Real Estate: Real-life risks associated with leveraging.

A while back I wrote an article called "Cash vs. Mortgage, and a Scenario." There I explain a few key differences between paying cash for investment properties, or mortgaging them.  Today I reviewed my real-estate portfolio and was in shock about how much risk I am really taking on.  I want to provide insight for my viewers to see some real-life examples and to further motivate me to pay my debts off!

I went into my investment properties with nothing down, since I really had nothing to give.  This leverage allowed me to take on long-term debt without using any short term cash.  Having three properties in the portfolio provides 8 renting possibilities.  Assuming no property destruction and no tax benefits, here are the 8 outcomes:

As you can see above, vacancies result in serious financial consequences.  To help minimized risk, I have tenants sign 1-year leases which are staggered so the possibility of multiple vacancies is reduced.  But still, things still can happen that can put me in a bind.  Over the years I have established a hefty emergency real-estate fund for tough times ahead (though this could be easily wiped out should multiple vacancies occur over extended periods of time).

Having real-estate debt has always put a damper on my dividend investing contributions.  I often opt to pay additional cash onto the principal over purchasing a good-valued dividend stock.  This results in less long-term debt and risk.  If I manage to pay off the properties, here is how the 8 outcomes would look like:

After reviewing the chart, the risk here is almost non-existent.  All 3 properties would need to be vacant in order to have a negative cashflow!  If this was the case for me every month I would have a much easier time getting additional properties or helping the dividend-investing portfolio.

It is important to note; that when vacancies occur there are always repairs that need to be done (or house cleaning).  This is usually a minimum of $150 if you have a professional involved.  Insurance and taxes have been included in the scenarios above, making the data easier to digest.

Disclaimer: I am not a financial planner, advisor, or accountant. The financial actions mentioned were only suited for my own risk tolerance, strategy, and ideas. Copying another's financial moves can lead to large losses. Each person needs to do their due diligence in researching and planning their own actions in the financial markets.

Rental Property - Ranch House 2

Description: 3 bed, 2 bath, 1500 square feet, 1 acre.

Major work completed:
Everything, built this house from the ground-up.

Financial Information:
Estimated monthly cash-flow: $240.43

Disclaimer: I am not a financial planner, advisor, or accountant. The financial actions mentioned were only suited for my own risk tolerance, strategy, and ideas. Copying another's financial moves can lead to large losses. Each person needs to do their due diligence in researching and planning their own actions in the financial markets.

To protect the tenants and their identities, this is only a visual representation of the rental property, not the actual home itself.

How to tenant-proof your rental property.

With rentals, there are 2 ways to improve and sustain the return on your investment.  The first is to "get by" as quickly and cheaply as possible, and rent the property out for quick cash flow.  The second is to provide adequate maintenance and invest in upgrades to the home, then renting the property out.  This post covers the second method, as it is the one I'm more familiar with.

There are three key results I have discovered while applying upgrades to my properties:
1 - Tenants are more careful/respectful when they live in a home that was given to them in good shape.
2 - Tenants are happy to pay a small increase in rent when they have upgraded homes.
3 - Property value increases.

With this in mind, I look for upgrades that are relatively inexpensive, provide good protection against tenant destruction, and provide a decent return.

Floors.
This is a big one.  After my first lease ended I had to deep clean the carpet in the house.  After purchasing an expensive steam-cleaner and investing several hours of labor, I discovered this was not going to work long-term.  The house got re-rented and the next tenants moved out and guess what?  The carpet was now destroyed.  In terms of dollars per square foot, I found tiling my own property is cheaper than having a company like Lowes install carpet in my home, even with their free installation promotion running!
When the tile was complete, new tenants moved in, and were very  happy with having a tiled home.  When the tenants moved out, a quick 2 hour mob job and the floors were as beautiful as the day they were laid. 

Landscaping
Design the yard to be maintenance-free (or at least easy to maintain), and your tenants will take better care of it.  Find low growth shrubs or trees that don't require too much pruning, along with grass that doesn't require lots of water, and your tenants will not disappoint you.

Roof
A metal roof is a long-term plus.  With a metal roof you get a lifetime warranty (or 50 years).  Traditional shingles typically last 20-30 years.  This alone gives you a greater return, not to mention your less susceptible to wind, hail and storm damage.  This can also qualify you for a discount on your insurance, which is great.  Just know that if your home has a hole in the roof, all it takes is that one tenant who either doesn't care or doesn't pay attention and you will pay big.

Counter-tops and Cabinets
Heavy duty is always better.  Lower the chance of replacing your cabinets or counter-tops, lower the number of times you pay to replace them.  Statistically, aside from landscaping, money spent in the kitchen can add the most value of your home.  Additionally, your tenants feel they get more value for their buck too.


For those doing serious remodeling or new construction, here are a few suggestions.

Plumbing:
Utilize PEX pipe.  This handles extremely hot and extremely cold water very well.  This does not corrode like your traditional metal pipe and does not crack like pvc pipe.  There are never joints behind your walls, and when installed correctly, you have the opportunity for a shutoff for every water exit, which is HUGE.  If you need to replace a faucet in the guest bathroom, you can simply flip the switch to shut the water off to that bathroom faucet without having to shut water off to the entire property.

Electrical:
Pre-determine the location of your electric meter and strategically place major appliances as close to that location as possible.  Less lineal feet of heavy duty wire means huge cost savings, plus you have less wire in the wall that can be damaged by tenants.

Structure
Metal studs with brick exterior (or stucco) is the way to go.  Remember that termites love to eat wood, and are expensive to kill.  The local bug killing company charges 6$ per lineal foot around your home to treat termites.  This averages to about $1100 for one of my rentals.  Also, tenants love to hang picture frames, what happens when they put a hole through a wooden stud containing conduit? Not good.

This post will be updated as I get more photos of my work.

Disclaimer: I am not a financial planner, advisor, or accountant. The financial actions mentioned were only suited for my own risk tolerance, strategy, and ideas. Copying another's financial moves can lead to large losses. Each person needs to do their due diligence in researching and planning their own actions in the financial markets. 

Banks Becoming Landlords, What Should We Do Now?

As I go to shut my laptop down, I notice an article pop up on my screen titled "Bank of America Starts Foreclosure Rental Program".  This states that homeowners at risk of losing their homes to foreclosure will have the titles handed back over to the bank, at that point they become tenants of their current residence....Although very little info is being provided here, I foresee a huge impact this program will have on the average American's future.
With 'bad loans' being written off, and toxic assets will be converted into money making machines, Bank of America will have success here.  This pilot program will start small, but I think it will be expanded exponentially.

This graph was pulled straight from the federal reserve's site, highlighting the correlation between monetary rates and housing prices.....


With interest rates at their all-time lows, there is only one way they can go; UP.  This being said, the rise of interest rates translates to:
1)Loans being even harder to get (since its near impossible to get one now)
2)Loans costing borrowers more (having even a 4% mortgage rate is still a drag, imagine have rates near 20% like in the past....)
3)Housing prices plummeting so current home-owners will either be upside down on their loans or will never be able to afford to purchase property, driving down demand.

I sense Bank of America will set the standard for the 8000+ banks in the US in becoming new owners of rental businesses.  All of the factors above will come together, to make it an easy decision for homeowners to just 'walk away' from their loans and become tenants.  Next thing you know purchasable homes are nowhere to be found, rent artificially being increased across the country, and everyone is miserable.

Maybe I am taking this article the wrong way or just over-thinking the possibilities.  But if the situation above happens, what should we do next?

1)Sell our homes now, pocket the equity, rent for a bit, then throw down cash when the prices of homes plummet?
2) Buy a house now while rates are low, and accept the fact that your future purchase will decrease in value?
3)Invest in Bank of America 'BAC' (or other banks)?
4)Pray the pilot program fails?

I would like to know what my readers think, please email me or comment, thanks.

Cash Vs. Mortgage, and a Scenario

Its easy to debate whether to mortgage rental properties or get them with cash.  With record low interest rates and ever-increasing difficulty of accumulating cash, mortgaging seems to be the only option for most of us.  Using figures from one of my properties. I will demonstrate the differences between the two sides.  I will also throw in a quick scenario to highlight the risk levels associated too.

To make things easier, I will scale up the mortgage on the property to $1000.

With a paid property, assuming this property remains rented all 12 months of the year, you would be taxed on $11504 income generated.  At a 30% rate you would pay the government $3451 and pocket the remaining $8053.

With a mortgaged property, assuming its rented all 12 months of the year, you would be taxed on 4800 in income.  At a 30% rate you would pay the government  $1440 and keep the remaining $3360.

With my experience I can tell you two things: 1)Your rental investments will rarely be filled every month of the year, and 2)Things go wrong.  Yes you do pay less in taxes at the end of the year, but I would much rather give the government 30 cents than to just hand over the banks a dollar....   Plus if you are worried about making too much money on the property re-invest in the house through major improvements.  You could do this with good cash-flow, but you wouldn't make enough if you were barely breaking even.


Lets apply this way of thinking to a possible real-life scenario:
Your property is rented the majority of the year, but is vacant during the months of July, August and September due to lack of tenants in the market and your flooring needs replaced...  The floor job requires $3,000 to tile your property.

Looking at the data above you will now see the danger due to lack of free cash flow from the investment property.  Writing off the 2400 dollar loss on your taxes is always a plus, but paying $1291 in taxes and pocketing $3013 is better any day.  There are numerous tax advantages to acquiring losses with rental investments, that you cannot claim with other investment vehicles.  But the piece of mind and profits you get from having 'paid-for' real-estate outweigh the "tax advantages."

Disclaimer: I am not a financial planner, advisor, or accountant. The financial actions mentioned were only suited for my own risk tolerance, strategy, and ideas. Copying another's financial moves can lead to large losses. Each person needs to do their due diligence in researching and planning their own actions in the financial markets.

OPM and Real Estate Purchases

OPM (other people's money) is a tool to gain serious leverage in real estate investing, often used by Robert Kiyosaki, author of Rich Dad Poor Dad.  The basic principle here is to buy a property with the least amount your personal money, then cash-flow that property via rental agreements.  This has huge advantages and at the same time, can be very dangerous.

When I purchased my Victorian property, I had a very small income and almost nothing in savings.  I managed to dive into this contract for less than $1,000 down and start generating $2,400 cash each year from that initial investment.   With the revisions of modern lending polices in place, it would be impossible to jump into the market like I did.

It was fun reaping the rewards of the big yield when I became a landlord, but one factor kept my profits low and my risk high.... this was the huge DEBT that the deal put on my lap.  If the property becomes vacant I get stuck with a huge bill, thanks to the mortgage.  I find that buying real estate with cash is most sensible option for me now.  Being in my situation back then, OPM was my only choice.

I feel like the main reason I didn't fail was because the houses I purchased were cheap, and never lost value during the declining housing market.  Imagine the others who tried what I did, who were stuck with huge house payments, taxes and declining house values...  From now on if I don't have the cash for it, I wont buy it.  With leverage out of the picture, risks decrease and rewards increase.  This is always a good thing for investors!

Disclaimer: I am not a financial planner, advisor, or accountant. The financial actions mentioned were only suited for my own risk tolerance, strategy, and ideas. Copying another's financial moves can lead to large losses. Each person needs to do their due diligence in researching and planning their own actions in the financial markets.

Rental Property - Ranch House 1

Description:  3 bed, 1 bath, roughly 1600 square feet, 1 acre.

Major work completed:
100% floor tiled.
Interior repainted.


Financial Information:
Estimated monthly cash-flow: $74.74
Disclaimer: I am not a financial planner, advisor, or accountant. The financial actions mentioned were only suited for my own risk tolerance, strategy, and ideas. Copying another's financial moves can lead to large losses. Each person needs to do their due diligence in researching and planning their own actions in the financial markets.

To protect the tenants and their identities, this is only a visual representation of the rental property, not the actual home itself.

Rental Property - Victorian house 1

This property was purchased before the beginning of this blog.  It is a beautiful Victorian home located downtown.

Description:  2 bed, 1 bath, roughly 1650 square feet, 0.6 acres.

Major work completed:
25% floor tiled.
Driveway repaired.
Exterior repainted.
Rear ramp repaired.
Hot water pipes replaced.

Financial Information:
Estimated monthly cash-flow: $251.43
Disclaimer: I am not a financial planner, advisor, or accountant. The financial actions mentioned were only suited for my own risk tolerance, strategy, and ideas. Copying another's financial moves can lead to large losses. Each person needs to do their due diligence in researching and planning their own actions in the financial markets.

To protect the tenants and their identities, this is only a visual representation of the rental property, not the actual home itself.

Real Estate Portfolio Introduction

Real estate should play a key role in everyone's portfolio.  Personally, I have had good luck with rental homes in my real estate portfolio.  Yes there are horror stories out there about evil tenants and destruction etc.  But there are ways to minimize risk in rental investments that I will get to later in this section of the blog.

Statistically, the average person's largest investment is their house.  As time goes on, this trend appears to be declining, as more choose to rent instead of own.

There are 2 points I would like my readers to know.  1-Real estate offers great diversity to your portfolio and 2-With the current tax code, there are many benefits to real estate ownership that you can take advantage of.  These will be addressed in the future.