The Do’s and Don’ts of Investing in Real Estate

Real estate investing has created fortunes for many people, including the top three richest real estate investors:

1. Donald Bren: Estimated net worth: $15.5 billion
Bren made his fortune by purchasing a big stake in Irvine Company, which controlled 93,000 acres of land in Southern California, known as Irvine Ranch. That was in 1977; he became the sole owner of Irvine in 1996 and now owns more than 115 million square feet of real estate, primarily in Southern California.

2. Sun Hongbin: Estimated net worth: $9.2 billion
Although an American citizen, Sun Hongbin has made his fortune from investments outside the U.S. His Sunac China Holdings is one of China’s largest real estate developers, focusing on developing large-scale, medium- to high-end residential properties, as well as the Wanda Group’s hotel and tourism portfolio.

3. Stephen Ross: Estimated net worth: $7.6 billion
Stephen Ross began his real estate investing foray by developing affordable housing, then expanded into the Hudson Yards Redevelopment Project in NYC, a development that features eight structures that house residences, offices, a hotel, retail space, and a cultural center. Ross is also the owner of both the Miami Dolphins and Sunlife Stadium.

But it’s the Little Guy who Owns the Most Rental Properties
You might now be thinking that real estate investing is only for the rich. But you would be dead wrong. The truth, according to the U.S. Census Bureau, is that individual real estate investors account for 74.4% of rental properties in the United States. And the average real estate investor owns just three properties.

And even if you start out small (which I wholeheartedly recommend!), you can do very well by investing in real estate. When I was in my 30s, I worked in banking, and one of my fellow managers—with his wife—had started buying townhomes in Florida right after they were married. By the time I met them, they owned four properties. Now, they have a very large inventory of rentals and a booming property management business!

Of the 140 million housing units in the U.S., some 80 million are single-family homes, and about 15 million of those are rental properties. Here are some more fun facts about real estate investing, courtesy of Getflex.com:

• 6 million Americans earn income from rental properties
• Landlords have an average income of $97,000 a year
• Half of all landlords manage their own properties
• Landlords have raised rent rates an average of 31% since 2010
• Just 6% of rental properties are unoccupied
• Landlords handle 6 repair calls a year from tenants
• “Mom and pop” landlords own 22.7 million rental units
• Half of single-property landlords purchased the property as a primary residence
• Evicting a tenant may cost a landlord up to $10,000

The Rental Market is on Fire
The rental market is growing, and also becoming pretty lucrative—in terms of rents collected. Realtor.com reports that rental costs increased in 66% of U.S. counties between March and April 2019. And the market is even hotter today! Feeding the rise in rentals is an interesting statistic. According to RentCafe, as Baby Boomers continue to retire, many are choosing to rent, instead of buying a smaller home. In fact, the number of over-60 renters increased by 43% between 2007 and 2017.

Not surprisingly, the most expensive rental market is San Francisco, with an average rental rate of $3,690, according to Zumper. Zillow says San Fran is also one of the most expensive places to buy a home, with the average home coming in at $1,477,442.

According to Pew Research Center, rentals in the U.S. are at their highest percentage—36.6%— since 1965.

Renters are Getting Pickier
As the rental market grows, so do the expectations of the tenants. The top ten rental amenities desired, according to Zumper, are:

1. Air Conditioning
2. In-Unit Washer/Dryer
3. Dishwasher
4. On-Site Laundry
5. Assigned Parking
6. Central Heat
7. Furnished
8. Balcony
9. Garage Parking
10. Hardwood Floors

And the least-searched amenities were:

1. Roof-Top Deck
2. Package Service
3. Concierge Service
4. Residents Lounge
5. Dry Cleaning Service

However, if you want to invest in luxury rental properties, these last five amenities will become very valuable. A Venturebeat survey reports that 63% of renters want smart home security, 63% desire smart home climate controls, 58% expect smart lighting, and 56% want safety devices like carbon monoxide detectors and nightlights.

So, keep these wish lists in mind as you search for potential properties to buy.

The Top 5 Criteria for Zeroing in on the Right Investment Property
Investing in real estate requires some serious research. You’ll need to study your market, know the demographics, look at housing trends, understand how to maximize the property value, and very importantly, figure out when to exit the property.

But before you do all that research, first pay special attention to the following criteria, which are the essential elements of real estate investing:

I’m sure you’ve heard this frequently spouted mantra regarding buying a home: “location, location, location.” That is still true—whether it’s your personal home or your investment property. Location can mean different things to different people. You may want to live in a home close to your work or your children’s school. Or you might desire a home with acreage, rather than a location in the suburbs. Some folks like to live in a thriving downtown.

Those are all personal preferences. But when it comes to real estate investing, they are major considerations. A professional real estate investor knows that choosing the right location can have a big impact on your investment returns. For example:

Big city or small town? Highly developed cities will be more expensive than less-populated areas. There’s no room to expand; they usually have a large number of vacant homes—many in disrepair—that may provide investment opportunities. However, be aware that large cities can also see rapid population declines, as was the case during the COVID pandemic.

According to the Brookings Institute, “Among the 10 largest cities, eight registered lower growth in 2019-20 than in 2018-19; six displayed their lowest growth in the last decade; and five lost population. The latter include New York, Los Angeles, and San Jose, Calif. (displayed in Figure 2), as well as Philadelphia and Chicago.”

You can see the results in the following graph.

Accessibility, appearance, amenities, and safety are the hallmarks of a good neighborhood. You want your property to be close to major highways, with several egress points. Also, where applicable, consider how close you are to public transportation for commuters.

A nice-looking neighborhood is also desirable. Neatly kept lots, large trees, and nice landscaping are a plus. One way to gauge if a neighborhood is desirable is to look at the turnover. It’s a good sign if homes don’t stay on the market long.

Amenities such as parks or community spaces, restaurants, grocery stores, schools, fire stations, hospitals, and other retail shops, should be conveniently located. Schools are another important amenity.

Lastly, make sure the neighborhood has a low crime rate. You can usually find that out from your local law enforcement.

Determine if future development is on tap. Are their current plans for new schools, hospitals, public transportation, other civic infrastructure, or commercial or residential development that might improve property values?

Is it a good lot? Lots on busy streets or near noisy roads or highways are harder to resell. Likewise, a lot close to a commercial property is not usually desirable. Most of you know that I also own a real estate company, and I’ll give you a couple of examples of properties that had challenging locations. One was a gorgeous, all-brick, custom-built 3,600-square-foot home on five acres. It sat right next to a junkyard, and although there was a nice border of very tall trees between the house and the salvage yard, it took years—and a very reduced price—before it sold. Another property I showed a few months ago, was a great commercial building on a lovely tree-lined lot. However, right next door was a juvenile detention center. The building is still on the market.

On the other hand, lots that are near or on water or golf courses, wooded, or with mountain views are more likely to increase in value.

Choosing the right house is essential. Do you take your chances with a fixer-upper or buy “move-in-ready?” That depends on how much you think it’s going to cost to renovate, if you have the skills to do it yourself, or if you are going to have to pay someone else to do the reno and what your expected returns will be. But I’ll get into more detail on that in a minute.

Just know that choosing the right location is critical. In the choice between a fixer-upper on a better lot, compared to a decent house in a less desirable location, I would opt for location first.

All of these criteria are important when choosing properties to buy. And yes, you must keep reselling in mind before you make a real estate investment. A home that appreciates in value and doesn’t take long to sell will make your total profit picture much rosier.

Are you a Flipper, or a Long- or Short-Term Real Estate Investor?
Individual real estate investors come in three flavors: 1) folks who want to buy low and flip; 2) investors who buy vacation properties to rent out on a short-term basis; and 3) buyers who buy and rent homes over a long period of time, reaping the rewards of long-term income.

Note that in each of these scenarios, some renovations will most likely be required to outfit the property for resale or rentals.

So, you Want to be a Flipper of Properties?
Flipping properties sounds romantic, doesn’t it? And if you are a fan of HGTV or DIY (like me!), you are privy to scads of shows illustrating the “fun” of buying real estate for almost nothing, doing a few renovations, and then selling for a very nice price—usually within 8-12 months following your purchase.

Certainly, there are plenty of people who are really good at flipping. But, unfortunately, the reality of flipping properties is much less romantic. You’ll note that one or more of the stars of each home remodeling series is either a designer, craftsman, or general “can do anything” type of handyman. Now, if you are or have access to one or more of those types of people, you’ll be well ahead of the game. If not, your costs, time, and frustration are going to mount up.

To be an effective flipper, you’ll need to have some spare cash. The general consensus is the 70% rule, which states that an investor should pay no more than 70% of the after-repair value (ARV) of a property, minus the repairs needed. After the home is repaired/renovated, the ARV is what it is worth to buyers.

Next, it’s imperative that you create a budget; you need to know exactly how much money you have to 1) purchase the home, 2) renovate/repair it, and 3) cover marketing, real estate commissions, and other selling costs. A recent study from Harvard University reports that HGTV is doing its job—spending on remodeling reached $350 million by Q3 2019, up $20 million over the same period in 2018.

Here are a few ideas to help you reduce your cash outlay as you renovate:

• Carefully choose which home features are worth spending a little bit more on—such as upgraded appliances, wide woodwork, elegant doors, etc.
• If you can find them, use recycled or previously used materials you get from salvage sales or associates
• Buy your supplies with a cash-back credit card, or a credit card with good rewards points

Also, don’t put funky features or designs in the home you want to flip. Vanilla is good; gilt is not. You want to attract the normal, mid-stream buyer, so stay true to classic designs that will easily resell.

If you need to take on a contractor to do the reno, secure references and get written estimates.

If you must get a mortgage loan to purchase the property, you’ll have to add the carrying costs (interest, closing fees, appraisal, credit check, etc.), into your expenses.

Determine how you are going to advertise the home once renovations are complete. To be on the multiple listing service (MLS), you’ll need to work with a Realtor. You can also list the home for sale on Zillow, but you will then be responsible for setting up and attending showing appointments and dealing with the mountainous paperwork. You can also hold open houses and advertise in the local newspaper. Note that all of these efforts will require some investment of your money and time.

Lastly, if you intend to make a business of flipping homes, you might consider getting your real estate license so you can at least save on commissions. One added benefit: Realtors have access to some of the best contractors, suppliers, and lenders to help you through your entire flipping process.

Are you in it for the Long Term?
This is a great way to build long-term passive income—buying properties and collecting rent over a number of years.

Besides the cash flow, landlords have some very nice tax deductions. Per nerdwallet.com, landlords can deduct mortgage interest (because it’s a business expense), depreciation of the property (usually over 27.5 years), property taxes and certain repairs.

When your tenant calls you in the middle of the night because the toilet is leaking, cheer yourself up by knowing you can deduct the repair! Now, there are lots of rules about what can be deducted immediately vs. what is a capital expense to be deducted over time. For example, adding a room on would be a capital expense. The IRS (Publication 527) also considers the following repairs to be capital expenses: landscaping and sprinkler systems, storm windows, new roofs, security systems, heating and A/C systems, water heaters, flooring, and insulation.

You may also be able to deduct transportation expenses associated with collecting rent, managing your rental or maintaining it; costs of advertising your rental; insurance on your rental; and utilities.

The IRS says you cannot deduct costs associated with travel between your home and the rental property (unless your home is your principal place of business), uncollected rent (but this depends on the accounting method you’re using for your rental income), and lost income during periods when your rental was vacant.

Lastly, be aware that most banks will not lend on long-term rentals unless they are move-in-ready. They generally will not provide rehab funds.

Do you Want to Buy Short-Term Vacation Rentals?
It sounds exciting to own a vacation/rental home, doesn’t it? I’ve done it before, and it was very lucrative. I was able to use a ski home in New Hampshire for an occasional vacation and rented it out via a property manager during the rest of the year. I held it about four years and sold it at a nice profit. And I learned a lot about owning a vacation rental!

First of all, you need to make sure that the home is in a popular location with lots of demand. Make sure to investigate your local city and county regulations to ensure they allow vacation rentals in that neighborhood. My friend was all set to buy a short-term rental in one of Nashville’s regentrified neighborhoods but learned that the city would not allow any more short-term rentals in that neighborhood.

Next, you’ll want to own properties for which you can steadily increase the rent year after year. And lastly, the home should be a good bargain when you buy it and have plenty of appreciation potential. This tool can help you determine value vs. income.

As with all real estate, there are pros and cons. These are from mashadvisor.com:

Pros of Buying Short-Term Rentals

• Higher rental income than longer-term rentals. In some resort areas, you could make as much as $5,000 for a weekly rental.
• Pricing flexibility; you set the rates.
• Flexibility in use: you have the opportunity to vacation at your own property.
• Unlike long-term rentals, you will be able to check on your short-term rental regularly, clean it, and do required maintenance.

Cons of Buying Short-Term Rentals

• Managing is time-consuming, but you can also do as I did—hire a property manager. More on that later.
• Your property will probably not be rented 365 days a year. Ski rentals are popular in the winter. Cabins on northern lakes get a lot of use in the summer. This seasonality is important to consider when calculating your cash flow.
• More risk—you can expect more damage, theft, or nuisance calls from neighbors when the renters’ parties get too loud.
• Legal restrictions. As I mentioned above, some governmental regulations may not be favorable for short-term rentals.

Again, location is paramount. Here are some of the most popular places to own vacation rentals, according to airdna.com:

1. Palm Springs, CA
2. Sevier County, TN (my neck of the woods: think Pigeon Forge and Gatlinburg)
3. Lake Tahoe
4. Augustine, FL
5. Panama City Beach, FL
6. Flagstaff, AZ
7. Big Bear Lake, CA
8. Las Vegas, NV
9. Sedona, AZ
10. Savannah, GA

Of course, you may have a favorite place you like to visit; if so, check out the demographics to make sure there’s enough demand to keep you in steady cash flow.

Do you Need a Property Manager?
When I bought my New Hampshire ski home, I was very fortunate to have a property manager who handled most of the vacation rentals in the area. It was a very small town (Mt. Washington), and the monthly fees were reasonable. But, again, there are pros and cons of doing it yourself or hiring a property manager. These tips are from tsquareproperties.net:

The Pros of Self-Managing Your Rental Property

• You’ll have 100% control over your investment.
• You don’t need to pay the 7%-15% per month to a property manager.
• You’ll get the chance to learn and gain experience in the rental property industry.
• You’ll probably take better care of your property than a property manager would.

The Cons of Self-Managing Your Rental Property

• The job is often very demanding and time-consuming. You are the person the tenant calls when the A/C stops working; the roof leaks; or the toilet stops up. That means you have to take care of the job or have a handyman on call.
• You have to spend time collecting the rent.
• You may not screen tenants properly and end up with a tenant that is consistently late; is a nuisance to neighbors; doesn’t take care of your property; and that you may have to evict.

However, if you employ a professional property manager who has the skills to screen tenants, knows how to collect rent, and has an iPhone filled with handymen and contractors, it may just be worth the monthly nut.

Do you Need a Loan to Buy Your Rental Investment?
There are several ways to finance rental properties:

Your cash.

Conventional Mortgages from banks and credit unions. Loans for investment properties generally require a 20% down payment. Before you apply for a loan, you will need a healthy credit score, of at least 650 or more; a debt-to-income ratio of 43% or lower; a financial statements for at least a couple of years listing your income, expenses, and assets; the ability to pay for any existing mortgage on top of your investment property’s mortgage; and six months of mortgage payments in the bank

Hard Money Loans. These are individuals or private companies that accept property or an asset (not necessarily the home you are buying) as collateral. They are usually short-term loans often used by residential developers. The term “hard money lending” doesn’t refer to how difficult it is to apply for; it refers to firmer financing terms when compared to other types of lending.

Hard money lenders are generally private investors or companies that deal specifically in this type of lending. Instead of looking at your credit score, they look at the value of the property—the after-repair value (ARV) in determining if they will make the loan.

These loans are usually a lot quicker to obtain than bank financing, and their loan terms are more flexible. But you will only have a short period in which to repay the loan (good for mostly flippers). And you’ll pay a higher interest rate. Hard money lenders will usually ask for about 11% to 15% and about five points (additional upfront percentage fees based on the loan amount).

To find a hard money lender, you can ask around, or just Google the term. I found pages of them in Tennessee. But make sure you check them out!

Private Loans. These are the ones you borrow from friends, relatives, business associates, or accredited investors. Terms are flexible, but these loans are also difficult to find.

How Much Money can you Make with Rental Properties?
Now, it’s time to put all this together and find the bottom line—how do you figure out if a property is worth your hard-earned money?

First, let’s start by defining some common terms used in rental property financing.

Net Operating Income (NOI) is how much money you make from a given investment property. To calculate it, take your total income and subtract operating expenses. Operating expenses include property manager fees, legal fees, general maintenance, property taxes, and any utilities that you pay.

Don’t include your mortgage payments—they are not operating expenses.

Capitalization Rate (Cap Rate). Think of it as similar to the stock market’s return on investment. It’s the ratio of the amount of income produced by a property to the original capital invested (or its current value). It tells you the percentage of the investment’s value that’s profit.

Cap Rate divides your net operating income (NOI) by the asset value. This should be equal to the property’s sale price. Know this: the higher the cap rate (higher returns), the higher the risk.

Internal Rate of Return (IRR). This estimates the interest you’ll earn on each dollar invested in a rental property over its holding period, or the rate of growth that a property has the potential to generate.

The calculation estimates long-term yield. When calculating IRR, set the net present value (NPV) of the property to zero and use projected cash flows for each year you plan on holding the building. Net present value is the value of money now, versus in the future once the money has accrued compound interest. It’s a complicated formula, so most investors use the IRR function in Excel to calculate the ratio.

Be aware that IRR assumes a stable rental environment and no unexpected repairs. A typical IRR metric ranges from 10-20% but can vary widely. It’s a way to measure whether or not a property is performing well for you.

Cash Flow. This tells you whether your property is making money for you—or not. It’s what you have left over after you’ve collected your rents and paid your expenses. It should be positive—or you are losing money—which is not why you got into the rental business!

Gross Rent Multiplier (GRM) helps you determine your investment’s worth. It’s calculated by dividing the property’s price by its gross rental income. The lower the GRM the better, but an average GRM is between 4-8.

LTV Ratio, or the Loan to Value Ratio measures the amount you’ll need vs. the property’s current fair market value. The difference between the percent a lender will finance and the property’s total value is the amount of cash that you will have to put into the deal. As I said earlier, most lenders will require at least a 20% down payment on an investment property loan. That would make your LTV 80% (100%-20%).

Debt Service Coverage Ratio compares the operating income you have available to service debt to your overall debt levels. Divide your net operating income by debt payments, on either a monthly, quarterly, or annual basis, to get your DSCR.

Lenders give great consideration to the DSCR. They want to make sure you can repay the loan. A high ratio indicates that you might have too much debt, and you may not qualify for a loan. A typical lender wants to see a DSCR in the 1.25–1.5 range. This means that your rental property produces 25% more of additional income after debt service. The higher the better.

Operating Expense Ratio (OER) shows how good you are at controlling expenses. To calculate it, add all operating expenses, less depreciation, and divide them by operating income. The lower the better.

Occupancy Rates consider two rates: 1) Physical Vacancy Rate—the number of vacant units, multiplied by 100, and divided by the total number of units. This gives you the percent of your units vacant when compared to the total units available. And 2) Economic Vacancy Rate, or the income you’re missing out on when a unit is vacant. Add up rents lost during the vacancy period and divided by the total rent that would have been collected in a year to get what the vacancy cost you.

Capital Gains Tax. There are two types:

Long-Term Capital Gains Tax is applicable if you sell a property you’ve owned for more than a year. You will pay tax on the profits you make.

Short-Term Capital Gains Tax is applicable when you’ve owned the property for less than a year (ex., house flip). Your profits are taxed according to short-term capital gains rates.

1031 Exchange is a great way to postpone capital gains taxes. With a 1031 Exchange, the IRS says that you can sell a property and reinvest the profit into what the IRS calls a “like-kind” investment. However, there is a time limit. You have to identify a replacement property for the assets sold within 45 days and then conclude the exchange within 180 days.

At last, we are getting to the bottom line! To determine if a rental property will be profitable for you, you must calculate its ROI. Return on investment (ROI) measures how much money, or profit, is made on an investment as a percentage of the cost of that investment.

For a cash purchase, to calculate the ROI, take the net profit or net gain on the investment and divide it by the original cost.

If you have a mortgage, you’ll need to factor in your down payment and mortgage payment, as well as other costs such as repair and maintenance costs, and regular expenses.

Here’s the formula:

Total gain on investment – original cost of the investment. Take that net gain and divide it by the original cost and you get the ROI.

Example:

Cash Transaction
You paid $300,000 in cash for the rental property.

The closing costs were $1,000 and remodeling costs totaled $9,000, bringing your total investment to $310,000 for the property.

You collected $2,000 in rent every month.

A year later:
You earned $24,000 in rental income for those 12 months.

Expenses including the water bill, property taxes, and insurance, totaled $2,400 for the year. or $200 per month.

Your annual return was $21,600 ($24,000 – $2,400).

To calculate the property’s ROI:

Divide the annual return ($21,600) by the amount of the total investment, or $310,000.

ROI = $21,600 ÷ $310,000 = 0.0697 or 6.97%.

Financed Transactions
For example, assume you bought the same $300,000 rental property as above, but instead of paying cash, you took out a mortgage.

The down payment needed for the mortgage was 20% of the purchase price, or $60,000 ($300,000 sales price x 20%).

Closing costs were higher, which is typical for a mortgage, totaling $2,500 upfront.

You paid $9,000 for remodeling.

Your total out-of-pocket expenses were $71,500 ($60,000 + $2,500 + $9,000).

There are also ongoing costs with a mortgage:
Let’s assume you took out a 30-year loan with a fixed 4% interest rate. On the borrowed $240,000, the monthly principal and interest payment would be $1,146.00.

We’ll add the same $200 per month to cover water, taxes, and insurance, making your total monthly payment $1,346.00.

Rental income of $2,000 per month totals $24,000 for the year.

Monthly cash flow is $654 ($2,000 rent - $1,346.00 mortgage payment).

One year later:
You earned $24,000 in total rental income for the year at $2,000 per month.

Your annual return was $7,848 ($654 x 12 months).

To calculate the property’s ROI:

Divide the annual return by your original out-of-pocket expenses (the down payment of $60,000, closing costs of $2,500, and remodeling for $9,000) to determine ROI.

ROI = $7.848 ÷ $71,500 = 0.1098.

Your ROI is 10.98%.

Now, the longer you hold your property, hopefully, the more value it will accumulate. So, when you finally elect to sell it, you can throw your home equity into the equation, and you’ll end up with a higher ROI.

Bottom line, ROI can vary greatly; so, it’s essential that you compare the expected ROI of each property you are considering purchasing.

5 More Tips to Becoming a Profitable Real Estate Investor
Finally, (I bet you thought we’d never get here!), I’ll leave you with a few other tips to help you maximize your profitability and minimize your costs in your real estate investing career:

Beware of High Interest Rates. Money is cheap right now, but it won’t always be. Keep that in mind, as you may be subject to variable interest rates at some point.

Calculate Your Margins. If you are buying distressed properties, investors should set a return goal of 10%. It’s a good rule of thumb to estimate maintenance costs at 1% of the property value annually. But don’t forget other expenses like homeowners’ insurance, possible homeowners’ association fees, property taxes, monthly expenses such as pest control, and landscaping, along with regular maintenance expenses for repairs.

Invest in Landlord Insurance. This covers property damage, lost rental income, and liability protection.

Expect Unexpected Costs. Think about emergency repairs (e.g., storms, fires, and burst pipes!) You’ll need to stow away 20%-30% of your rental income for such expense.

Invest in Less Expensive Homes. Your ongoing costs will be less.

Know Your Legal Obligations. This includes state and local landlord-tenant laws.

I hope this information is helpful in giving you some tips on real estate investing. Know that I am not an accountant or tax attorney, so make sure you seek qualified help before you begin your investing journey. I wish you good luck and healthy profits!