I have spent some time this summer/fall reviewing real estate investing topics. There is so much crap on the internet on this topic, its unbelievable. It seems like everyone and anyone thinks they can get rich with real estate. The hype and misdirection takes a long time to sort through, but since I have waded through all the crap to bring you some simple fundamental principles behind this method of making money. I’ll just discuss rentals for now.

I became interested in this topic probably 12 months ago. There are a number of famous people who got their start with real estate investing. Andy Beal comes to mind. He made his fortune initially buying dilapidated government owned apartment complexes, then turning them around. He later formed his own bank, and made a large amount buying loans at discounts. The Professor, the Banker and the Suicide King is a good book that profiles him to an extent.   The key with all the stories of the successful people was that they were buying for less then the value of the property to begin with, not buying and hoping for appreciation because someone else would like it more.

My conclusion after studying the asset class is that if you have the skill and patience to wait for the correct deal it can be a  worth wile diversification. If you want to go out and buy a house and rent it just so you can say your a real-estate investor, its going to be a waste of time. Many people unfortunately fall into the latter class, because guess what that is the easier path. I want you to remember when you hear the term real estate investor, that to paraphrase Orwell, all investors are equal , it’s just that some are more equal then others.

Some Thoughts/Tips:

1. Its a business– Buying rental properties is a business, plain and simple. If you approach it like a hobby or a “passive income source” you are in for some trouble. The people who make money at this are systematic and have a process they implement. It takes time to build the process, but you can learn it.

2. Know your numbers– You have to understand what the value is that your paying for. Basically the house is an asset that when rented will generate a cash flow. From this cash flow you have to deduct out the expenses of running the business such as insurance, reserve account for repairs, taxes, mortgage payment.  I would suggest that if you can rent the home for 1-0.7% of its value per month it will work out fairly well. In another words a 100k home would rent from 700-1000/month for it to be a property worth your consideration. If you annualized it this will work out to a return of 8.4-12%  of the property value per year, some of that return will go to the mortgage servicing. As the property is paid down more of it will become free cash flow that you can use to either save spend, or acquire more properties. With that said it is fairly tough to find homes that sell for 100k that rent for 1000. It may be done in some markets by buying retail properties ( those listed in MLS and sold by agents), but most of the time you will need your own marketing campaign to find them, and skill in negotiation to get the price to a level that makes sense.

3. You will be managing people– Part of your business will be dealing with the public. As part of this you will need to create criteria for tenant selection, from which you will not deviate. If you do , maybe because you feel sorry for them, you will have a big problem. The legal implications of moving the wrong person into your home can be painful.  Not only can they physically damage the property, and never pay for it, they can also make it very difficult to evict them. By the time it is said and done you can be out thousands of dollars, completely screwing up the value proposition from doing this. The important point is that you set up criteria based on income to rent ratio (I would suggest that rent be no more then 30% of their take home after tax pay), credit history, previous rental history (have they ever been foreclosed on?), and home visit (what does the property they live in now look like, because that is what yours will look like in 12-18 months after you rent to them).

4. Risk– In buying a single home you take a large amount of risk. Lets say that the current tenant moves out, and it takes you 3 months to get the property re-rented, that means you lost 25% of your revenue for the year, say good by to any positive return that year. If you have a run of people leaving this could really eat into the return, this is limited by good tenant screening. There are other types of risk inherent in owning a single asset, environmental risk (hurricanes, fire , hail), area risk (the value falls because of surrounding economic, political or population reasons).

5. Scalability– To do this you have to have the credit to get mortgages in the first place. Second, once you reach a certain number of homes it will be difficult to get financed from traditional sources, ie big banks. Some regional banks/ credit unions will make exceptions, so called portfolio loans. There are also friends and family. Finally there is something akin to running an investment business called syndication. But for most people the upper limit of this will be 2-3 mortgages at any one time. Also the work that goes into managing multiple properties will be rate limiting if you have a job that is more demanding.