Interested in Investing in Rental Properties

[Tommy B.]

Although it scares the hell out of my wife I am developing an interest in rental properties and I'd like some advice. I am fortunate enough to earn a very good living that allows for 3-4 days off per week due to a compressed work week. I have a lot of time on my hands and have always been interested in running a business, but I have had a difficult time pulling the trigger. I'd like to run a business, but at the same time I don't want to be busy 100% of the time and miss my kids (2 YO son and 6 YO daughter) growing up. I think real estate would be a better fit for my personality than investing strictly in the stock market.

A little about me. I will be 40 years old this year. I am very handy and can handle most painting and repairs myself, but I would hire for major repairs such as roofs and carpets. My wife and I are very disciplined and do not have debt outside of our house payment, which we have about $50K equity in. A newer vehicle is on the horizon in the next year or two. I have about $13K in investments outside of my 401K. I believe we can save an additional $10K this year. I am able to save and invest about 15-20% including 10% to my 401K.

I am able to afford a good life for my family, which allows my wife to stay home and raise our kids, but at the same time I am uncomfortable that our comfort hinges solely on my job. My goal is to create wealth and feel less dependent on my job in the long run. 10 years from now I would like enough revenue to live on with or without my job.

So this leads me to a few questions.

How much capital did you have to get started?
Is $10K in reserves after a purchase adequate to have on hand?
Do you have an LLC established for your property and an LLC established for the property management?
What books did you read to educate yourself? (I just finished Buy it! Rent it! Profit!)
How would you recommend starting out?

Thanks in advance for any advice!

[David Beard]

Tommy, you look like a perfect candidate to purchase and personally manage moderate to good quality SFRs using conventional financing (with your good W2 income and apparently low debt-to-income ratio). Try to buy such that the gross monthly rents will be at least 1.25% of your purchase+rehab costs (i.e. purch+rehab is $80K, rent for $1,000). These properties in decent neighborhoods should hopefully give you a reasonably pleasant landlording experience with your initial purchases, and allow you to sell for top dollar if you decide it's not for you.

Note that you will NOT be given credit in your Debt-to-Income ratio for the rental income until you have two years of landlording experience on your taxes (i.e. after you file 2014 taxes in 2015, if you start investing this year). In the interim, your DTI ratio will have to absorb the PITI of new rental properties in the numerator. That DTI ratio will then need to be no greater than 45%, and possibly just 40% if you don't have stellar credit, in order to get financing. Be careful to keep credit inquiries off your account and keep your use of credit card lines modest in the meantime, to keep your scores high in order to get the best rates. You'll want to use only 30 yr mortgages initially to keep the PITI as low as possible (so that it increases your DTI as little as possible until you have that two years of experience). Down the road, if you want to accelerate payments to pay off mortgages more rapidly, you always have that option.

Drop your 401K contributions to no more than the amount that gets the company match, so that you can increase your after-tax savings as rapidly as possible. Your capital is light, you will need reserves (count on needing 6 mths of PITI sitting in reserve, after you've done the purchase and rehabbed it). You probably have a healthy 401k balance with that savings rate, so note that you can borrow up to $50K from that account (but no more than you have vested) to use for real estate downpayments if necessary. If you do that, you will have to pay it back to your account at the rate of $900+/mth or so, so be aware of that drain on your paycheck should you elect to do that. Many folks will borrow $50K, and keep some of it liquid just to make the necessary payments. (However, that 401K payment will NOT be considered debt for DTI purposes, so that's a plus, and with $50K you could invest in a couple of properties). Psychologically, recognize that you are not raiding your 401K, but effectively investing it in terrific undervalued cash-flowing assets, and you will use the cash flow from those assets to replenish the 401K. After a year, if the property value supports it, you can potentially refinance to pull some cash out and retire that loan. This is just a thought to accelerate your investing, some people are uncomfortable with it, you be the judge.

The car purchase could be a big hit to something, either your DTI ratio if you finance, or your cash reserves. Determined real estate investors getting started do NOT buy new cars, look for models several years old. Large car payments will crush your DTI ratio, and new cars are just simply a bad investment. Use your new RE negotiating skills to find a hell of a deal on CL.

As far as the math, 1.25%/mth of gross rent is 16%/yr. Assume you finance 67% (you can go up to 80% LTV on purchase but you'll need some money for rehab and closing costs so this will dilute your effective LTV down to perhaps 67%). Let's assume that self managing in a decent neighborhood, you can net 9.5% out of the 16% gross return. So 9.5% is your cap rate or net yield.

Then you layer in your financing at 4.00%, and your ROI (including principal payback) will be around 20%. When you factor in the tax benefits of writing off the depreciation, your ROI will jump to around 24% BEFORE considering likely capital appreication over time. So you very plausibly will have an investment earning in the high 20 percents. Make a few investments like that and you will be on track to retire early and retire wealthy.

As far as your "scared to death" wife, you will need to get her on board, obviously, prior to moving forward. Go to the local REIA and find a successul landlording couple, and ask them to dinner (ask them to please not tell horror stories about tenants!). Also, many wives love the aspect of taking something ugly and making it attractive (guys as well, but by and large this comes more naturally to women, whereas men are all about the numbers!), so this could be a part of it that will really get her interested. And heck, if she' really good at it, you might want to look at flipping down the road. Many successful flipping couples have the numbers-guy deal-making husband and the creative-decorator wife (while making stereotypes I might as well just jump right off the cliff!)

Oh, as far as the LLC, forget about that initially, you can only get conventional mortgages in your personal name anyway. Talk to your insurance agent about getting a $1mm umbrella insurance policy (cost about $250/yr). Once you own a handful of properties, you can consider an LLC.

Best of luck!