Q: I am planning to start investing in real estate. I read your column a couple months ago about how to manage rental property. I agree with the two points you made, the first being that this will be a part-time job for me and the second on the importance of finding a good tenant. Now that I’m ready to get started, can you give me some information regarding the initial purchase? I am learning some basic rules of thumb, but I want to feel very comfortable that I am not gambling. – P.T., Everett
A: First of all, there’s an old saying in real estate that you make your profit when you buy, not when you sell. In other words, you have to buy the property at a low enough price so that you are certain to make a profit when you sell. If you count on appreciation to raise the value of your property and generate a profit, then you really are gambling.
The same idea holds true in rental real estate. In the “old days” of rapid home value appreciation, many of the get-rich-quick gurus advocated buying real estate for “no money down.” They said all you had to do was hang on for a year or two, then sell for a big profit.
There are two major problems with this strategy: 1) It is relatively easy to buy property with little or no down payment, but it is virtually impossible to generate enough rental income to cover the high monthly mortgage payments every month. 2) You are gambling on appreciation to generate your profits.
The reality is that you will need a significant amount of cash to buy a rental property – at least 10 percent of the purchase price and preferably more. I believe in investing in real estate to make money. That means you should have a positive cash flow, or at least break even, before taxes. Don’t count on tax write-offs to bail you out. Tax laws can change – just ask the real estate investors who were wiped out by the 1986 Tax Reform Act.
You will need enough money to make at least a 10-percent down payment on a property, and probably a lot more, in order to achieve a positive cash flow on a rental house. You’ll also need a cash reserve to cover the inevitable repair bills.
As I mentioned above, you make your profit when you buy. So you must find a house or condo that you can buy cheap enough that the monthly rent that you receive will be equal to your monthly mortgage payments. An old rule of thumb is that the price should be about 100 times the monthly rent. For example, if a house will rent for $1,000 per month, you shouldn’t pay more than about $100,000 for it. Now I realize that is very difficult to do in most housing areas around the Puget Sound these days, but you should try to get as close to that ratio as possible. That means you will probably have to look outside your neighborhood. If you live in an area of $300,000 to $400,000 homes, there is no way you can make money buying a rental house in that price range. Look for lower-priced housing areas where you can get closer to the “$1,000 times rent” price goal. However, if possible, try to stay within a 30-45 minute drive from your home in order to make it easier to rent and manage the property.
There are many books available at your local bookstore and library that go into great detail about how to buy rental properties. I suggest you read a few of them and educate yourself before you buy your first property. Don’t expect to pay full price for a nice clean home because you will not be able to achieve a positive cash flow unless you make an enormous down payment. You want to search out a house that is in bad condition, but in a good location. You might also look for “financially distressed” properties such as foreclosures. There are good deals out there, but it takes a lot of work to find them. Don’t rush, take your time and make sure you buy right.
Mail your real estate questions to Steve Tytler, The Herald, P.O. Box 930, Everett, WA 98206. Fax questions to Tytler at 425-339-3435, or e-mail him at economy@heraldnet.com.
Steve Tytler is a licensed real estate broker and owner of Best Mortgage, Inc. You can visit the Best Mortage Web site at www.bestmortgage.com.
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