In my last article, I talked about what I see as danger signs for the Washington-area real estate investment market. I have had those concerns for quite a while, and for the past year or so I’ve been putting together a plan to diversify my real estate investing activities.
It wasn’t all that hard for me. This is essentially the same plan I executed back in 2003 and 2004 when I felt this market just didn’t make sense anymore. The difference is that I’ve learned a lot of lessons since then, and I’ve grown much more confident in my abilities and investment criteria.
About a year ago, I actively started to lay the ground work for my plan to start buying properties outside of our local market. These homes would be long rental properties and the target markets would have better returns and the prices more in line with local economic activity — for example median household income and job growth.
Initially, I had identified four possible markets: Northern Florida, Richmond/Norfolk, Northern Utah and Southern North Carolina. I keyed in on these markets for different reasons but typically the price to monthly rental income ratio was attractive and housing prices did not appear to be overheated. I had previously invested in two of the markets and had some on-the-ground help in place. That was a big plus.
By late summer of 2017, I was finally ready to begin making offers on properties. Markets move, however. I no longer felt so good about some of my initial markets. Two of the markets — Northern Florida and Northern Utah — have been on a tear. They had really taken off and had already seen big price appreciation. Most of the bargains seemed to have been snatched. They just didn’t look quite as appealing.
The market I concentrated on was down in Jacksonville, N.C., a military town supported by a couple of large military bases. I had lived down there for a few years in my younger days and I have held a couple of rentals down there for about 15 years. The market is steady with only a little upward movement in price but also very little downward movement in price.
I already had in place property management with whom I’ve comfortably worked for more than a decade. That is a huge piece of the puzzle and a big incentive to start in that city. The property manager also had a group of trusted contractors who had done work on my properties over the years.
What I was lacking was a good real estate agent or bird dog on the ground. Good property management didn’t translate into good real estate agent. I tried using the agents at my property manager’s office, and it didn’t work out. They seemed to move too slowly, and I missed a couple of deals.
To fill the void, I just got online and started building searches on some of the major real estate websites. Soon I was getting a bunch of emails with properties that met my criteria. With that, I started calling listing agents. It’s not easy finding good people; it takes a little effort.
I called maybe a half a dozen listing agents, and I found one that said the right things. It worked out pretty well. She became my go-to person on the ground. She sent me a few deals, and I sent her deals as I saw them on the Internet.
Before long, we were writing offers. It only took three or four offers before I got a contract accepted. Things were working out. I usually make many more offers than that before I get an acceptance. But I ended up letting the first two deals go because the home inspections revealed a lot more work than I’d budgeted. That’s another challenge of working out of state. I can’t go easily see the properties. I’m sort of flying blind.
Finally, I got a contract that stuck. It was a two-bedroom and three-bath townhouse. I felt that it was worth about $70,000 to $75,000, and it probably needed about $10,000 of work. It really just needed paint and carpet and it had a possible electrical and furnace issue.
I got it under contract for $45,000. I paid all cash for the property to get the best deal. My property manager sent over the contractor right after closing. It turned out that the electrical problem was just a bad breaker. It cost me about $200. The furnace problem resulted from a bad outside AC compressor. That cost me $1,100, about half of what it would cost me up here. Then I put in new carpet and painted the entire place. My total renovation cost was under $3,500. My total cost for the property — including the purchase price, closing costs and fix up — was just under $50,000.
The rents in the area for similar homes ranged from about $675 to $750 per month. I put mine on the market right at the bottom of the market. I asked $675 per month even though my home was nicer than most of the competition. It’s better to get the home rented out quickly for a little less than to try to get top dollar. You can raise the rent after a year if the tenants renew. Most tenants in this area stay for at least two years so a modest rent increase is fair for everyone and the price hike is not enough to anger the tenant to the point they move out.
Here are the hard numbers on this deal:
Purchase price: $45,000
Closing costs: $1,000
Total Investment: $49,500
Market value: $70,000
Instant equity: $20,500 or 41.4 percent of the initial investment
Rent per month: $675
Total Costs: $370
Net operating income: $305
Now there is a downside to this property. It’s in a coastal county, so the insurance is higher. You have to get a separate wind and hail policy even though it’s more than 10 miles from the coast. The wind and hail more than double the price of the insurance costs. Eighty dollars might not sound like much, but it’s nearly 12 percent of my gross monthly income. That’s a big hit. Many markets have their own little unique surprises, and that’s a major danger of taking your investments out of town.
All of these expenses are key expenses that an investor has to account for. Many times they’re just best guesses. I relied heavily on the costs I was accounting for on my existing properties in the area. But items like maintenance are just a best guess. I used 6 percent of the income. That’s based on my other similarly sized properties. I typically spend $500 to $750 per year on leaky faucets with the occasional bigger-ticket item bringing up the average costs.
Note that these costs do not include the monthly mortgage payment. I paid cash for this home, but even if I didn’t, debt service is not an operating expense. I tell people that you should expect 35 to 55 percent in operating expenses, not including debt service. Most people think I’m crazy when I tell them that, but look at the expenses above. My operating expenses of $370 equal 54.8 percent of my gross monthly rent.
Despite that I still make a net operating income of about $305 per month or about $3,660 per year. I spent $49,500 on the property. Divide the net annual income by the total costs for the property and you get an annual return on investment (ROI) of about 8.3 percent. That’s not bad.
But wait, there’s more. I have $20,500 in equity on day one. It will cost you closing costs and commissions to actually get that equity. So realistically I have maybe $15,000 in equity, but that’s still more than 30 percent. At the end of year one, I expect that I’ll make about 38 percent return on my money.
I still have one more trick up my sleeve. Remember the home is easily worth $70,000. Most local banks have a commercial loan called a portfolio loan. They are happy to lend out 75 percent of the value of the property. Seventy-five percent of $70,000 is $52,500. I am only into this home $49,500. I can go take out a loan for say $51,000 which would return all of my investment plus cover closing costs. Now I have zero money in the deal and I still have 25 percent equity.
Assuming I have an interest rate of about 6 percent, my payment would be roughly $306 on a 30-year amortized loan. My operating expenses are $305 so it would move me to essentially break even on the deal, but I would get all of my cash out.
Here’s the power of debt. My tenant is paying my mortgage and about $51 of that mortgage payment is going to pay down the principal of the loan — it’s increasing my equity by $51 every month, or $624 per year, which is roughly 1.2 percent of my initial investment. Each year that principal payment grows. By year five, it’s up to almost $70 per month.
To further sweeten the deal, I anticipate that the market will continue to go up its historically consistent 1 to 3 percent. If we project a 2 percent average appreciation, that’s yielding me another $1,400 per year in equity because appreciation is based on the value, not my purchase price.
By the end of year two, I could expect to have none of my money in the deal and still making more than $2,000 in debt reduction and property appreciation. If I raise the rent by just $25, at the beginning of year two that would increase my gains by a full 15 percent. And since I no longer have any money in the deal, my return on investment is infinite.
Do I recommend you finance all of the cash flow out of your deal? No, I don’t recommend you do anything. Being a landlord in general is difficult. I don’t even recommend buying rental property. I’m just sharing with you some possibilities.
Your risk tolerance may be low and you might just opt to play it safe and pull out 50 percent of your money. In general, I like to keep my properties with between 50 and 75 percent debt.
I plan to buy a small portfolio of properties in a similar fashion and then refinance them together as a bulk. Then I’ll get my cash out and buy up another batch.
My buying criteria is pretty simple. I need all of my acquisition and fix-up costs to total less than 75 percent of the market value of the home, and I need the market rent to be high enough to support the debt.
Usually, my rule of thumb is that the monthly rent should be 1 to 1.5 percent of the total acquisition costs. So if I’m going to spend $100,000 on a property, I need it to rent for $1,000 to $1,500 per month depending on the market operating costs. In a lower-cost market, you may be able to hug the bottom end of the range. The key is to make sure that you can still get a little cash flow with a 70 to 80 percent mortgage on the home.
There is no risk-free real estate investing strategy. Investing your hard-earned money into property that you can’t drive out and see on a whim is highly risky. These homes I’ve recently purchased aren’t going to make me rich. I’m just hoping they’ll be a nice little shelter for me when the market turns again.
Justin Pierce is a real estate investor and real estate agent who regularly writes about his experiences buying, renovating and selling houses in the Washington area.