How to buy your first investment property-a case study.

We’ve all heard it. Owning real estate is how the rich get rich. True. The vast majority of the rich do own real estate as part of their investing strategy. But, what’s also true is that the average Joe can easily lose his shirt by taking that advice and then just plunging into the real estate market without doing any sort of research.

It’s like hearing that those crazy intense boot-camp workouts, where they have Plain Jane and Average Joe throwing Olympic weights over their heads suddenly and repeatedly, are a great way to get fit, and then just jumping right into it with no preparation whatsoever. You don’t automatically become fit just because you jumped head first into some crazy intense workout class. It’s a sure way to get hurt.

Similarly, you don’t automatically make money just because you own real estate. You don’t just suddenly become rich because you’re able to say “I own 2 houses!” The numbers have to make sense. You have to do lots of research. And, there has to be a profit.

Get your financial house in order

Your first step toward real estate investing is to put your own financial house in order. Sure, there are all kinds of “creative” ways to invest in real estate. But, the traditional and safest route is to build up your credit, have a great credit score, and save for down-payment and closing costs (Most banks will want 25% down for an investment property, and closing costs run about 5% of the value of the property in New York.)

It’s difficult enough to manage your primary house and finances. It’s even more difficult to do that with a second house and all its related costs. So, it’s important that you have an emergency fund as well as the ability to save extra money every month. You want that safety cushion just in case things don’t work out (tenants could stiff you for months, the boiler breaks, etc)

Having a steady job with the ability to save money on the side really helps (I’m talking you, young LEOs and other civil servants with dual incomes. Start saving).

Research

We bought our first rental property-a tiny 1-bedroom condo in a gentrifying area-in 2011, when the real estate market was starting to come back in NYC. We had been on the sidelines, researching, reading, and watching for years before that. And, it still took us nearly a year to pull the trigger after getting really serious about buying.

I’m not saying you need to do that much research or wait that long to buy. We were just being really cautious.

Our first investment property purchase was absolutely frightening. What if the market never comes back? What if gentrification turns tail and runs the other way? Will we be stuck with a house that loses money every month after we’ve spent so much money on it? Will we be stuck with a house that we can’t sell? Will we have to sell at a loss? Will we have to hold the loser property for another 20 years in order for the market to come back around? There was no end to the questions and doubt.

Hindsight is 20/20. We now know it was pretty much baseless fear. We had done the research. Prices were coming up, along with the rents. More young professionals were moving in every time we visited. And, we had built up a large safety cushion in terms of pricing the rent conservatively, having an emergency fund, being able to save money from our salaries every month, etc. We were very flexible and adaptable.

Run your numbers

Ultimately, the number one reason for pulling the trigger was just the numbers. It all comes down to the numbers.

We knew what our monthly expenses would be-mortgage, common charges, taxes, insurance, plus a set percentage for vacancy and miscellaneous fees. We ran conservative estimates for the rent based on widely available data. We projected a monthly cash flow of a few hundred dollars after all expenses, a decent safety cushion in case rents took a nose-dive.

We thought that appreciation would also be a good reason to buy. The signs were certainly there. But, we had no idea what the rate of appreciation was going to be. It was anybody’s guess. If the property did appreciate, it would be icing on the cake.

Your Return on Investment

You might have heard of the term Cap Rate, which refers to the ratio of Net Operating Income to Value of the property. It’s not really useful to small time investors like us. It’s more of a tool for professional real estate investors to take a quick comparison look at buildings.

As small time investors, what we were concerned with was Cash-on-Cash Return. Basically, we wanted to know how much interest our money would be earning per year, as if we were putting the money into a bank or investing it in the market.

We had put out a total of some $80,000 on that first property, including the down-payment and closing costs. If we had left that money in the bank, it would’ve generated 1% per year, or $800. If we had invested in the stock market, it would’ve generated 8% per year, or $6400. And, that’s without lifting a finger. No fixing leaky toilets or taking phone calls from tenants, etc.

We had to beat the stock market in order to make it worthwhile. After all, you don’t want to actually fix toilets and make the same 8% that investing passively in the market would get you (real estate investing may be called “passive income,” but there’s nothing passive about it when you’re a small time investor and you have to do all the work yourself).

Our initial cash flow barely made us 8% per year. However, our current return is about a 10%.

Did our 8% beat the market’s 8%? Yes, and by a larger amount than the 2 obvious numbers. (OK, so the market has also done much better than the average 8% over the last few years. Keep reading). You’ll have to consider all the perks of owning real estate that owning stocks/mutual funds don’t:

1. *Our little condo currently generates over 10% /$8000 per year, net, after all expenses. But, due to depreciation-an accounting method that spreads out the cost of the property over a set number of years-virtually all of the profit is tax free. (Yes, it’s perfectly legal. In fact, it’s standard practice). So, the $8000 is worth more like $10,000.
2. *Somebody else was paying down our mortgage-around $1200 a month, or $14,000 per year.
3. *We got to write off the mortgage interest and real estate taxes, as well as expenses that came with maintaining the property, such as the condo common charges. That’s all hard to justify with a definite number, but it’s certainly another benefit over investing in the stock market. You could easily say it’s worth a few thousand dollars of benefits per year.

It adds up to a very conservative $22,000 ($8000 + $14,000) a year in benefits, not including the write-offs. Therefore, our initial $80,000 is making us at least a 27% return.

True, I had to do some toilet fixing and tenant managing. But, the returns handily beat the market, and therefore made the investment and work worthwhile.

But, that’s not all!

If you call within the next 30 minutes…sorry, couldn’t resist.

The biggest advantage we had over the market was appreciation, the icing on the cake that we hadn’t bet on. Our little condo has more than doubled in value since 2011, as with many areas of NYC. It went from $300,000 to well over $600,000. That means that our investment of $80,000 was now worth many times its original. It was no longer just producing 8%, 10%, or even 27% a year. It has in fact produced over 400% in the last 5 years, on top of the 27%. That’s about 100% interest per year! Try getting that from the bank!

(Yes, the longer I hold it, the lower the average appreciation will be. You can’t depend on the kind of appreciation that happened from 2009 on. That was NYC coming out of the biggest crash in history. In general, real estate just keeps up with inflation-about 3%. It’s also extremely difficult nowadays to even get a decent cash-on-cash return on that type of property. But, the 27% return, plus an average 3% appreciation, still handily beats any market, in any year)

Some warnings

Do not buy an investment property that bleeds cash every month (the rent doesn’t cover your expenses). It’s a sure way to lose money. (Of course, there are investors who buy simply based on potential appreciation, and end up making big bucks. But, you have to be very knowledgeable of your market, have very deep pockets, and probably be very lucky.)

Do not buy simply because you think you’ll have a free house after 30 years. It’s possible your money can do better in the market in the long run, and without you lifting a finger. Think of all the houses that were bought right before the crash, in areas outside of major cities. They still haven’t returned to their pre-crash values, and likely will not for many years to come.

Finally, do not, I repeat, DO NOT buy one just so you can say “I own 2 houses!” It sounds great, but doesn’t do anything for your wallet.

It’s an investment property. Investments should MAKE money. Period. (Yes, I nearly made all 3 mistakes.)

Summary

So, how do you buy your first investment property? Get your financial house in order; save up the 25% for down-payment; study your area to make sure it’s growing; crunch your numbers to make sure that your investment actually makes a good amount of profit every month; and, enjoy your little extra money every month (actually, don’t just spend it. You can enjoy some of it, but make sure you save and invest most of it so you can buy more investments!!)