amount of built-in equity record. Instead, it is a vehicle you use to create the passive income and net worth required so you can design and live the life you want.

Even when you pull off the most amazing real estate deal of all time, if the aggregate of your investing efforts fails to create the life-changing circumstances that set you financially free, it’s all for naught. Or put a different way – if all you do in a lifetime of investing efforts is pull off a couple of “most amazing deals” but fail to fundamentally alter your financial life then what good did it do?

August 25, 2016
The Fermi Technique: How to analyze investment properties in under 5 minutes

Over the last decade, I have worked with many successful long term real estate investors. They have different personalities, different professions and often employ different strategies. But they all have one critical thing in common:

Successful long term real estate investors possess the ability to quickly and accurately “size up” a potential deal.

If someone were to call you on the phone to offer you a potential real estate deal, would you know how to evaluate it quickly and accurately within 5 minutes?

If not, the technique I will share with you today will change that. It will allow you to analyze any long term real estate deal in 5 easy steps that fit in the back of an envelope.

The technique was developed by world-renowned Italian physicist Enrico Fermi. He created the world’s first nuclear reactor, has been called the “architect of the atomic bomb” and had a substantial role on the Manhattan project. So, in a nutshell a brilliant fellow. Fermi was known to use his technique to get quick and accurate answers to very complex physics problems on the back of an envelope. Today, I’ll show you how to use the same methodology, to solve a much easier problem: How to analyze a real estate deal in under 5 minutes on the back of an envelope.

Let’s dive right in. Someone calls you and tells you about a potential investment opportunity.

It’s a single family home that would make a great investment property – according to the caller. Here’s how you can run a back of the envelope analysis within 5 minutes.

Collect Information and/or Make Assumptions

To get started with the analysis you need 5 numbers that you can easily get by asking or making simple assumptions: A) Purchase price B) Monthly Rent C) Down Payment D) Loan Amount and terms and E) Monthly Payment. Let’s say you determine that the property is being sold for $170,000, would rent for $1700, you’d put 20% down, borrow $136,000 at 4.5% for 30 years and pay $689/mo.

Calculate key data

• Step 1: Calculate the annual rent – Monthly Rent x 12

• Step 2: Calculate cashflow before financing – Annual rent from Step 1 multiplied by 0.54 (operating expenses typically run about 46%)

• Step 3: Calculate the annual cost of financing – Monthly payment x 12

• Step 4: Calculate cashflow after financing – Cashflow before financing (Step 2) less Cost of Financing (Step 3)

Final Step – calculate critical metrics

There are three critical metrics that will tell you everything you need to determine if this is a good deal: Return on Assets, Cost of Financing and Return on Equity.

Return on Assets is calculated as the cashflow before financing (Step 2) divided by the price of the property. Another term for this metric is Capitalization or Cap Rate. It simply tells you the rate of return the property would produce if you owned it free and clear.

Cost of Financing is calculated as the annual cost of financing (Step 3) divided by the loan amount (your Assumptions). You would calculate this metric so you can compare it to the return on assets figure. If your return on assets is higher than your cost of financing that means you have positive leverage. Put a different way, you using the bank’s money to generate higher returns than what it cost you to obtain that money. You should avoid the opposite at all costs.

Finally, Return on Equity is calculated as the cashflow after financing (Step 4) divided by your down payment (your Assumptions). This metric tells you what your invested capital is earning. When you achieve positive leverage, your return on equity will be higher than your return on assets. Or put a different way, you are earning a higher return by using the bank’s money to finance part of the purchase.

The first time you do this analysis, it will take a little longer to complete until you get used to it. Afterward, it becomes second nature and a powerful skill to make you a better investor.

The technique is especially powerful, after you’ve run the initial analysis because it allows you to quickly evaluate potential scenarios (i.e sensitivity analysis). What if you paid $160,000 for the property instead – how would that impact your returns? What if the property rented for just $1600 instead? What if you could secure financing at lower interest rates?

Run the Fermi Technique and within 5 minutes you have critical information to make better investing decisions and make more money in the long term.

Closing Note

The Fermi Technique is an approximation method that provides some insight whether you should pursue any further, deeper analysis. It is NOT a substitute for the full fledged analysis that we discuss in How to property calculate the return on a long term investment.

January 7, 2016
5 Critical Real Estate Investing Lessons I learned in 2015

Today is the last day of 2015. In a few hours, the bubbly will flow and we get to write a new chapter. That’s why this is the best time to reflect back on the year that was, learn the critical investing lessons it taught us and become better investors in the process.

Year in Review

Real estate markets across Texas entered 2015 with a lot of momentum from the previous year but one giant “elephant in the room”. Oil prices had dropped by 50% at the end of 2014 and everyone questioned how it would impact the labor and real estate markets. And nowhere were these questions as loud as in our home base of Houston – the energy capital of the world.

In “Why did oil prices drop in 2014” published here in February, I offered my take on the impact it would have on our real estate market. The central thesis of that article was that oil prices would certainly have an impact as expected layoffs would affect housing demand, but it would not lead to significantly lower real estate prices in 2015.

After a somewhat nervous start in January, the Houston real estate market didn’t miss a beat and resumed the “song” it had been singing over the last 24 months. The spring and summer seasons swept in and brought with them bidding wars, multiple offers, rising prices. Move on, nothing new to see here.

On the rental market front, it was the same story. High tenant demand, low days on market and multiple applications.

In September, official stats remained strong with rising sales and prices but in the trenches we started seeing the signs of a slowdown. Price reductions, more room to negotiate, some unsold listings. Major players in oil and gas had trimmed down their workforces by 15-20%, decimated exploration budgets and the inward migration of people coming here for work slowed. As it’s often the case with the oil market, no one really knows what will happen before the fact (although many are “experts” afterward). I suppose that after seeing lower prices stabilize and slightly rise midyear, the market and its players realized we were in for a longer slog and lower prices were here to stay.

In October and November, the official statistics reflected what we had seen for some time. Year over year sales dipped during that period and average prices were lower in November as the luxury segment of the market bore the brunt of the hit. Properties priced closer to the average price mark still posted stronger YOY sales and prices. December numbers won’t be out for another couple of weeks but they’re likely to follow the same fourth quarter trend.

After intensified calls for location diversification, Investing Architect explored the DFW market in October.

Again, the rental market followed a similar trajectory to the sales market. October and November are typically slower than the red hot spring and summer season for rentals but this year we felt it more than others.

Lessons Learned

All considered, 2015 was a fantastic year despite some of the challenges posed by volatility in oil markets. When all stats are done and counted, it will be yet another year of strong sales and rising prices.

There are 5 critical real estate investing lessons I learned during 2015 that I want to share with you now.

Lesson 1: Mama said there’d be days like this

When you invest in real estate long term, for next 10, 15 or 20 years, the one thing I can guarantee you is that there will be volatility. I don’t care which period in time you pick, it will never be a linear, sunshine and butterflies, comfortable ride. You can rest assured that there will be times when the rental market is blazing hot and other times when it’s sluggish, when vacancies are zero and when tenants are harder to come by, when values rise by double digits and when they stagnate or fall.

When things are volatile, the best advise I can give you is to trust the process and stay disciplined. Keep your principal goal front and center and don’t forget it. You will be tempted to sell and get out (when you should stick it out) and worst case you might even feel like you don’t have the stomach for it.

Stay the course. Execute.

Lesson 2: “Moving on up” – Interest Rates

December brought us our first FED quarter point rate hike in God knows how long. It was the first but likely not the last. The FED seems determined to get some “bullets back in their gun” just in case there’s another economical slowdown. After all the economy is doing better but not THAT much better. But if they don’t hike now, they won’t have any room in the principal mechanism they have to stimulate the economy.

So in 2016 you should expect a couple more similar hikes. The question I hear most often is: What effect are these rate hikes going to have on investment property mortgage rates? The short answer is: Rates will be higher but only by a fraction of the actual rate hikes. Typically, mortgage rates rise 0.25% for each 1% hike in FED rates. The first hike had more of a 1:1 impact because it was the first time the FED hiked in many years. Subsequent hikes will likely increase rates only incrementally.

Lesson 3: Value increases = Property Tax Increases

Regular readers of Investing Architect know that we are conservative with numbers. Despite the fact that in the last 36 months property prices have appreciated by 2-3 times that rate, we run our cashflow analyses assuming an appreciation rate equal to the rate of inflation (3%). Still, for existing owners of long term investment properties appreciation is the cherry on the cake also thanks to that beautiful thing called leverage.

Let’s say you purchase a property for 170k and you put 20% down. If that property appreciates by 6%, that represents an increase of $10,200 in property value. But you don’t have $170k of invested capital in the property – you only invested $34,000. So that 10,200 increase in property value represents a 30% return on your $34,000 investment. In other words, when you only invest 1/5 of the value of the asset, your return is 5x the property appreciation rate. Like I said, a beautiful thing.

But you know who else notices that your property went up in value? Taxing authorities that rely on property taxes for their revenue. They think to themselves – would you look at that, market values are up, so should property tax values.

And so, your property taxes, the main driver of operating expenses go up.

What are the real estate investing lessons? First, this is exactly why a disciplined long term investor should not engage in optimistic, best case scenario investing. If the analysis was performed correctly, there should be room in the numbers to absorb tax increases when they happen. Second, the disciplined long term investor should always pursue periodical rent increases with their renewal tenants. I know what you’re thinking – they’re great tenants, they pay on time and take care of the place – if I ask for an increase they will walk away and never talk to you again. I get that and the fact is it may not always be possible depending on the market. But it should be the investors ongoing policy to pursue periodical rent increases. Then the decisions on how far that pursuit goes can be made on a case by case basis.

Lesson #4: Greedy when others are fearful

The aggregate behavior of real estate investors is very similar to stock market investors. Both groups tend to invest heavily when the market is comfortable (read: higher) and step back when Volatility brings his old friend Fear to the party. In Buffett’s sage words, be fearful when others are greedy and greedy when others are fearful.

Volatility is opportunity. If properties aren’t selling as fast, you have significantly more leverage in negotiations with Sellers. That presents some interesting opportunities. For example, you could negotiate for the Seller to pay for closing costs thereby lowering your total investment in the property and boosting your return. Or you can make an offer below market and the Seller won’t throw it back in our face like they did 2012-2014.

Don’t sit it out. Adjust your strategy so returns reflect risk.

Lesson #5: Location Diversification

The reaction of the local economy, labor and real estate markets to substantial volatility in global oil markets reinforces our long held belief that Houston remains a strong market for long term investors. If our economy was not diversified, the impact of such a drop in commodity prices would be devastating – similar to 1980s. Having said that, investors with a strong Houston presence in their portfolio should take a look at other Texas locations as well as other similar states to bring some location diversification to their portfolios.

Location Diversification is a major theme for us in 2016. Stay tuned, or better yet (email us) for what’s to come. Hint: We plan to expand our focus to markets across Texas and other similar states in 2016.

December 31, 2015