Investments in real estate have been quite lucrative for many people, but before you buy several properties to begin your own real estate empire, there is a lot to consider.
Expectations should be set because not all properties work the same way. For example, residential rental property has its own set of "pros and cons" just like commercial property has its own. Unfortunately, there are many misconceptions. For one, many people mistakenly buy single-family residential dwellings with the expectation they will be "cash cows" stuffing big denominations in their pockets each month, but they typically work more like "piggy banks" instead, creating a savings account of sorts in the form of equity.
How do I know this? As a banker, I've seen borrowers do this time-and-time again. Some are successful with the right mind-set from the start, while others learn and adjust along the way, eventually becoming successful too. Another group winds up selling everything at a loss to get rid of the problems they didn't anticipate.
In fact, that seems to be the key: setting good expectations.
To illustrate, let's work backward to find out what amount of rent charged per month will make you break-even at "one-to-one" debt service coverage after expenses. That is banker-speak for what amount of rental income will be enough to cover the monthly mortgage payment and other normal expenses with the only "profit" being some principal amount paid down on the property each month. (As you may already know, a portion of each mortgage payment is directed toward the interest due and the remaining amount toward paying down the principal of the loan.)
The median single-family residence in Linton is valued at approximately $50,000, according to the 2000 Census and another recent housing study conducted for the city in 2005. For this price, the property will most likely be a two-bedroom home with one bathroom and situated on one city lot. (If you'd like to view current homes on the market, you can go to http://www.realtor.com/ and enter the city and state or zip code to search.)
For simplicity, we will finance this hypothetical home with a bank that will loan 100% of the purchase price, assuming we made an excellent purchase and it appraises for more. (This is not likely now due to current nationwide credit crunch, but even if this isn't the case, shouldn't the investor make at least as much as a bank would for lending the money to the project? So, using this argument, we will use a 100% loan on the property.)
Using a 7.5% interest rate (non-owner occupied homes are typically higher interest than owner-occupied property) and an amortization period of 360 months, the monthly payment will be about $350. Again, for simplicity, we will assume the home will not need any remodeling or repairs and is immediately available to rent. (This is very unlikely, too, but we will keep everything simple.)
The property tax on the home should be "market-based" and we just paid $50,000 for it. Applying the 3.66% tax rate (2006 payable 2007 rate) for the City of Linton to the $50,000 assessed value, the annual property tax bill will be $1,830. (Remember: there is no homestead or mortgage exemption available for rental property, but the new property tax relief MAY help this figure to go down in the future. I say "may" because the caps placed on rental property in 2009 will be 2% of assessed value. Remember, though, that property taxes are not only based on the rate, but the assessed values, so assessed values could go up overall.)
Maintenance will run, say, $500 per year. This arbitrary figure will cover a variety of miscellaneous items, such as fixing holes in the walls, replacing light bulbs missing or burned out when the tenant leaves, fixing a leaky toilet from time-to-time, and covering any winter heating costs or summertime lawn mowing fees when the property is vacant.
For argument's sake, the property and casualty insurance will run about $400 per year, but of course this can be impacted by many things, such as credit scores, past losses, deductibles, etc.
We will use only one month of "vacancy" expense for the year. If you are unfamiliar with this term, "vacancy" is defined as the money lost due either to renters not paying us, paying us with bad checks that are never collectable, or the property is simply empty and not rented to anyone for a time. Sometimes this is referred to as "vacancy & collection" expense, which is probably more accurate.
At this point, you should be starting to realize that the check each month from the tenants -- if you even get it -- is far from pure profit. Even if the expenses thus far are covered, you may be actually paying for the renter to stay there in the long run if you are not careful because of yet another important consideration: reserves.
When we talk about "reserves" it means those "big-ticket" items that will need to be replaced in future years, such as the roof, floor coverings, HVAC system, and exterior that will eventually need new paint or siding. Inexperienced landlords often overlook this important consideration, which can be a very costly mistake for them when these items eventually fail. After all, even though they are not monthly outgoing expenses, there will come the day that they will need to be replaced. If money is not collected and set aside, where will the money come from to replace the roof or any other expensive repairs or replacements?
(The alternative is bad, too, if these items are not maintained because the overall appearance of the property goes downhill -- and so does the quality of renter -- leading to more vacancy and collections expenses. Think: slumlord.)
An estimate of some of these major items is shown below, showing the item, estimated useful life in years, estimated cost to replace based on size of example property, and annual allocation (which will be further divided down into a monthly allocation later):
Roof - 20 - $ 4,000 - $ 200
Exterior - 20 - $ 2,500 - $ 125
Floor Coverings - 10 - $ 3,000 - $ 300
HVAC System - 20 - $ 4,000 - $ 200
Other - 20 - $ 1,000 - $ 50
Total Annual Allocation => $ 875
Keep in mind, too, that these are only estimates, as there are a wide variety of materials, brands, service providers, etc.
Total everything mentioned above on a monthly basis, such as $350.00 mortgage payment + $152.50 property taxes + $41.67 maintenance expense + $33.33 insurance + $72.92 reserves + $59.17 vacancy expense, and you will need to charge $710 per month (rounded) to just cover the loan payments and other expenses!
The only "profit" in this example besides the $10 (shown below) would be the principal that is paid down on the loan ("the piggy bank"), which in the first year will be less than $461 for the year, if all of the assumptions above go as planned. (Keep in mind if your vacancy rate goes up to two months, for example, even this profit is completely erased -- and then some.)
To illustrate how a simplified, annual income statement would look when everything goes "as planned" on the above-described property, please see below. Amounts in parenthesis ( ) signify a negative amount or a loss:
INCOME STATEMENT
Gross Income ($710 / month) - $ 8,520.00
Vacancy (1 month) - $ (710.00)
Gross Profit - $ 7,810.00
Insurance - $ (400)
Property Taxes - $ (1,830)
Maintenance - $ (500)
Net Operating Income - $ 5,080.00
Interest Expense (1st Year) - $ (3,734)
Estimated Reserves - $ (875)
Income After Expenses - $ 471.00
Principal Paid (1st Year) - $ (461)
Cash in Pocket - $ 10.00
Although the discussion and figures above may be discouraging, especially the amount of cash in your pocket after everything is accounted for, it is really meant to be thought-provoking.
Sure, from time-to-time, you may be money ahead from these calculations, but just then your a/c unit may go out...
A person must plan very well and do several calculations before jumping into real estate investing. However, the funny thing is, you don't have to be a landlord or renter to use these calculations. This is essentially what it costs to own a home (like the one in the example) long-term. After all, shouldn't you as a homeowner be building equity in your own home, just like the investor would? Or, are you treating your home like an ATM?
One last thought:
If this example was a business building that you owned and operated your business out of, are you really making money off of your business? To find out, you must separate out your real estate "business" from your actual business because, as an owner-occupant, you are really in two lines of business, whether you realized that or not. A business person should be maintaining his/her building, while setting aside reasonable reserves for the big ticket items that will eventually fail, plus make an income from their time and toil in his/her business too.
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This blog post by Chris Wathen was also published in his Linton, Indiana based Greene County Daily World blog entitled, "Riddle Me This".
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