Three Ways to Make Money Owning Real Estate

Photo by Stanislaw Zarychta on Unsplash

It doesn’t take a lot of time on The Lousy Investor website to realize my fondness for rental properties. I truly believe that a well constructed real estate purchase is one of the best ways for individuals to create wealth. The key to building this wealth is to have a path to profitability. It is very dangerous to purchase a property just because it is in a good area or because a mortgage broker will fund your deal. In this post we are going to dig into the simple analysis that my wife and I use to evaluate a potential real estate deal, to determine whether we should make an acquisition. This post is about understanding the big picture. I believe there are three ways to make money owning real estate.

1. Equity in the Property

The most obvious reason that many investors will purchase a house, duplex, or apartment building, is the equity in the property. Equity is the amount of profit that you have in the deal on the day that you purchase the property. For example, if you purchase a house for $100,000, and you believe that the property, in the current condition is worth $140,000, you have $40,000 in equity on the day you purchase the home!

Determining the equity of the property is not as easy as it may seem. There are so many variables that go into the value of a house, or any other type of real estate, that you are realistically trying to find a general range of what the home is worth. Let’s say that you purchase a home in a cookie cutter neighborhood where there are only 7 different floor plans, it may seem as though you could figure out what your house is worth down to the penny, but it may not be as easy as it seems.

Analyzing the Value of a Property

• Recent Comps– In order to understand the value of your property, you want to be able to identify the most similar properties that you can find that have sold recently. Do not rely on the properties that are currently listed on the market for sale as the property might eventually sell for less than the asking price. If there are no recent comps in your neighborhood, that will make it more challenging to feel comfortable with the value of your property. Ideally, the most recent and the closest comps that you can find will ensure the most accurate results.
• Condition of the property- Ideally you can find properties in your neighborhood that are the same model, or are similar in terms of square footage, bedrooms, bathroom, etc. Next, you want to research the condition of those properties at the time that they were sold. If the other property had carpet, and your property has nice hardwood floors, your property would certainly be more valuable, all other elements being equal. As investors, we tend to be easy graders when comparing the property that we want to buy with other properties that have recently sold. Make sure you are doing a reasonable analysis. If the sold comp has been fully rehabbed with new cabinets, granite countertops, and updated bathrooms, it is worth much more than a property that has been a rental for the last 10 years that you are buying from the landlord before it has been cleaned up.
• Unique Situations- It is important to look at both the quantitative (numbers) as well as the qualitative (attractiveness) aspects of the deal to make sure that you do a full analysis of your potential investment. There are truly hundreds or thousands of possible factors that determine the equity that you have in a property and below are just a few significant questions to ask:
• Is the neighbors’ house a junkyard?
• Is my property in a flood plain?
• Is my house on city water or sewer?
• Does the home have a bad reputation in the neighborhood due to a death in the property?
• Was there an un-permitted addition put on the property?

2. Buying with Great Cash Flow

When purchasing a rental property, I strongly believe that cash flow is the single most important aspect of the deal. Everyone has a different idea about how much cash flow is sufficient to justify purchasing a rental property, the key is to completely understand the analysis of the income and expenses associated with renting out a property.

If you construct a portfolio of cash flowing rental properties AND you maintain a solid cash cushion to deal with issues in your life and repairs to your rental property, you do not have to worry about running out of money.

Conversely, if you are flipping houses and the market softens making it tougher to create chunks of money, you can find yourself in a precarious situation. I would rather purchase a property that will net me $400/month in cash flow, with no equity, versus a property with $30k in equity, that does not produce cash flow. Depending on your lifestyle, you may only need 10-20 of the properties that produce $400 a month in cash flow, but after that, you are done from a necessity standpoint. You may also decide to purchase additional properties to fund your children’s college, support charities, or simply create a family empire because playing golf more than a few times a year is boring.

The other benefit of purchasing properties for cash flow is superior tax treatment. If you purchase a property, fix it up and sell it in less than a year, you will be hit with some pretty heavy taxes. With rental properties, especially when you use mortgages to buy the properties, you may not have to pay a dime in taxes based upon the write-offs/deductions that you receive from being a long term investor.

3. Buying with Great Terms

When you purchase a stock or Mutual Fund/ETF (passive investment), you are going through a very specific process to make the acquisition. The only variable is the price that you are willing to pay for that purchase. There is no negotiating or creativity to employ, the structure is the structure. Some investors take great solace in knowing that that they are going down a tried and true path while others see the regimented structure as a barrier to getting above average results in their investing. As you review my plan, you will notice that I believe there is space in your portfolio for both passive and entrepreneurial assets.

Real estate can be an entrepreneurial investment. If you have the knowledge of a specific neighborhood and the communication skills to negotiate with an owner of a property, you can create a profitable investment outside the realm of a ready-made product from a financial services company. There are a significant amount of elements that you can negotiate when you have the ability to deal directly with the seller. You can ask for a longer period of time to purchase the property, allowing you to shop mortgage options thoroughly. You can also ask for certain items in the property such as the refrigerator or a particular piece of furniture. In my experience, the most important tool for negotiating with the seller is the ability to have them participate in the financing of the property.

Arguably the best real estate investment I have ever made was asking the seller of a house to allow me to make him payments for the property, instead of a bank. This technique is commonly referred to as seller financing or owner financing a property.

When an owner is willing to finance the property for you, it opens up endless possibilities of how that loan can be structured.

Price

Investors are most familiar with negotiating the price of a property. While price is the most important aspect of negotiating a deal when trying to buy with equity, it may not be the most important aspect when purchasing a rental property that you are looking to purchase for great cash flow or on great terms. You can allow a seller to “win” on price if they are willing to give you favorable financing terms.

Interest Rate

In my mind, interest rate and length of financing term from the seller are the two key components for creating a great seller-financed deal. I have seen a mentor negotiate a 0% loan with a seller because the seller absolutely needed to sell a property for a certain sales price and was willing to accept getting paid that money over a 20 year period so that he could feel as though he had “won”.

My Face when i witnessed the 0% loan negotiated. Photo by Jamie Haughton on Unsplash

The buyer was more than happy to pay full price for the property because they were able to cash flow the property approximately $400/month. Again, if your primary goal is cash flow, your monthly payment is the primary concern.

I am forever grateful to that mentor for allowing me to sit in on that negotiation. It doesn’t seem logical that someone would be willing to receive their money over a few decades with no interest but it does happen.

Years later I negotiated a long term seller-financed deal with a 3% interest rate and it was due, in large part, to knowing what is possible if you are able to sit down face to face with a seller!

Length of the Loan

As a conservative real estate investor, I want to have as long of a seller-financed term as possible. While you can make the case that a loan with good terms is helpful, even if it is a few months or a few years, I like to set it and forget it when it comes to financing. I have never purchased a 50 unit building in large part because I don’t like the short term financing that banks are willing to give you on those deals. I would much prefer to have a solid 20 or 30 year fixed loan from a bank or seller if possible.

Down Payment on the Property

When you are in the growth phase of your real estate investing, it is especially important to put as little down on a property as possible. It is important to understand that the more we put down on a particular property, the longer it will take to save up a down payment for our next investment property.

I mentioned witnessing a mentor negotiating a 0% loan to encourage you to believe that almost anything is possible in a negotiation. The same is true with down payments. There are many sophisticated buyers that are able to acquire properties with very little money as a down payment.

Being able to negotiate a seller-financed deal with a minimal down payment, is arguably one of the best reasons to pick real estate over any other type of investment. If you want to purchase 100 shares of an index fund or a stock, you have to come up with all of the money to make that investment. Conversely, with a house, you may only need to come up with a 5% down payment to acquire that asset! NOT TOO SHABBY!

What is your primary reason for buying rental properties? Are you an equity investor? A cash flow investor? Or will you buy pretty much anything as long as you get great terms?