There was an advanced discussion in our highly popular post on passive income. We’ve taken it and organized the content into a readable blog post (thank you to all the commenters “ownmyhood”, “Nixon”, “RE Guy”, “YM” for creating this idea). In addition to adding highly valued comments, we have vetted a few of the named individuals to confirm they are millionaires from the real estate game (ambiguity for double protection of their identities!). As many are aware we prefer the online route, but lets get started on this path.
Step by Step to Making Big Money in Real Estate
There are a lot of books on real estate investing out there, problem is most are terrible (and written by get rich quick gurus rather than people who have been there). If anyone’s actually interested here is an 8 step process to get started in real estate that actually works:
Step One – No Need for College: Skip college and go to a technology school for a building trade, preferably the one that pays the most in your area (plumber, electrician etc).
Step Two – Become a Contractor: Get a job with a reputable contractor in your field, preferably someone who offers overtime opportunities. Work as many hours as possible, learn all you can and get licensed as quickly as possible. Make friends with other tradespeople on job sites, preferably the more intelligent, young, hungry ones (these can be tough to find). Save every penny you can.
Step Three – Location, Location, Location: Locate an area that is run down, but shows some signs of turning around. Meaning multifamily buildings for sale that bring in double digit cap rates are common enough to where as there might be a few listed on the MLS and the population of the immediate area (or least the surrounding area) is not decreasing and preferably growing. Also, being within commuting distance to a desirable downtown area helps a lot.
There is quite a bit more than this when locating a suitable area, but there are some things that must be left out for others to figure out (notice no one gives away their business, otherwise they would be out of it!). If this area is local, good for you, if not, time to pack up and move. There are a lot of places where you can buy double digit caps all day that aren’t total war-zones. You don’t want rodeo drive (entry cost too high/tough to make money) but make sure it isn’t a demilitarized zone either.
– Investor Note – RE Guy: You can call these run down areas with signs of turning around “the borderlands” because they normally are on the border between a garbage area and a nice area. You shouldn’t count on anyone giving away all their trade secrets, especially not for free, especially not on a public blog, the same way this blog won’t give you specific stock picks or exactly the products they market online. However, all these resources combined make a great starting point for anyone looking to get into real estate, so if it is something you’d like to do, after us giving all this information in one place, you have no excuse not to start!
Step Four – “Campaigning” (no different than affiliate marketing): After locating the right area, use the MLS, targeted mailings, call campaign (anything else!) to locate a building with potential for a double digit cap and an owner willing to sell. Bonus points if they are willing to hold paper. Remember these properties are rarely pretty, be prepared to deal with some rough tenants and buildings. If either of these scare you, stop reading now.
– Investor Note – RE Guy: He’s currently setting up a deal with a single digit cap on a multi that will convert into a double digit cap, based on the purchase price and what he put into it for the renovation and subsequent higher rental income. Not based off it’s “true” cap, it’s new after rehabbed value which he believes will remain single cap. Cap is more tied to the general area than the building, it’s more “how risky is it to rent properties in this neighborhood” or “what quality or income level of tenant will possibly be attracted here” and cap will generally decrease as the quality of tenant increases (it’s less risky to rent to a doctor than a bus driver, and the market recognizes this and makes doctor friendly buildings more expensive than bus driver friendly buildings, relative to cash flow). Currently the owner is warming up to the idea of holding paper.
Step Five – Cash Flow Positive: Buy the building using a method that allows for at least some cash flow after all expenses (lenders don’t like negative cash flow). Meet the tenants, keep the decent ones, immediately evict the bad ones, raise all rents to market rates if they are not already (if you lose sleep over raising ol’ miss McGillicudy’s rent $50 per month or start shaking in your shoes when you realize you have to hand Chopper the Hells Angel an eviction notice, this ain’t your gig). Renovate the lousy units into nice apartments using low cost but durable materials. You’re not going for a luxury penthouse, just a nice clean apartment. Now is the time to call your buddies you met on the job to help you or at least learn enough to be proficient at a few other activities. Hanging drywall, painting, basic carpentry can be learned by anyone who’s willing to put in a little time.
Investor Note – RE Guy: Decide ahead of time what the rules are and enforce them. Make them firm and strongly in YOUR favor. Add to that a moderate dose of pragmatic compassion; evictions are an expensive proposition and you may need to decide between a small and large loss. Make the decision to evict more on something like the person not answering phone calls than on them not being able to pay for a week or two IF there is an agreed upon payment plan that you believe they will stick to. If you conduct yourself ethically, you will have no problems with evictions.
Step Six – Learn from Competitors: Learn how local apartments are advertised, list your vacancies, learn how to take nice pictures and write coherent, appealing descriptions. Price them right, don’t overprice or they will sit vacant and carrying costs will eat up any profit. And most importantly SCREEN YOUR TENANTS THOROUGHLY. Nice people will rarely tolerate living next door to dirtbags for any length of time.
Investor Note – RE Guy: If you get too few phone calls you know it’s priced too high, too many and it’s priced too low (art that turns into a science over time). Know your market, know the seasonal variance, know what to expect as reasonable so you can adjust accordingly. Sometimes trying to squeeze every dollar out of a place leads to having to compromise on the quality of the tenant… and that knowing this is also knowing what is a good tenant for that particular neighborhood.
Step Seven – To be the Best, Never Settle Like the Rest: Alright, you’ve got one building cash-flowing, good work. Time to sit back and let the rent checks fill up your bank account right? Wrong. Visit the property often, pick up litter, respond to maintenance calls promptly, evict non-payers and troublemakers and ALWAYS PAY ALL OF YOUR BILLS ON TIME. Credit will *make or break you* in this game.
Step – Eight Wash Rinse and Repeat: Now just repeat steps 4 through 7 over and over and over…
–When you are starting out, nothing is beneath you: Unclog toilets, keep your own books, do apartment showings, represent yourself in court. Learn these things now so you can teach and competently evaluate others to do them for you later.
–Don’t let emotions get the best of you. From buying a property to resolving tenant disputes emotions run high in the real estate world. Dealing with a stubborn moron who you want to purchase a building from? Be nice. Handing a tenant an eviction notice? Be nice. Nothing to be gained from losing your cool.
–Keep in touch with people that matter. RE agent points you toward a good deal? Keep in touch. A seller holds paper for you? Keep his contact info and reach out to him later if you need a reference. A bank loan officer mentions they have some foreclosures in the works? Call him in a few weeks and see how their coming along. All pretty obvious stuff if you read this blog. The moneys out there, if you want it, it’s yours.
– Income Property Debate: Opinion one: Don’t be the guy who buys a duplex in order to “live in one unit and let the other unit pay my mortgage” as a side hustle. If you’re going to get into this game plan on going big or not wasting your time (scale remember). Real estate is a complex endeavor that involves quite a few areas of expertise (sales, advertising, legal, building trades, tax accounting etc). You don’t have to be a master of all of them, but must be at least competent enough to judge whether someone else who you’re paying is doing a good job. Learning all this takes a lot of time and doing so just to “pay your mortgage” is foolish. Opinion two: If you buy it well enough to much more than cover the mortgage (which is a standard you should absolutely set for yourself) it is possible. In addition, you can go up to 4 units of pure residential while still qualifying for residential mortgages.
The main point of ownmyhood that I agree with 100% is not just buying a property to pay your mortgage, but buying a place to live in it and have it as an investment can be done all sorts of ways (including renting rooms, always legal if you live there to my knowledge a.k.a. Airbnb before there was an Airbnb), and for those who are really strapped for cash, that means you can even get a single FHA loan for a few % down.
How To Manage Once You Get the Hang of It
Once you’ve got the hang of it there is potential to see cash on cash returns of *at least* 10-20%, with minimal work (relatively speaking). If you don’t want to manage tenants you don’t want success bad enough (Real estate being your chosen path to riches). If this is the mindset someone has to be successful… well it is the most common red flag example. The second most common red flag? Are you willing to spend your Saturday checking out and analyzing deals rather than watching sports from 12pm to 12am? No? You don’t want it bad enough.
Back to dealing with tenants…hire a property manager. Yes you will pay money for the service and it will hurt your returns, but if you buy a property correctly you will be able to afford it and still make plenty of money. Average rent per month on units can come in around $800 and managers typically charge between 5-10% depending on your scale. If you’re just starting out and paying $80 ($800/rent x 10% mgmt. fee), that’s the best $80 you’ll ever spend because you don’t have to deal with tenants, contractors, or accounting. As a note, don’t choose a property manager solely based on the management fee. You can find a manager for 6% ($48/month in my example vs $80) and save a few bucks, but the wrong property manager can cost you *much more* than that in excess repairs or lost income. Find a manager who is going to look out for your best interests as an investor, not just someone looking to increase their revenue.
Deal Example – Nixon: Here’s the deal he’s working on today. 16 units priced around a 10% cap rate for $500K (that means around $50K of cash flow a year *after* paying a manager, but before debt service). The lending terms he went with on the last deal was 75% LTV at 4.5% using 25 year. That would cost about $25K of debt service a year on this deal, leaving $25K of the original $50K cash flow. He’d put up $125K of equity and end up with a 20% cash on cash return on a semi-passive basis.
Investor Note – ownmyhood: In most cases would recommend training and hiring your own property manager over a paying a management company. While the short term costs in time and money may be greater (training, setting them up with office, tools etc), in the long term you’re not going to pay for someone else’s overhead and the needs of your tenants/buildings will always take preference.
Basic Real Estate
You throw money at the property and hand the keys over to someone else to deal with it. This is not a risk-free situation given 1) potential debt load, 2) trust in property manager, 3) interest rate environment and 4) any one time hazard/maintenance issue that kills your yield for the year. We peg a solid return at somewhere around 6-9%. This includes a management company eating into your yield and of course the natural reserve fund for any maintenance issues.
Another option is working through a private equity firm such as a Blackstone, Lone Star or Brookfield. You’re locking up your money for a longer period of time (typically) but the returns should be notably higher as well (double digits). Now there is certainly a wide range of private equity transactions from low to extremely high risk… But. Locking the money up for longer periods of time is generally the theme here. Unless you’re in the Ultra Rich group, it’s one of your best bets to get exposure to commercial real estate (apartment buildings, offices etc.).
Bigger Pockets: Biggerpockets can be a good resource for beginners, and possibly if you have some good knowledge already a resource for looking deeper into specific topics. For example there is a thread there on construction of a full home from a lot. The issue with it is that it’s got a whole host of contributors of various levels of competency, different backgrounds, goals etc. It is easy to get confused or get misinformation in the form of biases you may not recognize as a beginner from there.
That said it is a a good beginner’s guide to real estate, because the person who wrote it called the system of “buy, renovate, rent, refinance”, he says “BRRR”, which he correctly stated was something many investors have been doing for a while and he was just creating an acronym for easy understanding. In other words, if you treat it as a summary of various concepts and a jumping off point for either further study or just to give you a basic framework to use while you go out and start taking action then it is good.
Of course, your best education is your first deal. A single deal is worth an additional 10k-20k because you’ll be getting your education out of it. Like as if you were paying a college for a semester of classes on real estate.
Example of Bias: There is a segment example where it discusses using someone to do certain repairs and spoke against it, while another contributor (who had many more units) said “I could see if you already have your portfolio and are just trying to maintain cash flow, then it is good, but if you want to keep building it, you’re better off paying someone to do it and looking for your next property.” Also, if you are just starting out and don’t have a background in the trades, it could also possibly be useful (this is another point of dispute among some people).
Basic REITs Exposure
A Real Estate Investment Trust is a company that owns and operates income producing real estate (yes there are other types like healthcare but we’ll keep it simple). While they do offer high yields (distributing 90% of earnings to shareholders), the REIT is exposed to 1) tax rate changes – you’re taxed based on your personal income bracket vs. dividend distribution rate, 2) reliance on debt, meaning more leverage is needed to boost returns, 3) real estate can be extremely location dependent and is prone to cycles just like we saw in 2008 and 4) since it’s an equity product and as a shareholder, we have to realize they can only re-invest 10% of net income since the rest is being distributed. Take a look at REITs and you’ll see they move around in ways un-related to the stock market.
Your best bet is to DCA into VNQ for REIT exposure (0.12% expense ratio as of this writing), although be mindful at the moment as REITs tend to underperform in a rising interest rate environment thanks to the bond-like income. Dividends will be taxed at your ordinary rate vs. qualified rate, but netting 66% of VNQ at 4.7% is higher than 85% of VYM at 2.8%. Check out PFF as well for another high yielding (5.7%) ETF that isn’t related to real estate