Just starting out in real estate – where to begin

I’m fascinated about learning how great developers and real estate investors got their start in the industry. Titans of the industry always seem to be negotiating multi-billion dollar deals or announcing the plans for some new ten million square foot master planned development, but they all had to start somewhere—usually from very humble beginnings.

Here’s what stands out so far:

  • There never seems to be one clear-cut path to follow to be a successful real estate professional.
  • Despite this, they all seem to follow a similar formula: gain expertise in a particular facet of the industry –> start with a small enough project where one can use that expertise to add value while reducing risk –> grow.

If you’re a 20-something guy/gal just starting out in the industry, you may want to strike out on your own someday (maybe that day is today, maybe it’s ten years from now).  Yet many of us don’t know what to start with, which steps to take, and how to go from step A to step B to (eventually) step Z. I was delighted to read this article over the weekend by Jeff Brown of bawldguy.com via biggerpockets.com.  It demonstrates some very simple (yet doable) steps a 20-something real estate pro can take to get that first project under the belt and start to grow a business.

 I Want To Be A Real Estate Investor. How Do I Start?

I’m Not A Flipper — I’m 20-Something and Want To Be A Real Estate Investor — How Do I Start?

I get asked that question almost weekly, usually by the 20-something generation. Their relative profiles are fairly similar with a few obvious exceptions. They’re pretty smart. Most of ‘em have degrees of one sort or another. They make decent money — generally speaking, in the $40-60,000 a year range. They’re evenly split between married and single. To their credit, and my undying appreciation, their ‘spidey sense’ tells ‘em the get rich quick with other people’s money nonsense involves somebody on the losing end, financially. They just wanna know how they can begin the journey to earning their piece of the financial pie.

Fair enough — here’s what I’ve been tellin’ beginners for years.

Instead of using my home market, San Diego, I’ll use a market more in line with values experienced by most regions. Though the concept works just fine, thank you, in San Diego, most prefer to use the numbers the majority of the country is used to. Let’s talk about the concept. But first here are the factors usually involved in the front end of the process.

1. You don’t currently own squat, unless you count the used car you drive to work and the payments taggin’ along with ya.

2. You’ve either already saved some money towards this end, or can in a reasonable time, say 6-18 months.

3. Your credit is either fine now, or you can make it so, and sooner rather than later.

4. Ditto with too much auto and plastic debt.

Here’s the end game in a nutshell, so if you’re not interested, you can move on. 

You’ll find a 2-4 unit property in an area in which you’d feel comfortable living, cuz you will be. You’ll be renting the other unit(s) to others. This will not only get you started, but will give you the mostly irritating experience real estate investors need to succeed in the long run. You’ll be buying this property using either FHA or VA financing. I guess in some cases HomePath would work, but I’m not all that familiar with their operation. The down payment and closing costs will end up in the $8-15,000 range.

The numbers

Let’s use the price and rent from a recently closed transaction. Price: $262,500  Rent: $1,350 each side — it’s a duplex. The location is good enough that I’d put my own mom to live there, alone. She’s 81, and I wouldn’t be where I am today but for her. So I care. Here’s how your FHA loan might roll out.

LTV: (loan to value) 96.5% or $253,300 (rounded).

Payments: This will include three separate factors. 1) Principal & interest 2) Taxes and insurance and 3) Mortgage insurance

Principal and interest at today’s rate of around 3.75%, would be approximately $1,173 a month.

Taxes and insurance will vary a great deal from market to market of course. Let’s cut it down the middle and say your annual tax bill will be around $4,000. In San Diego it’d be about that or a tad less. In other places a lot more, blah blah blah. Insurance will run around $1,200, more or less depending upon the state and the carrier, your mileage will indeed vary. So, let’s pick a monthly number and call the monthly tax and insurance portion of your monthly loan payment, roughly $435.

Mortgage insurance will run around 1.25% the last time I checked with the FHA lender. Add another $265 or so to the monthly payment.

We’ve arrived at your monthly loan payment which, in addition to principal, interest, taxes and insurance, will include mortgage insurance. It all comes to a pretty grand total of about $1,875 a month, rounded up a couple bucks.

I know what you’re thinkin’ ’bout now, which isn’t what’s gonna happen. “Let’s see, if our monthly payment including taxes and insurance, etc. is $1,875, and our tenant is giving us $1,350, we’re freakin’ awesome! That’s just $525 a month to us. Why doesn’t everyone do this?!”

You’ll VERY likely be paying for their water and sewer. You can probably, in most markets, have your tenants pay for trash pickup. But how ’bout landscape upkeep? Who’s gonna mow the grass if there’s a lawn? Oh, that includes the backyard too, right? Right. Also, the tenants will probably pay for their own power and gas. That is, if there are separate meters. Most 2-4 unit properties do sport separate gas and electric meters, but not all by any stretch. Sure, your rent would likely reflect no G&E bill, but that almost always goes against the landlord when the dead presidents start their monthly escape from your wallet. When tenants don’t pay for something, they tend to, um, use it like somebody else is. Make a note.

Figuring your monthly real world net

This isn’t rocket science, but the rose colored glasses need to be set aside when figuring your actual bottom line. Let me first give the same talk here that I give in person or on the phone to investors. There are two bottom line numbers when you’ve invested, as it relates to cash flow. There are the spreadsheet numbers, over which you sweat blood. Then there are Murphy’s numbers, and he doesn’t sweat at all. He just cackles. Go ahead and do the spreadsheet. Get the numbers as painstakingly accurate as humanly possible. Get every operating expense down to the penny. Then pat yourself on the back, and set it aside for future comic relief. That’s experience talkin’ to ya there.

The spreadsheet says that your annual NOI (net operating income) will be around $20,000. But that figure assumes both sides are rented, which ain’t the plan. Your real spreadsheet NOI should approximate $3,240 or so — $270 monthly. That’s after all operating expenses (including taxes and insurance, so remember not to shock yourself by double counting them when computing your monthly bottom line), a vacancy rate, and exiting your unit’s rent.

Your principal, interest, and mortgage insurance payments amount to $1,173 + $265 = $1,438 a month. Subtract the (spreadsheet monthly NOI) $270 from that, and you’ll get $1,178. That’s what the spreadsheet says, more or less, will be your before tax (as in April 15th) monthly cost of living. When we compare that figure to having opted to buy a traditional detached home, you’re probably saving in the neighborhood of $400-900 a month. Figure $1,500 PITI + $265 for mortgage insurance = $1,765 monthly. That doesn’t include those pesky utilities, water/trash, gas & electric. We’ll lump those together and add $200 more to your monthly nut. That brings the traditional detached home to just under $2,000 a month, pretax, using the same price and loan.

The difference is simple. You’d save around $800 monthly, +/- by opting for the duplex. That’s almost $10,000 yearly.

Now for the reality check

Throw the spreadsheet numbers out. Instead of applying the vacancy rate and operating expenses on which you worked so hard for accuracy, simply divide the gross schedule rents for BOTH sides by two. Then, decide that’s your real NOI. Might it be even less? You bet. Murphy knows where all of us live. Sooner or later it’ll be your turn in his barrel, cuz that’s the way it works in real life. Not to worry, cuz you’ll still come out ahead with the duplex approach. Understand that real estate income properties don’t pledge allegiance to the spreadsheet. I know, it’s crazy.

After tax

The traditional detached homebuyer will benefit from $13,400 a year in tax shelter, ballpark. That’s interest paid and taxes the first year of ownership. If their marginal income tax rate, state/fed, is around 30% or so, that results in a direct tax savings of roughly $4,000 for the year. They get to take interest/taxes dollar for dollar against their job (ordinary) income.

The duplex buyer who lives in one side would (assuming sides are perfectly equal) be allowed half the interest and taxes as direct write-off on their income. In other words, $6,700 a year, or about $2,000 in tax savings. But wait! There’s more!

They get to take the half that’s rented, and depreciate it. Depreciation is a ‘paper’ loss that you didn’t experience. In this case it’ll be, more or less, around $3,800 annually. Again, unlike the interest and taxes you deducted on the ‘owner occupied’ side, this is a phantom loss. You still get the tax shelter from it though, which is almost always way cool. This property’s depreciation would generate an additional tax saving of $1,140 yearly. When combined with the tax savings garnered from your ‘homeowner’ side, $2,000, your total annual tax savings the first year comes to give or take $3,140. In other words, the guy across the street who brags about the superior tax savings generated from his traditional detached home, gets pretty quiet when you show him your monthly before tax cost of living.

He’s ahead about $860 a year in tax savings. However, before taxes you lived for nearly $10,000 less than he did. Even if you ignored your spreadsheet’s numbers, your Murphy numbers still beat him by $7,000 a year before income taxes.

This doesn’t take into account the strategies which would accrue to having opted for a 2-4 unit property vs traditional home. When you ultimately wanna sell and move, you can neatly separate the two ‘entities’, AND their equities. But that’s another post altogether.

The only factor that really counts in this decision

What it comes down to is your personal comfort zone. Are you ok being a landlord, with your tenant next door? Are the long term benefits worth it to you? There are no right or wrong answers here. If you’re not comfortable, and it’s not due to false information, there’s likely little that could change your mind, right? I know that’s how I am. Don’t violate your comfort zone. Life is way too short for that kinda stress. But if you are comfortable with this approach, it can put your future financial plans ahead of the normal chronology — and usually impressively so.

You can also find the original article here.

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