Ah, real estate investing. What an exciting world that can make an average Joe into a Mr. FIREescape. BUT. Buying a house is not as simple as buying a stock or two. The returns can be huge, but only if you buy a good house.
So after buying a pile of houses over almost a decade, these are the rules I’ve made for myself, and the official Mr.FIREescape guide to rental properties.
See all the FiveYearFIREescape Real Estate Posts
0. First, Consider the Alternatives.
Full disclosure, owning real estate has been my secret sauce to building wealth and early retirement. Sure, it’s been a headache sometimes, but this is the path I’ve chosen and I’m sticking with it.
That said, when I started almost ten years ago, a lot of the modern real estate investing options just didn’t exist.
Case in point crowdfunded real estate (or eREITs.) This is where you invest in a company that uses your money to invest in large-scale rental properties and pays you as you go along.
If these were around when I first started, they would have wildly changed my portfolio and FIRE strategy, and if you like the concept of investing in real estate but don’t think you’re up for it just yet, definitely consider the eREIT route.
1. Buy In Cities With Population Growth.
It doesn’t have to be the fastest growing city in the country, but the trend needs to go up, not down.
Real estate is meant to be long term. You’re buying it and holding on forever. If the population is growing, you’re only more likely to find tenants who need a home. (The opposite is also true, and you don’t want to be stuck with a rental in a place nobody wants to live.)
By the way, don’t stress over buying into “the fastest growing” city. That would be nice, but it would also mean that the property values may already be out of reach. This is why I only focus on long-distance real estate. My city is crazy!
2. Location Location Location?
Don’t stress about buying into the hottest neighborhood. Yes it’s nice and all, but all that really matters is the vacancy rate. If the vacancy rate is under 5%, you’re golden.
You can find this information with a little help from the internet, but your best bet is to connect with a realtor or a property manager who specializes in that area. Specifically, you need to ask them what is the turnaround time for a vacancy, and they better be able to answer.
Read more about Long-Distance Real Estate
Having a vacant house sucks and makes planning very difficult. It gets worse if you bought an expensive house, say something that rents for $3000/month, because missing out on even one-month’s rent leaves a huge dent in your bottom line. That said…
3. Don’t Go Cheap.
This comes from experience. I won’t ever look at a house that goes for under $850/month in rent, and for the most part, try to stay above $1000/month.
I’ve made the mistake of buying a cheap house before, and never again.
Low-priced houses look very attractive because of the numbers. The cap ratio (the ratio between the rent income and the cost of the house) looks amazing. It’s like 20%/year in returns! But it’s a trick.
Repair costs don’t shrink with the cost of the house. I have one house that makes $750/month in rent. If the toilet breaks, that’s 300 bucks. Factor in all the other expenses like taxes and fees, and I have a month with no profit.. Stack up enough repairs, and you might even have a net-loss year. That sucks.
I’ve had one house with zero profit for over 3 years. True story. That house was cheap, but I hated it every moment until I sold it. I have another house that brings in $3400/month. A broken toilet doesn’t affect the bottom line all that much and it makes financial planning much easier.
If you’re a general cheapo like me, you’ll be tempted to buy a cheap house because the numbers look good, but don’t do it.
4. More Expansive = More Lucrative.
So we just covered that cheap houses aren’t great for returns, but what about expensive ones? Well, with higher-priced homes everything just works out better in your favor.
I bought a $525K house and here’s how it’s working out:
- The downpayment was $85K
- The rental income nets $3400/month
- It appreciates around 7%/year
That’s almost 50%/year return on my investment!
If you buy a house for over $500K. You’ll have thousands of dollars per month in income for a relatively small down payment. That’s mortgage magic! Plus, pricier homes in swankier areas appreciate more.
5. Don’t Buy Cashflow-Negative Houses.
This might sound like obvious advice, but cash flow-negative houses are more common than you’d think. In expensive cities investors are happy to rent houses out at a loss, because they’ll make more money on the crazy appreciation. So it’s not exactly a losing situation.
BUT. If you’re losing money month-to-month, it creates a real limit on your investing future. You HAVE TO bank on your house appreciating, which makes any kind of recession super-scary. Not only that, at some point with negative cash flow you can’t buy more houses. So if an awesome deal pops up, you have to make some difficult choices.
You could have an infinite number of zero-cash flow houses (meaning your expenses balance out your income.) But if you lose even a hundred bucks a month to your house on a regular basis, you’ll reach a point where you won’t want to support it anymore.
6. Consider ALL the fees.
Before buying a house, understand ALL the fees that are involved, and then some. What does that mean?
- Repairs. Always assume there will be some major repairs every year. (I factor in about $3K/yr forever for every house I buy.)
- Property manager. Property managers generally charge 10% of rental income, (maybe 5% for pricier homes) and might charge extra for arranging repairs. Factor this in unless you want to be stuck managing the house forever.
- Vacancies. People forget about this pesky little nuisance. But if there’s a turnover, not only are you not getting rent, you have to pay to fix up the house before the new tenant. I bake in about 1 vacant month per year into my calculations. I actually have almost zero turnover, but you don’t want to go the wrong way when you’re making your decision.
- Property tax. Depending on where you buy, property tax can be a gigantic expense. Do your research.
Read my property management software reviews.
7. Your Job Income Should Cover the Expenses.
Yes, in an ideal world what you want is for your rental income to cover all your property expenses. But you’ll have way more peace of mind knowing that you can handle that house with just your job income in case something bad happens. And yes, bad things can happen.
I make sure that I can handle my most expensive house making absolutely no rent. That’s never happened, but I don’t want to lose my shirt if something goes wrong. This is an extreme backup plan, but I don’t want to have to worry about it.
If your income can’t support owning the investment property, and you’re counting on your rental income paying for it right away – you’re not ready to buy that house.
8. Start Big.
Sometimes when we’re trying something new, we tend to want to ease into it. Dip our toe with something small and then work our way up.
For sure, don’t bite off more than you can chew, but as long as you’re following my rules, go with the most expensive house you can handle. From experience, the returns are better with one expensive home than five cheap ones. Plus, having a bunch of cheap ones just means more mental work. No thanks.
If you want to ramp up your learning curve, instead of starting with a tiny house with a tiny income, try this:
- Create a free account with Roofstock – which specializes in selling rental homes. I’m not crazy about buying from them (I outline why in my review,) but it will definitely give you a great idea of numbers.
- Create a free account with Crowdstreet – it’s a crowdfunding real estate company. They’ll send you the rental properties you could invest in, so you can start getting a feel for what’s a good investment.