Ask Brian is a weekly column by Real Estate Expert Brian Kline. If you have questions on real estate investing, DIY, home buying/selling, or other housing inquiries please email your questions to [email protected].
Question. Chelsea from Kalamazoo, MI writes: Hi Brian, I’m ready to plunge into real estate investing but there seems to be too much information out there to comprehend as a beginner. I see tons of suggestions that little or no money down is easy and the best way to go. Yet, I also read all of the time about how these are scams or that less than 5% (my guestimate) of those who try this actually make any money. I suppose that I’m a bit conservative when it comes to handling money. I managed to get through college mostly on my own while taking on less than $25,000 in debt (which I’ve paid off). I’d like your thoughts on what is a relatively low risk method for a beginning investor?
Answer. Hello Chelsea. It sounds like you have a pretty good head on your shoulders when it comes to handling money. That’s a great starting place for a beginning investor. I have to agree with you that many of the overhyped investment strategies don’t work for most people. Especially the ones that get you deep into hock with credit card debt or trying to flip a major renovation when you don’t have any experience renovating houses.
That’s not to say there isn’t any money in renovating houses but you’re better off learning as you go. In my humble opinion, one of the better ways to get started is as a landlord in a relatively inexpensive house that has positive cash flow from the beginning. A place that already has a renter or one that you slap some paint on and have a renter a month later.
Taking a conservative approach means following a key rule for beginning landlords. The rent you will collect should be at least 1% of the acquisition price. This is a pretty easy rule for beginners to understand and follow. In a nutshell, if your acquisition price is $100,000, the rent should be at least $1,000 a month. There are certainly other considerations that go into the decision but that one weeds out most potential deals that won’t work so that you don’t spend a lot of time on due diligence for a deal that is very unlikely to work or has more risk than you should take.
Your acquisition price isn’t the same as the purchase price. The acquisition price includes everything it costs to get the property to cash flow. That’s not just your down payment. It includes borrowed money, the cost of the borrowed money (closing costs, inspections, etc.), and any renovation costs. The 1% rule eliminates most expensive properties. For instance, how many $700,000 properties can be rented for $7,000 a month? Not many. Not all $100,000 houses can be rented for $1,000 either. You’re still going to have to search out good deals. Chelsea, the good news is that Michigan is a pretty good place to find these types of houses. I anticipate you can find houses with acquisition prices around $60,000 or $70,000 that will rent for $600 or $700 per month. One of the important parts of your detailed due diligence should be making sure you won’t have a high vacancy rate because too many houses are available at comparable prices or that a sinking local economy won’t soon drive up vacancy rates.
What this strategy will do is give you a low risk and cross section investing experience. Importantly, you’ll gain experience with cash flow and expenses. Another general rule that you want to understand and manage is that roughly 50% of the cash flow goes to paying expenses for rental properties. This doesn’t include the mortgage payment. This is for the basics like taxes, insurance, repairs, HOA (if applicable), and some discretionary expenses like capital improvements and property management.
Chelsea, this conservative approach won’t make you rich overnight but it will build a foundation to accumulate wealth over time. Most investors who are successful long term start out frugally. You do that by plowing your profits back into your investing business. First of all, you should maintain a healthy reserve account to take care of any unexpected emergencies. That reserve account is also the building block for investing in future properties. As you gain experience, you’ll figure out how to do this in a way that works best for you.
A good place to begin is with a minimum cash reserve. Maybe this is $5,000 with access to a line of credit or $10,000 in cold cash. Once you get above that amount in savings, you start looking for ways to earn a decent profit (above a meager interest rate) on your excess cash. That could be venturing into the stock market, paying off the mortgage early on your rental (to increase positive cash flow), partnering with someone experienced at flipping houses, or something else. Once you have successful experience as a small time landlord, you’ll know what you’ll be comfortable expanding into.
A conservative approach to growing wealth over time should be building a bigger foundation of multiple rental properties. You could take the profits from a flip or the stock market to invest in another low risk rental following the same basic rules that made the first one successful. Although there are a lot of get rich quick real estate strategies out there, most successful long term investors build a small real estate empire one investment at a time. Retiring early on the income from 20 or 25 rental houses that you own free and clear is a pretty good long term goal.
What are your thoughts for beginning investors? Please leave your comments.
Our weekly Ask Brian column welcomes questions from readers of all experience levels with residential real estate. Please email your questions or inquiries to [email protected].
All really good advice here. I would just add that the reserves depends on the mortgage, operating expenses, and the condition of the property. I aim to keep 6 months of cash expenses in reserves but it will depend on your market and risk tolerance.
Thanks for the comment and for adding more detail.