From the Forums: One Thing That Most Beginner Investors Should NOT Do

Dave:
You posted your juiciest real estate questions to the BiggerPockets forums today. We’re answering them. Hey everyone, it’s Dave Meyer here with Henry Washington and for today’s show we picked four hotly debated recent topics from the BiggerPockets forums and we’re going to weigh in with our opinions on what the posters should do. We’re going to cover in this episode whether it’s a good idea to use private money for your first deal, when to accept a tenant with red flags, how to raise rent for inherited tenants, and whether these 70% rule still works for flips in today’s market. Henry, you ready to dive into these community questions?

Henry:
Yeah, man, this is good stuff. Let’s do it.

Dave:
Awesome. Well, I’m glad to have your help. Let’s dive into our first question. All right, Henry, this question comes from Chris on the BiggerPockets forearms. He is wondering about raising private capital and specifically what happens if you do that and then a deal goes bad. He wrote, I’m a beginner investor who still hasn’t gotten their first deal. I’ve spoken with some real estate friends and they’ve told me about how private money has helped their business grow massively. It’s something I believe will help me finally get that coveted first deal and first paycheck. So before we get into the second part about a potential deal going bad, curious your thoughts here, Henry, on whether raising private capital is a good idea in the first place for someone who’s trying to land that first deal?

Henry:
I think raising private capital is a big responsibility. I mean, you are borrowing other people’s money and I think too often people want to borrow money because they’ve been bad with their money and so they’ve got bad spending habits and want to borrow money because it feels less risky.

Dave:
I’ve never thought of it that way, honestly, but when you put it that way, it’s not a very appealing situation for the lender.

Henry:
Exactly. Most beginners want to borrow money because they feel like they don’t have any, and a lot of people don’t have any money saved up because they’ve got bad spending habits, and so now you want to take those bad spending habits and apply them to somebody else’s money and I think that that can be risky. Now, to answer the question without emotion in it, sure you can absolutely borrow private money and do your first real estate deal, but is that the right thing to do? You really have to ask yourself, well, why don’t I have any money? Why don’t I have any money to put into a deal? And if it’s because you are bad with money or savings, then it’s probably not a great idea for you to go borrowing somebody else’s money to do a deal when you don’t have any experience yet because you’re going to make mistakes. I mean, I was just telling people last night that I made a rookie mistake on a house. I just finished flipping right now and I’m very seasoned, right? That’s going to cost me about $7,000. So I don’t know that borrowing private money is the best decision for a brand new investor.

Dave:
I agree with you and I’ll follow up in a minute, but I’m curious if you consider partnering with family and friends private money or is that a different category?

Henry:
It depends. Partner to me means you get equity, right? And so

Dave:
That’s true.

Henry:
If you’re partnering and you get equity then I think that is different, but if you are just borrowing their money and paying them some sort of interest, then that’s just borrowing money and you’ve got to really look in the mirror and say like is it a smart decision for me to borrow somebody’s money when I haven’t been great with money and to get into a deal that I am not certain is a good deal or not yet? I just don’t know that that’s the best move.

Dave:
I tend to agree with you. I do some private lending and I will tell you categorically no doubt that if someone who had never done a deal asked me to borrow my money, I would not even look at the numbers. I wouldn’t look at anything. I would not lend someone money who has never done this before. Most people who do private lending, they do it once. They’re already wealthy and it’s a capital preservation strategy. They’re just trying to make some solid interest. They’re not trying to make big swings, they’re not trying to take huge amounts of risk and betting on a rookie investor is risky. Even if you have the best intentions and you do all your homework, it’s just riskier for the lender. Now, I think what I sort of hinted at before partnering with someone whose friends or family, I think that’s a great way to get started and I know not everyone has friends and family that they can partner with, but if that option is available to you, I think most people actually get started in some way. We talked to a lot of people on the show, people figure it out, they partner together. And so that’s how I would go for two reasons. First and foremost, the people who know you are going to be most willing to bet on you and going to someone who doesn’t know you is going to be really tough. The second thing is just sort of legally and technically about how this works, but if you borrow money from a private lender, that means that they have a lien and they have a right to that property.
And so if things go poorly, that lender, depending on the structure of it, can repossess that house and take it from you and you could lose everything If you partner with someone who has the right understanding of the deal and one month you don’t make your cashflow or maybe three months you don’t make your cashflow or six months you don’t make your cashflow. If you’re equity partners, you could partner together to make up that shortfall. Hopefully it’s not that big, but you’re not going to be at risk of losing your property to a private lender because they have a first position lien on the property. So I just think that going for real private money is going to be tough and risky for a new investor.

Henry:
Amen.

Dave:
Thanks for the question Chris. Hopefully it was helpful to you and to all of our listeners, we are going to take a quick break, but on the other side we’re going to answer a very common and important question. Henry, is there ever a scenario where you should accept a tenant with a red flag? We’ll be right back. Hey everyone, I’m back here with Henry Washington. We are answering questions from the BiggerPockets community. The next question comes to us from Sandra and she is curious about whether or not it’s better to take a vacancy or to accept a tenant with some red flags. She writes, this is our second rental in Indianapolis and we closed on it a couple of months ago, but it’s been difficult to find tenants. The first rental we closed on in April rented quickly with no issues with a great tenant. Wanted to ask everyone what their experience is with tenants that have had multiple late payments on their report and one of them also declared bankruptcy in the past. Is it better to wait for a tenant that is more on time with payments and leave the place vacant for now or accept whoever applies new to all of this? So any advice is appreciated. Henry, take the first shot at this one.

Henry:
So there’s, there’s a couple of elements here. So first it says a couple of late payments and then second it says bankruptcy. So now if the late payments weren’t in the picture and it was just someone who had a bankruptcy, I wouldn’t necessarily let that red flag stop me from renting to them if I knew what the bankruptcy was about because there are a lot of situations that cause bankruptcy that don’t have much to do with if that person is a person who can and will make payments on time. People file bankruptcy because of divorce situations, because of medical bills. Medical bills are crazy, man,

Dave:
For sure. Yeah, medical debt.

Henry:
Yeah, if it’s medical debt that’s caused you to have bankruptcy, that will not stop me from renting to you because most people in this country can’t afford their medical debt.

Dave:
Can you find that out though? Is that something you just ask and trust them on?

Henry:
Yeah, I would ask them, but you can look at their credit report typically and find out you want to look into what’s causing it now, the late payments plus the bankruptcy and if I find out the bankruptcy doesn’t have anything to do with medical debt or a divorce or something like that, then no, I’m not going to rent to that person. The problem with late payments is look, people get behind. I have been a tenant who’s got behind on rent before and it happens, but there it’s very few and far between that I’ve found where tenants get behind and then actually truly get caught up. And so once you play that, I’ve kind of gotten behind game, it’s very, very hard to get caught up and so to me, I would wait for a more qualified tenant than renting to a person in this particular situation, but I don’t have a problem renting to somebody that may have some red flags. It just depends on what those red flags are and why and how they got there.

Dave:
I think that’s great advice to really look at each individual situation and not just apply cookie cutter advice. I’m going to admit something to you that I’m very mad about. Henry, I missed a payment on a random credit card this year.

Henry:
Oh no.

Dave:
I live in Europe and my bill went to my dad’s house and this whole stupid thing, it was for like $80 and my credit score dropped a hundred points overnight. I missed 30 days late on an $80 thing. So obviously that’s not a very serious situation, but if someone looked at my credit report right now, they would see a late payment
And so I think it’s super important to just take these things in context. Now, for me personally, if there was a history of late payments and it was recent, that would concern me. I think if it was two years ago or three years ago or four years ago and they could tell you a reasonable story about what happened and they’ve been able to pay rent recently on time, I think that wouldn’t concern me as much. That said, if you don’t feel confident that they’re going to be able to pay, I take the vacancy every time, every time, every time you got to take the vacancy, honestly, you’re going to get the vacancy sooner or later and I’d rather take it on the front end and then find a great tenant, then take a chance on a situation that I don’t feel confident in, and then I’m going to just have a vacancy a couple months down the road and a lot of

Henry:
Stress, nine times out of nine when I find myself in this situation where I don’t have a good gut feeling about someone and about what’s on their application, nine out of nine times it ends up going south. I don’t have any stories where I was like, I had a bad gut feeling, but they turned out to be amazing, not one.

Dave:
Yeah, that’s a really good point. Yeah, it’s like I talk about this with hiring in general at BiggerPockets or elsewhere, it’s like it’s got to be a hell yes. You have to feel really good about it, and I think that’s true regardless if there are red flags on someone’s credit report, I’ve definitely rented to people who have had late payments before and it’s worked out fine. Like I said, not super recent and severe late payments, but people get behind and they can turn it around financially for sure.

Henry:
Yeah, life be life in.

Dave:
Okay, so Henry, before we move on, let me just pose a hypothetical here. We don’t know the actual situation, but let’s just assume that Sandra thinks about this, decides this isn’t the right tenant. What do you do from here? You just keep the same rent, do you lower your rent? Is there anything you would recommend to her that she could do to try and fill this vacancy?

Henry:
So if you think about a property, it’s either going to be three things that stop somebody from renting it. It’s either the price, the condition or the marketing. One of those three things is out of whack or multiple of them are out of whack. And so those are the levers you have to pull. If it’s been listed for three months and it’s listed everywhere where it needs to be listed, where people can get eyeballs on it, meaning the marketing is good and the condition is good, then you have to adjust the price. Right now it may be that it’s priced what it should be for a property of that size and square footage in that particular neighborhood or area. And if it is everything around you is priced similarly and is renting, then it’s probably your condition or your marketing. And so I would look at your competition and see what do they have that you don’t have? Why are people picking somebody else’s before they pick yours And the marketing? That’s just something you’re going to have to research. If you’re the one doing the marketing, maybe you’re not good at it, maybe it’s not true,

Dave:
Tell it to them straight.

Henry:
Think about who your ideal tenant is and then how that ideal tenant looks for a property and is your property visible in those places? If the answer to that is no, then your marketing’s bad. So those are the levers I’d look at.

Dave:
One other thing I’ll add there too is that the rental market is very seasonal, meaning that there are times when it’s a lot easier to find tenants and there’s times when it’s a lot harder to find tenants. This post came in and it is tough. I don’t know if you’ve had to do it, but I have always struggled to find tenants in either November, December, and January. And so you might need to lower rent to try and attract a quality tenant there. And then I always recommend to people if you do find a good tenant, you either do like a six month or an 18 month lease to make sure that you don’t find yourself in a situation where you’re, again, it’s just kind of like fighting uphill, like you’re trying to push against the grain and then instead get your leases renewals and April through September, you’re going to be fine.

Henry:
Yep, agreed.

Dave:
Our next question comes from Larry Nelson in Venice, Florida, and he says, I own a rental property, but I’ve had them for a while. I’m now looking at a property that is tenant occupied going to a month to month in November. It’s a long-term tenant who has not expressed interest in leaving the current rent is about 500 less per month than what my research tells me it could be for this property. I know this is a business, but advice on purchasing a property and wanting to raise the rent up to fair market from being so much lower. Henry, what would you do in this situation?

Henry:
Found this situation a lot and the first thing you want to make sure of is that this tenant truly is a good tenant. If the tenant is a good tenant, they have great payment history. The unit they live in is in good condition, right? That’s gold. Good tenants are hard to find, right? And especially if they want to stay, I want to help them stay. Now it is a business and you need to get them closer to market rents, but there are several ways that you can go about that. First and foremost is just having a discussion with them and letting them know that you would love for them to stay and you want to work with them to be able to stay, but want them to understand that I had to pay for this property, which means I do have a mortgage to pay, which means I have to try to get this price up, so I want to work with you on that. And so I would have that conversation and say, Hey, market rent is about a thousand dollars a month for this unit. That’s what I could get if somebody else were to move in here, but I’d like to be able to keep you. Do you think you could afford $800 a month and if we could gradually stair-step you up to 800, do you think that would be reasonable? And a lot of the times they’re willing to do those things because most tenants know that they’re getting a deal when they have really, really low rents.

Dave:
Yes, they do.

Henry:
And if you can keep their rent lower than what it would be if they had to move because they don’t want to move moving costs money, moving costs time, and then they’re going to have to go pay a thousand bucks somewhere else. So if they can stay, not spend the money or the time and pay 800 or 700, they’re probably going to be willing to do that. And then I would work with them on either taking their rent stair, step it up maybe 50 bucks a month until we get there. Maybe it’s a hundred bucks every couple of months like you and that tenant can figure out what is financially reasonable to step them up to that over time. Maybe it’s we go up a hundred bucks every six months until we get there. You have to be able to figure that out. But keeping them in that unit if they’re a good quality tenant and they’re paying consistently is gold. You don’t have to get them all the way up to market.

Dave:
I couldn’t agree more. I feel like there’s some people who take this approach where it’s like, I’m the landlord, I own this business. I’m coming in. I’m telling you what rent is. I’ve never done that. Never, never. It could work. It could. But I just agree with Henry that typically in these situations, I bought a property this year where this happened. The person had been there for 18 years. I was like, this probably is great tenant. Why would I kick out a great tenant in a property that I intend to own for a long time? But at the same time, the way I underwrote the deal was to get rent close to market rate.
So I think that is a really important part of this is that if you’re going to throw the book at the tenant and say, Hey, I’m going to get this to the maximum rent, I can underwrite it that way, that’s fine. That way you’re saying, Hey, using Henry’s scenario for the first year, I’m going to get 800 and the second year I’m going to get 900. And then by years three or four, that’s how I think about it. By years three or four, I have to get market rent at a certain point, but I’m willing to stretch that out for a good 10, especially when it’s been there for decades. I’m going to work with that person. So that’s one thing is to underwrite it. The second thing is when you talk to people about market rate, I think Henry’s right, people know that they’re getting a deal, but at least maybe this is just me. I love data, but I like to tell people be like, here, this is what things are renting around you. Just so you show that you’re not making this up out of thin air. You’re not nicking and dimming them. And I think the third thing that at least tenants understand, and the part that makes me feel comfortable with this because it’s awkward, you don’t want to screw someone over, is that the current property owner has put this rental unit up for sale.
And so someone is going to come in and be a new landlord in this situation. And I always like to position it that the tenant feels that the best thing that could have happened for them is that I bought this instead of someone else, instead of some corporate landlord who’s not going to talk to them, who’s going to just say this number? It’d be really hard. And so I find if you take that approach and you sort of put yourself in their shoes and explain to your shoes too, I bought this property, I have all these expenses and just have a conversation with people. At least for me, it’s always worked out. And so I think taking the long-term, everything I guess I do in real estate is just think about the long-term here and don’t just fight over $200 that’s going to eventually lead to a vacancy and loss of a good tenant. It just doesn’t make sense.

Henry:
I agree with you, but you absolutely need to do that diligence and make sure they’re a good tenant.

Dave:
Absolutely. And then the other thing I will say is that if this is a multiunit to treat people equally and not say, Hey, this one tenant, you get to stay the other one, we’re going to max it out. I think you have to take a relatively similar approach with everyone to just be fair regardless of circumstances provided that they’re all solid tenants have been paying on time, take care of the property and so on. All right, so we’ve talked about private money, we’ve talked about tenants with red flags and we’ve talked about raising rent. Now we got to take a break, but when we come back, we’re going to talk about something in your wheelhouse, Henry, whether or not people should be using the 70% rule in today’s day and age. We’ll be right back.
Welcome back to the BiggerPockets podcast. I’m here with Henry Washington, answer community questions. And Henry, I got to throw this question to you because I have never flipped a house, and this one’s about flipping. It comes from Shahan who says, hello, everyone. I have a few questions for the fix and flip investors. I did two flips last year. One I made a profit on. The other one was basically break even. I learned a lot from both projects and hope to learn more. I wanted to know what are your thoughts on the 70% rule? Do you guys still apply that rule for all the deals here in South Florida? I’m not able to do 70%, and it seems like the profit margin is really small. What dollar amount or percentage do you look for in fix or flip properties? So Henry, I’m going to throw this to you like I said, but first maybe you can explain to everyone what the 70% rule is and then tell us if you use it.

Henry:
Yeah. The 70% rule is a air quotes rule came about maybe what five, seven years back when it got real popular, which is essentially saying you’re buying a good deal or you’re buying a deal that’s going to make money if you buy it at 70% of the after repair value minus the repairs that it needs. So in other words, if the house a RV or after repair value is a hundred thousand dollars and you’re buying it for $70,000, you have hit the 70% rule, but you have to subtract the repairs. So if it needs $20,000 worth of repairs, that means you need to subtract another 20 grand, which puts you at about a $50,000 purchase price. And so what it was saying is this is a quick and easy way for you to know what to offer on a property for it to be a profitable flip. Now, the 70% rule has always, to me just been a rule of thumb. It’s

Dave:
Not legally binding,

Henry:
It’s not the law. I think people use it because it’s a quick and easy way to come up with an offer price. But there are other quick and easy ways to come up with an offer price that are going to be a whole lot more precise and are going to be a whole lot more market specific. Because the 70% rule is not market specific, it’s just a general calculation. And so I don’t use the 70% rule. Instead, I do my own quick and easy calculation. It’s just a max allowable offer calculation, and I do it literally on the calculator on my phone. First and foremost, you need the after repair value. That’s the most important number you have to have. So if you have the after repair value, I take that a RV minus expenses, which would be your closing costs, your holding costs, and your commissions. So for closing costs, I typically do, in my market, it’s probably going to be anywhere between 5,000 to $10,000. And that counts the buy and the sale

Dave:
Because

Henry:
You’re going to pay closing costs twice when you buy it and when you sell it. So you have to do some research enough to know what’s closing costs typically going to cost you in your market, both when you purchase and when you sell. So a RV minus closing costs, minus holding costs. This is something you have to figure out for yourself as well. What are your typical holding costs? So for me, I’m using private money or hard money, and I’m typically paying 11 or 12% interest only. And so for me, it’s going to be anywhere between a thousand to 2000 bucks a month depending on how much I’m buying the property for. And then you have to take that and consider how long you’re going to hold that property for. So if I’m paying $2,000 a month in holding costs and I plan to hold that property for six months, that’s $12,000. So a RV minus closing costs, minus holding costs, and then minus the repairs. And the last and most important thing that you have to subtract is the profit that you want to make.

Dave:
So you use the profit almost as an expense, right? Yes. Just in my mind, I’m building a calculation here, and so we have rv, right? You start with the price that you think that you can sell it for. That comes from comps. Let’s just use an example here. Let’s say it’s a $200,000 property. So you said closing costs are going to be 10 grand. That takes you to one 90. Let’s say that we’re going to soft costs, I’m just going to make up numbers here. Let’s say it’s 30 grand and it gets you to one 60 and say that for your time, Henry, you need this to make you 50 grand, right? Yep. 50 grand. Okay, so that means that you would be willing to pay $110,000 for this property, selling it for 200. You have 10 K of closing costs, we said 30 for soft costs like financing, that kind of stuff, and then 50 in profit, you’d pay one 10.

Henry:
Exactly.

Dave:
Okay. And so that is not 70% rule, right? No, because I think the 70% rule is doing it backwards, right? It’s just saying how much profit you should be happy with, but you put profit earlier into the equation.

Henry:
Absolutely. I want to dictate how much profit I want to make given the amount of risk I may be taking on for a job.

Dave:
Got

Henry:
It. If I’m looking at a property and it is in a neighborhood where things are selling slow, it’s got foundation issues, or maybe it’s got a weird layout, I want more profit for taking on more risk, and so I’m going to bake that in on the front side to know what I’m willing to pay for it. I’m not going to let some arbitrary calculation dictate to me how much I should make on that property. If I’m buying a house and it’s in a rockstar neighborhood, it’s a cosmetic rehab, I may be willing to make less profit or offer more to do that deal. And so I dictate the profit that I want to make based on what that deal is telling me.

Dave:
So how do you come up with that profit, though? That totally makes sense to me. This is true of any type of investment, the amount of profit, the amount of reward that you should get is dependent on how much risk, how time that you’re putting into the deal. But I can imagine it would be easy to just say, Hey, I want to make on a 200 grand property, I want to make a hundred grand. How do you come up with something that is both ambitious but realistic?

Henry:
So the rule of thumb I use for the profit that I want to make is I typically want to make what I’m spending on the rehab. So if I’m doing a 50 k rehab, I’d like to make a 50 k profit. Now I’m willing to adjust that slider based on the things that we talked about before. How likely is it to sell at the A RV? Is it in a great neighborhood? Is it weird? The more weird things that house has, the more profit that I’m going to want to make and vice versa. So it’s a sliding scale, but the rule of thumb is if I spend 50, I want to make 50. In other words, I don’t want to go do a hundred thousand dollars rehab and only make 30 grand. To me, that’s not going to do it. So if I’m underwriting a deal that has a hundred thousand dollars rehab, I’m probably going to try to bake in a hundred thousand dollars profit, and then I’ll be willing to slide that based on some of those factors we talked about.

Dave:
I imagine that also gets easier as you do more deals or talk to other investors and say, Hey, on an average, solid, middle kind of risk middle effort deal, you can usually expect 40 K in rehab costs, 50 K in profits. And so you can sort of tune your radar a little bit to say, okay, this is on the spectrum, the right spectrum of risk reward profile for me. But that’s something you learn over time. Or if you’re new to this poster in the BiggerPockets community, that’s exactly why you go on the BiggerPockets forum and ask these types of questions because just like Henry just explained, someone hopefully in your market can tell you what types of profit you could expect for what types of properties. Absolutely. All right. Well, thanks for educating us on that one, Henry. Much appreciated, and thanks for all of your wisdom on this. This was a lot of fun. I appreciate all your input for the BiggerPockets community.

Henry:
Hey, thank you for having me. We should do more of these. This is a lot of fun. I love answering these questions.

Dave:
Same. I think these were really good questions. If you want your own question answered either by Henry and I or by the BiggerPockets community, make sure to go to biggerpockets.com/forums. You can ask these questions to literally thousands, if not millions of experienced real estate investors, completely for free, and you can get the wisdom of the crowd right there on biggerpockets.com. That’s all we got for you today on the BiggerPockets podcast. Thanks for listening. We’ll see you next time.