Losing Faith In The Formulas

General Real Estate Investing
1

I’m beginning to lose faith in some of the various formulas that are discussed. To follow them as a landlord in my area, I’d have to purchase homes at a 60% discount and would then have to charge almost double what the area homes currently rent for. The numbers just don’t jive. Sure, great fixer-upper deals come along, but consistantly being able to meet some of these formulas just doesn’t seem realistic.

It seems to me that some of these formulas can’t be applied to every local for various reasons. Also, different people may have different goals. If REI is the only income coming in, then of course adequate positive cash flows will be needed and will require every deal to be purchased at huge discounts. If however, REI is simply to supplement a future retirement income, then I can understand having a strategy with more emhasis on appreciation with renter-paid equity that can be cashed-in on one day (free house!). There are also tax advantages to consider, as they can be applied to personal income.

Also, I have a relative who has had rental homes in my area for the last 20 - 25 years. He told me that he allows about 2 months rent per year per house for all of his expenses, including vacancies. He currently has 12 SFH’s. He didn’t even follow the leveraging theories. He paid them off as he went along. After the first one or two were paid-off, they paid for the rest. He hasn’t owed on any of them for many years. Even though he’s had a few bum renters along the way, his approach has been very successful for him. That’s real-world experience.

I believe that if one were to purchase property in the “bad areas” of town that homes could indeed be bought at these HUGE discounts. The rent ratios would probably also be MUCH higher, especially if little rehab were done or if HUD is involved. The formulas would be satisfied. However, I don’t want to be a slumloard. I want nicer, single-family homes that are median priced, maybe slightly below. I realize that this will not guarantee better renters, but I think it would definetely increase the chances, and the homes would appreciate at a faster rate. It is also likely that this different pool of renters would also have a different mentality (working for a living and not lawsuit prone). Also, I would expect maintenance to be lower with nicer homes that have been rehabbed properly. These things sould lower expenses significantly.

OK. Let the volley begin!

2

Which formulas specifically?

3

Frankly, I love the cookie-cutter formulas that many rookies use in my area because they allow me to get deals that they underbid on.

I do agree with you, though, that if you are steadfast that you have to buy properties for 60% and 70% of their ARVs (less fixup costs), you will not have all that many properties available to you, especially if you are in a competitive market.

I tend to focus my business on “pretty houses” and I am a plain-Jane fixup-then-retail investor. I buy nice houses in nice areas, so I take less risk than someone buying a burned out house in a “gentrifying” neighborhood. Also, I put next to none of my own cash in all of my deals, so when I am looking at return on equity, my number is infinite.

As a result, I can afford to pay 80% of a house’s true ARV (less fixup) and still make a 10% net profit. For me, that’s great. My last deal was a house that will retail for $210K easily. I put $20K into it. I paid $147K for it, which is almost 80% of the ARV less fixup. The “guru” books will say that’s too much, but I’ll clear $20K at least, and I didn’t do any of the work myself, and I borrowed 100% of the money.

I know this is not an apples-to-apples discussion because you’re talking about buying and holding, but the point is the same in that each of us needs to use specific formulas that work for our business philosophy, our market, and our long-term strategy.

4

Paul,

You seem to be going for quantity rather than quality. That is mandatory if your buying properties at 80% of the ARV (less renovation). 20k net profit to me, is a risky deal, as all properties with a slim profit margin are. Buying a burned out house in a gentrifying neighborhood with a potential profit of 85k is must safer to me. In this situation I can do 1 property, and you’ll have to do 4. If you really did a detailed analysis you will find that doing 1 quality deal greatly outweighs 4 quantity deals in terms of risk, cost, time, etc. You’d be paying points, fees and interest on 4 separate 100% loans vs. one 100% loan. There’s also 4 times as many closing costs, 4 times as much carrying costs, 4 times as many agent commissions, etc.

Also, the closer a property gets to the tear down level, the profit margins get disproportionately larger as the price is more drastically reduced. A property that needs new carpet and fresh paint, will usually be discounted the price to put in new carpet and fresh paint (No profit). A property that needs an electrical heavy-up, HVAC, plumbing, a new roof, siding, etc. is hard to quantify in terms of a discount, so it’s greatly reduced to the point where you can do the required fix ups and sell it for a profit.

If you are talking about doing small cosmetic rehabs and rookies trying to buy at 60-70% of the ARV, they are crazy. The worse condition a property is in, the discounts become exponentially greater. That could even mean your paying “as-is” market value and still make a profit because the ones in bad condition are that much less desireable.

Your property:
ARV: 210k
Acquisition: -147K
Renovation: -20k
Cost of capital: -8%? of Aquisition+ Renovation
Realtor commisions: -6%? of ARV
Closing costs: 5k?
Carrying costs: 3,500?
Income taxes: @ 40+% of net

By my numbers (using a lot of probable numbers) your total expenses are $196,460, which leaves you a net before taxes of $13,540, assuming no price reductions. After taxes you’d clear less than $8,124.

You may of included some of these expenses in with your numbers or might not have them because your selling it FSBO. But you can see using probable numbers (that may or may not apply to you), why slim deals are dangerous territory to be in. It’s much better to not do a deal than it is to lose money on one. I always tell people to not settle on a marginal deal just because they get tired of looking for a good one.

5

Everyone has to do what makes them comfortable. I am not comfortable taking on a project that needs that much work. I would rather take a lower-margin deal in a nice neighborhood that needs paint, carpet, and appliances and feel that my budget is 100% rock-solid as is my target profit.

For example, in the house you detailed, the reality is that my ARV will be $225K or better. In addition, my sales commission will only be 3% (for the buyer’s agent) as I will sell it myself (fast-moving neighborhood).

So, net-net, I am making a minimum of $25K on this deal, and again, all I’ve done is move paperwork around and put my regular contractor on the job. It has not been very management-intense.

To me, this is also a “quality” deal as it’s a beautiful house in a really nice subdivision.

I can do 10-12 deals like this over a year without too much more in the way of marketing, and I like these kinds of deals very much. My margin is smaller, yes, but in my view, so is my potential downside or fear that something will go horribly wrong.

Perhaps as I get more experience (only been doing this since May 2006), I will work on projects that need more work and aim for a higher dollar return per deal.

6

Whatever floats your boat!

When I was talking about quality vs. quantity I meant in terms of the bottom line, not physical properties. I’d rather be rehabbng in nice areas to. If your in a nice area and find the one and only boarded-up mess of a property, you might find gold hidden in it.

My margin is smaller, yes, but in my view, so is my potential downside or fear that something will go horribly wrong.
My fear would be of small margins and the potential downside of losing money. Biggger profit margins = room for error.

P.S.- What is your actual cost of capital?

7

I’m in the Northeast. Rents don’t come anywhere near paying the monthly cost of a single family home up here. That is telling you something. The market here has still got a ways to fall before things get back to normal and fall they will. Right now, in Providence, we have at least 8 high rise condo projects going. There is no way these things are going to sell is this enviroment, already seeing the auction business pick up on unfinished projects. The problem is no one is showing up to bid.
In my opinion add to your cash postions and wait a little bit longer. Right now the subprime mortgage default rates are going into the stratosphere. Just wait, I’ve seen this movie before. As a famous Wall Street investor once said “I buy when the blood is running in the streets” Stay tuned?

8
As a famous Wall Street investor once said "I buy when the blood is running in the streets"
Didn't Rockefeller say that? Wouldn't surprise me if a Wallstreet investor stole the quote...
9

Why not just go where the deals are? if its cash flow your looking for, there are plenty of deals out there that will cash flow for you. The “trick” is to have a competent managment team, and always get your own appraisal “as is” remember, your not doing rehabs.

10

stejpn,
I can tell you why I don’t just go anywhere that cashflows…When RE is a secondary income we as investors have to rely on property managers…And I can tell you it’s easier picking the next Microsoft than finding someone in another state that will earn you money minus the headache…I have spoken to landlords who I’m purchasing a property from and they will flat out tell me if your going to hire a property manager you won’t make money…I would love nothing more than to own 15-20 SFH anywhere that cashflow for using a property manager,it’s a dream at best for me so far…And I have zero intention of moving to a region that cashflows(Rochester,Buffalo,Upstate NY in general) and make chasing tenants my occupation…I rather watch paint dry…

petefa,
I live in NYC/the 5 boroughs and I can tell you prices are coming down slightly but I don’t expect the floor to cave in the nicer areas…If you are talking about lower income regions then I agree…Those are the higher foreclosure numbers always but there is simply too much money around…Wall street is handing out money faster than it can be printed to everyone from the cleaning guy to the top traders…This money filters back and I for one would love to buy a NNN property at a %40 discount, I just don’t see that happening…To the contrary of what Wall street thinks I just don’t see a total collapse in the RE market coming,a healthy pullback yes but blood in the streets no way…At least not in the areas I would want.

11

I will agree that finding a good managment team is not the easiest thing in the world, but take my word for it there are good ones out there.

You find what you focus on. Its really just that simple. Can’t tell you how many times I heard realtors tell me I can’t find homes at <60% FMV in Phoenix last year, yet we did about 13 of them. Others tell me you can’t find cash flow properties with terms, yet we sell them all the time.

My point is if you focus on finding the right managment and you buy at the right price you will cashflow. I also promise you that its much easier than finding the next microsoft. Just don’t be a pushover. Focus on finding boneheads and thats exactly what you will find.

I realise this reply is somewhat philosophical, but its true. You follow a “formula” so you might as well follow one that works. Your frustration comes from the fact that even if you managed to “steal” a rental in NYC it probably wouldn’t cash flow for you. But look around the country, you will find cash flow properties that will still cash flow with property managment in place.

12

LandBaron,

Stjepah is absolutely right. The formulas work is all markets, however that is completely different than saying that good rental properties are easy to find in every market. In fact, I would go so far as to say that good deals are hard to find in almost all markets.

The formulas that I frequently talk about are simply mathmatical equations that can be used to ensure that you will make a profit - which is the entire point of owning a business.

You seem to be saying in your post that it’s necessary to have a profit if you’re doing this full time, but not if you’re only doing this for retirement. That is true. In fact, if you’ve got enough money to keep pumping into the business, it is fine if you want to take even a huge loss each month. However, my goal is not to lose money but rather to make it!

Will the tax depreciation and appreciation of the property offset the monthly loss of cash flow? You will have to run the numbers and hope that your assumptions of appreciation are correct. I found out long ago that hoping and guessing are not good ways to run a successful business.

What you’re talking about is more of a forced retirement plan, where you put money into your properties each month in hopes of having some money down the road. Is there anything wrong with this approach? No. Would you simply be better off putting your money in a bank CD or money market account? That depends on the numbers.

In the end, the only thing that really matters is whether you are satisfied with the results you get. If you are happy losing money each month, than who am I or anyone else to say that your approach is wrong?

Mike

13

I wouldn’t go into a deal where I actually thought that I would be losing money each month with the hope of appreciation being on the far end to bail me out.

I’m talking about a scenerio with low cash flow. After adding in annual tax savings against a full-time job income, it might add a bit more. I’m also just acknowledging that buying the right home, at the right price, in the right area will likely provide appreciation over time with both initial and renter-paid equity that can be cashed-in on at some point.

When it is suggested that we use 50% of gross rents for expenses, very negative things like major damage, lawsuits, court costs, eviction costs, etc. are stressed while seemingly assuming that they are normal and common occurances that every landlord can expect to have with regularity with each piece of property. I understand planning for the worst, but are these types of events really that common for a guy renting out a few median-priced SFH’s in a small town? I wonder if these costs and headaches are in proportion to the quality of the home, to the type of neighborhood that the home is in, and to the pool of renters that it’s targeting.

I’m also considering my relative’s 20 - 25 year experience as a landlord of several SFH’s in my area. His expenses are nowhere near 50%. By his calculations, over the years, they run about 20 - 25%. He manages them himself. Does most of his own repairs, but at times pays for labor on larger projects. Also, maybe a small town is just a kinder, gentler place.

I’m just suggesting that realities could vary greatly. On one hand, there could be a guy with a few nice SFH’s to supplement his retirement and on the other hand, there could be a guy who is in debt up to his eyeballs (leveraged) and trying to squeeze out every bit of cash flow that he can from a run-down apartment building in the slums. I figure that each scenerio, at opposite ends of the spectrum, would yield different experiences.

I’m trying to learn, and appreciate all the info that the experienced investors are providing. I’m digesting.

14

Hi Land Baron,

Operating expenses in residential properties are not ALWAYS 50% of the gross rent. I only own 2 apartment buildings, so I’m not the most landlord experienced of investors. However, the operating expenses in both buildings are near 50%, one is about 41% the other is about 43%. I have an in-house property management company with several full time handymen so I save from paying out profit to an outside company. Both buildings I want to get rid of ASAP because of the excessive management and high operating expenses relative to other commercial buildings.

Your relative might not be counting a lot of his expenses because of such a small portfolio of 12 units. I’m also not quite sure how his calculations of allowing 2 months of rents to pay for ALL the expenses equal 20-25%. Property management for SFHs is usually 8-12% for an outside company, so he’s “saving” there. Also, maintenance in my newly renovated apartment buildings run about 4-5% of the gross income. So your relative might appear to be “saving” 17% on his operating expenses. If he were paying someone else to do it or paying himself as he should be, operating expenses would be about 42%. Doing it yourself doesn’t save from expenses, it creates “phatom expenses”. It’s a lot like taking money from your left pocket and putting it in your right pocket. Money still changes hands, even if both hands are yours.

15

Thanks for the input DannyTheGreat,

If we’re considering “phantom expenses”, then it makes more since to me that the total expense percentage could be a higher number. I understand that my time is worth something even though money isn’t technically leaving the rental money in my right pocket and jumping over into the personal money in my left pocket. However, if painting every few years or changing a lockset ever year or so is keeping that much money “in” my pockets, I’ll call it good.

Seems to me that counting things that I do myself as an expense because I could have paid someone else to do it is a big ol’ gray area. For example, If I spend 10 minutes shooting down a side street on my way back from the mall to see if any homes are for sale, I’m not really going to consider that an exspense that I didn’t technically count, just because I could have had someone on the payroll to scout properties for me.

I understand what you’e saying, though. Time is money. Even my time.

16

Land Baron,

I think that you have a better understanding now. Danny gave a very good explanation. The 45% to 50% range that I always talk about includes ALL the operating expenses including paid management and paid maintenance plus all the other expenses I listed. I’ve posted this dozens of times in the past, but you must not have seen these posts. You now also see why I do all the management myself and almost all the maintenance myself - because I EARN back 15% to 20% of the gross rents.

When it is suggested that we use 50% of gross rents for expenses, very negative things like major damage, lawsuits, court costs, eviction costs, etc. are stressed while seemingly assuming that they are normal and common occurances that every landlord can expect to have with regularity with each piece of property.

ALL of these bad things ARE NORMAL and COMMON occurrances, although they are fairly rare. As I’ve explained dozens of times in the past, just because they are rare doesn’t make them irrelevant. THIS IS A HUGE MISTAKE THAT NEWBIES MAKE. If you only have a few rentals, you could literally go many years without one of these incidents. It is also true that you could have one or more of these things happen the very first month that you operate your one and only rental. I have met many landlords that have had only one or two rentals and had terrible things happen. It is random. There is no way to predict when you will have a tenant go bad (assuming that you’ve done a proper screening)

Even with dozens of rentals, I have not had a lawsuit yet (although we have a very near miss this summer which was saved only due to the entity structuring I use). I also have not had a tenant do huge damage yet, although I have had damage in excess of $2,000 twice. A friend of mine had over $10,000 of damage done to one of her rentals this summer. What you don’t WANT to understand or believe is that when these things do happen, they can literally wipe away YEARS of profit for any given unit! When you intentionally or inadvertently operate your business at a break even or loss instead of a profit, you have no profit to offset these expenses.

Do these bad things only happen in low income apartment buildings? NO! Unfortunately, they also happen in nice middle class rentals. In fact, although I have tenant related issues more often in my low income buildings, the 2 worst instances of damage that I have had were both in nicer SFHs. One was a Registered Nurse that I rented to. She allowed a friend to deal drugs from the house. The police used a battering ram on the front door; shot a concussion grenade into the house which burned a 3 foot hole in the brand new carpet; knocked a BUNCH of holes in the walls; pulled fixtures from the ceilings and walls, etc. The other was a slob of a woman who had 2 absolutely destructive kids. She was able to not only do a lot of destruction but to attract about 10,000 roaches in a very short period of time. Both of these tenants had been thoroughly screened.

Seems to me that counting things that I do myself as an expense because I could have paid someone else to do it is a big ol' gray area.

It may seem like a gray area to you, but it doesn’t to me. When I spent a couple of hours of my time working on a toilet the other day (with 2 trips to town for parts), that seemed real to me. The parts cost real money and my truck was burning real gas. I was doing real work - the same work that I would have paid someone else to do it. Gray? Not to me.

Again, I don’t care how you choose to set up your new business. Those of us who are experienced have only offered these formulas so that the new investors can see the realities of operating rental properties without having to learn the hard way. You can follow them or not at your discretion.

Merry Christmas!

Mike

17

propertymanager,

Thanks again for taking the time to share your experiences and to try to explain things to a hard-headed newbie.

I really want to get into real estate investing, and I’m the type of person who researches things thoroughly. Sometimes the “paralysis by analysis” thing gets me, but that’s why I’m spending so much time on the forum. Trying to understand all that I can.

My biggest concern at this point is that it is going to be VERY difficult to come across deals in my area that will meet your criteria and include adequate cash flow, especially if I want to keep my own money out of it by financing. I hate to think that it’s all or nothing.

One more question. When you include taxes in your list of expenses, are you including any taxes on income or profits or are you just talking about property taxes.

Thanks.

18

It is always difficult to find these deals. It requires real work.

Operating expenses include property taxes and other taxes related to operations. They do not include taxes on profit.

Merry Christmas,

Mike

19

Hi Landbaron, I too cannot invest in the area I live and make a positive cash flow without putting down over 100k on most properties. To me that just doesnt make sense. I invest out of my area and I do use a property manager. When you invest out of your area it is al about establishing good relationships with honest people. If you do do it get references, ask others how they go about their business. There is also an acredited association for property managers. You can find one in your area by going to irem.org In all reality I wish I could manage my own property but I do not want to move from where I am so I use a property manager and include that in my expenses. My goal was to build a large passive cash flow through rental properties so I had to go where there was cash flow to be found. I do not count on appreciation and if my properties never appreciate at all it does not matter to me because I am making money now not counting on it later. If I buy a property for 30k and can rent it for 1k per month then its safe to say that I will make a monthly cash flow on it. I need to do it and repeat multiple times of course and there are definitely headaches involved when you are not living in the area you are investing. I actually think it takes more work but to me its worth it. Just make sure when you do it you run those real world numbers and make sure they work for you because the numbers do not lie.

20

DWJ hit the head on the nail. I get many people asking me for cash flow rentals in Phoenix and they just don’t understand that while I can get them rentals in Phoenix, the prices vs the rents are just too high for cash flow unless they are putting down a considerable down payment.

When I explain to them that they are looking in the wrong area(s) they tell me that their coach/course told them not to invest in other areas! What most of them wind up being are frustrated wannabes. For some reason most of them think this is a risk free, stress free business. Follow DWJ’s advice and you should be on your way to some cash flow properties in no time.