Leverage

Leverage

Leverage can be a scary word, especially post-recession.  For many people, the idea of borrowing a lot of money is terrifying to the point of paralysis.  I understand this perspective and I believe it is perfectly acceptable to ease into the process of using other people’s money to accomplish your goals.

The first investment property I purchased, I put 10% down (not uncommon in 2004) and I used all of my own money to finance the remodel or my duplex.  I had recently sold my primary residence, so I had the funds available.  Because I used up all my money on the first property, I had to get creative when the second opportunity to purchase a single family house came along.  I had a really clear plan to minimize the down payment, utilize an investor’s funds for the remodel, flip the house and pay the investor back. As you will see throughout this presentation, the common theme is that things rarely go according to plan. You can read more about how that deal actually unfolded at “Getting Started is Rarely Pretty.” But from a financing standpoint, I was able to refinance the house once the project was completed and cash out my investor.  I still own the house, ten years later, as a cash flowing rental.

A key point here is that if you structure a deal properly, you will have a whole lot more options when it comes to financing and re-financing.  The saying goes “you make money when you buy a property, not when you sell it.”  What this really means is that it is critical for you to understand the nuts and bolts about putting together a deal both from your perspective as an owner and from the point of view of lenders.  That’s a big part of what I am going to try to lay out for you.

I am a product of Robert Kiyosaki (among many other things).  I played is board game “Cash Flow” in August of 2004 and decided to try to put it into practice in my life.  By November of 2007, I owned 79 rental units.

One of the most powerful and simple concepts that Kiyosaki talks about is cash flow. Basically all it means is that when all is said and done, a property needs to have more money coming in then it has going out.  There are all kinds of sophisticated was to analyze property (and you should get familiar with them), but really what would be the point of buying a property that is not paying for itself?  Sure some people would tell you there are tax benefits to having a property lose money, but there are so many expenses you can write off in real estate, why not have it be profitable while you are also getting some tax benefits.  Also, the discipline required to find and acquire a rental property that actually cash flows will never fail to set you in good stead.

The reason why the concept of cash flow was so powerful to me right from the start was that I knew that I did not want to have to get a job.  I wanted my real estate investments to support me in the short-term and allow me to build wealth and plan for retirement in the long-term. I simply could not afford to buy properties that did not cash flow.  Again, cash flow means that after the rents have come in every month and all the bills have been paid, there is some money left over (to pay yourself).

When I started, I used to run my numbers by hand. I would write out all the property expenses and subtract then from the income.  I wanted to really understand what was going on.  In time, I built and extremely simple spreadsheet that I still use to this day.  Some investors might say my calculations lack sophistication because I don’t compare pre-tax and after-tax income. Or that I am not a real investor because I don’t use cap rates to analyze property.  Perhaps they are right.  What I have found, however, is that often times people use sophisticated calculations to mask the fact that the property is not actually cash flowing right now (which is the true indicator of profitability in my book).  Realtors are particularly guilty of this sin.

You need to develop a consistent standard to help you determine if you should buy a particular property, because there will always be a ton of people wanting to sell you property. It is actually the most common thing I say to people when they ask me my opinion about buying rental property: Does it cash flow?  Once I break out the spreadsheet, the answer is usually no.

This may be a little off topic here, but let me dispel the myth that there are no properties worth buying that are listed in the Multiple Listings (MLS).  My first two properties were listed in the multiple listing.  The best multi-family property I have bought to date was listed in the MLS.  There are opportunities everywhere and the more you refine your analysis skills, the better you will be able to see them and ignore the hype.

I used to carry around a pile of the listings for all the properties I looked at to remind me how many deals I had to research before finding just one I wanted to buy.  The ratio that I have heard is you look at 100 properties to find 10 to make offers on and you end up buying one.  It really does work that way.  What happens, however, in this process is that you get so much practice running numbers and analyzing properties is that when you find a good deal, you are ready to act.  It also helps you build your analysis muscle so that after a year or so of doing it, you get to the point where with just the gross rent and the address, you know if it is worth your time to drive by the property.

Yes, I did just say DRIVE BY the property.  Your smart phone and your Google Earth and your Truilla’s can only take you so far.  For better or worse, people choose to live in a place, a geographic location, a fixed point in space.  And if you are going to be the one trying to rent out a space for people to live in, you want to make sure you pick one that is desirable to people.  There are all kinds of amazing things that happen when you get out of your car and walk around a property (or several hundred).  You start to learn about foundations and roofing materials that are used in particular price brackets and neighborhoods. You begin to understand what features you can expect to see at certain price points.   You learn which areas have sewers and which places to avoid because they are on septic. And finally, you might encounter one of the greatest sources of information: the neighbors.

Often times, neighbors know more about a property then real estate agents and even the owner.  They, after all, are the ones who live next door to the property.  Neighbors often know who lived there, when and if they moved out, whether there was police activity, if there are boundary disputes, how cooperative the owner is, and the list goes on and on.  You cannot meet those neighbors through your computer screen.

OK, so I have gotten a little far afield from where I started talking about leverage and borrowing money.  Basically, when I did my first transaction, I wanted to use my own money to prove to myself that I could do it.  I needed to build my confidence in myself before I felt comfortable asking other people to use their money.  Interestingly, though, once I started using more leverage (less of my own money) I actually started to tighten up my numbers and get clearer about making a specific plan for the property.  I was willing to be more fluid with my own money than with someone else’s. So leverage actually began to hold me to a higher standard.

Eventually, it will come down to a point of your willingness to take a risk.  But it is very different to take an informed risk versus a reckless risk.  An informed risk is one in which you have done your research, built your skills and experience, made valuable professional contacts and then make the choice to borrow an amount of money that still might make your heart skip a beat.  A reckless risk is one in which you rely on someone else to tell you that it is “the deal of a lifetime,” you refuse to pay for solid professional advice and you just believe that all the pieces will magically fall into place.  In that scenario, you should be hyperventilating if you are signing loan documents.

Once you get the process down-more money coming in than going out-it becomes easy to start to grow your numbers. Think of the income and expenses like beans, rather than dollars.  No matter how many zeros there are after a number, there needs to be more beans coming in than there are going out.  Nothing magical changes when you buy a million dollar property (well, actually you realize how much more you are building in equity just by doing the same thing you were doing before, more on that later).  In fact, it is even more important to have strong cash flow because chances are good you don’t have $10,000 lying around to make the monthly mortgage payment if the property cannot support itself.

At this point you might be wondering why I am spending all this time talking about property research in a section that is supposed to be about financing.  It is because what property you choose to try to acquire is going to have a profound impact on your ability to get financing.

Once you are convinced that a property is worth buying, it becomes a lot easier to convince someone else that they want to put their money on the line to help you close the deal.  There are a lot of creative financing strategies out there, but we are going to start with the basics: How to convince a bank or credit union to give you a mortgage for your first rental property.

Working with Lending Institutions

It has taken me a number of years to start to understand how a bank or credit union looks at the world.  And that worldview changed significantly post recession.  Well, actually, I would say it just intensified rather than altered dramatically.  When dealing with a bank or credit union, you should think of them like a super conservative, super paranoid wealthy uncle who oddly wants to give all his money away before he dies.  If you don’t have one of them, use your imagination.

Let’s break this down, starting with conservative.  Lending institutions have very strict standards that they use to determine how and how much money they will lend you.  One of the first terms you need to know is loan to value ratio (LTV). Basically, what this means is that the bank is only willing to loan you a certain percentage of the value of the property.  The “value” of the property will be determined by an appraisal. Depending on the type of property, LTV’s can vary from 70 to 80%, with the limits tending to be higher on single family house.  For example, if you are looking at a house with a sales price of $100,000, the bank will be likely willing to lend you $80,000.  On a property with four or more units, the limits are more likely to be 70-75% ($250,000 sales price, mortgage at 70% LTV would be $175,000).

A note on appraisals: Appraisers are independent reviewers who are hired by the bank to determine the value of the property.  Appraisers seem to be the group of people who are experiencing the most residual effects from the recession.   Usually, if a property is fairly priced and sold under normal conditions (no one is being held at gun point), the appraisal comes in at or around the sales price.  In some situations, that may not be the case. Post-recession, some appraisers seem to be valuing properties in an ultra conservative manner.  Most likely this is due to the fact that over inflated values help to contribute to the housing collapse.  Values may also come in lower in a refinance situation, particularly if you are taking out equity from the property.

Back to the LTV issue, the bank is only willing to loan you a certain percentage of the value of the property because that helps to reduce their risk.  The concept is that if you have $20,000 of your own cash in the deal, you are less likely to stop paying the mortgage because you would lose your cash.  LTV’s are higher on a primary residence, because most people don’t intentionally want to make themselves homeless by having the bank foreclose on their house.  So for the purposes of planning your real estate investment strategy, you should assume that you are going to need to have some of your own money available.

In future posts, I will explore some creative ways to come up with the down payment that the bank is going to want to see before they will lend you money.

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Checking Out Your Options Regarding Property Management Companies (part 2 of 2)

If you want to explore the option of hiring a company, here are some questions to ask perspective property managers:

  1. What type of property do you specialize in?
  2. What do you see as the role of the owner in the property management process?
  3. Will you require me to have an onsite manager?
  4. How do you work with on site managers?
  5. What does your fee include?  Lease ups?  Legal fees?
  6. Addressing problem situations:
    1. How long do you let a tenant fall behind on their rent before taking action?
    2. What is your process for dealing with noise complaints?
    3. What is the biggest challenge you have dealt with as a property manager and how did you handle it?
  7. Do you offer routine maintenance services?  Landscaping?
  8. What are the costs of these additional services?
  9. Does your company have a set policy on how you interact with tenants?
  10. Who is your accountant?  Attorney?
  11. Do you have a list of current clients who would be willing to talk to me about your services?

And don’t forget the rule of three (see “Working with Contractors” posted under Rental Property Maintenance).  Be sure to block out enough time to talk with at least three property management companies.  And don’t make your decision based solely on price, because it will probably end up costing you more in the long run.

If you are still on the fence about diving in and becoming a landlord, here are some unexpected benefits of managing your own property:

  1. Low vacancy rates—the more units you rent, the more you get paid. Self interest is a great motivator.
  2. The celebrity factor—I can’t set foot on my properties without everyone wanting to talk with me (and it is not always bad stuff)  Tenants, neighbors, contractors, everyone has something to say
  3. I have met people I never would have met in my ordinary life.  It is interesting.  It is better that TV.  It is like traveling without leaving home.
  4. You are a part of the community.  In fact, you are a leader in your community.
  5. You can make a serious positive impact on people’s lives beyond what you ever thought possible. Hopefully soon I will have an audio file posted that gives you a powerful example of this from one of my apartment buildings.
  6. You will learn more about yourself and realize your potential more than you ever thought possible—all while making money (hopefully)!!
  7. You get to create your own corner of the world.  For me, good manners are important.  I treat my tenants well and don’t tolerate bad behavior and, in turn, I am creating little pockets of better manners in the world.

Still Learning After All These Years

A couple of years ago, I tried to start a website called “The Landlord School.”  I was doing all the right things, but I simply could not get it off the ground.  I had a complete crisis of confidence and refused to believe that anyone would ever want to listen to what I have to say.  So, after a few excruciating months, I closed up shop.

Recently, when I decided to try it again, I realized that the website name had been all wrong.  First of all, most people hate school.  And second, I certainly don’t want to be the teacher in charge.  Even though I am a landlord, I hate to tell people what to do.  And I definitely don’t see myself as the expert.  Sure a lot has changed over the last few years and I have overcome some insurmountable problems (I will tell you more about that when we know each other better).  But my business is still a work in progress.

So, a new name came to me “Learn to be a Landlord.”  Being a landlord is a process and I am an active participant in that process.  In fact, the thing I love the most about my business is how much I have had to learn in order to make it work.

I hope you can learn something from my blog posts.  And feel free to share your comments so I can learn from you.  Also, if you have a specific question for me, just click on the “Ask Jessica” tab at the top and ask away.

Getting Started is Rarely Pretty

When I started as a real estate investor, I had only been in Spokane for about 4 months and I did not know anyone.  On top of that, I am a woman, which somewhere else may not be a big deal, but still is a bit of an issue in Spokane.  My first project was a major remodel of a severely distressed duplex (meaning you could barely stand inside for more than ten minutes without gagging because of the smell of cat pee, not to mention the pile of dirt, garbage, and hypodermic needles in the basement).  I was in a relationship at the time and made the classic mistake of hiring my significant other as my handy person.  It made perfect sense, right.  He had the tools and the time and the experience doing the type of work I needed.  Wrong.  We nearly killed each other and it was an uphill battle every step of the way.  We had very different expectations—I saw him as another contractor and he approached it as more of a partnership.  He was also not used to working for someone who had as much or more experience and knowledge then he did and my clarity caused a great deal of friction.  I wanted him to show up, do the work, and go home.  He wanted us to work on things together (but from my perspective, he had no financial investment in the property or any ownership interest so all the risk and responsibility fell on me).  Fortunately, he was only doing a portion of the work and we managed to muddle through with everyone’s body parts still intact.  If anything, it was the contrast between working with him and managing my other contractors that help me start to get clear about how I wanted things to go in the future.

Project number two, I wish I could say it went great and I implemented all of my new awareness and here is my “Six Point System for Working with Contractors” that you can purchase for $23.95 and implement tomorrow to build wealth beyond your dreams. No, I hired a meth addict to be the general contractor on my second house.  Of course I did not know that at the time, I’m not that dumb!!  In fact, this general contractor was recommended to me by the drywall contractor I had worked with on the duplex.  They had done a great job for me and managed to complete the work between Christmas and New Year’s at a fair price and high level of quality.  Licensed, bonded, the works.  So, as I started the second house and the company owner recommended this guy to me, I thought “Great, maybe this will be someone I can build a long term professional relationship with.”  Let’s call this guy Chad.

I am a cautious person by nature, so I originally met with Chad just to get his perspective on the house and what I was planning to do with it. Supposedly, he had been rehabing houses for a while and I was looking for some experienced input on my construction budget.  I met Chad in person at the house and we got along great.

I was exhausted and still finishing up on the duplex, so I decided to have Chad and another contractor bid on the second project as general contractors rather than just sub out certain portions of the work.  I put together an excruciatingly detailed bid packet and checked their licenses, insurance, bonds, and worker’s comp complaints.  So when Chad’s bid came back in budget, I breathed a huge sigh of relief and gave him the job.  He warned me that he couldn’t start right away because he had other work lined up, but even with a start time in early summer, it would still be done in time to get it on the market for sale before the winter.

So I kept plugging away at the duplex and started to look for other projects.  As the time came for Chad to start in June, I would drive over to the house in great spirits, glad to know the project was in good hands and I had hired someone else to do the dirty work (just like all the books say you should do it).  I wasn’t going to have to pick up a hammer or a paint brush, or . . . well, I started to have to pick up the phone. “Chad, where are you?  I thought you were going to start last week?”  “Chad, I am concerned that nothing has been done at the house.  Please call me and let me know when you plan to start.”  And so forth.  And nothing was happening.  And then Chad would call and I would say “Are you still able to do this project?  If not, I still have time to find someone else.”  And he would reassure me, yes, he could do it, he was just getting tied up in a big job for one of the real estate brokers in town.  Finally, I said “If you don’t get started by this date, you are fired.”  And guess what, he started.  Hugh sigh of relief, now we are on our way, back on track.  Except he never showed up again.

Then his wife got involved. How could she help, how we can make this work?  She was a landscaper and would do the yard work at a reasonable cost.  She was so sorry, they really liked me and wanted to make this work.   Could she meet me next week and look at the yard with me?  And when Monday came around and she didn’t show up—I officially instituted the “one strike and you are out rule”.  Fortunately, I had only paid Chad a small amount of money for the demolition work and was only out a few hundred dollars.  After a few attempts to contact him about the money, I realized that my sanity was more important and I just walked away.

It was a few years down the line, when I signed up as a real estate agent with the above mentioned broker, that I learned the truth.  To be honest, I had a bit of a grudge against the broker for tying up “my contractor’s” time with all of her change requests.  So when I met her, I casually said “I think we have a contractor in common.  Do you know Chad so-and so?”  She nearly hit the floor and so did I when she quickly exclaimed that he was a meth addict and had cost her thousands of dollars and months of lost time.  All of the sudden, his erratic behavior made sense.

But back to the house.  By now, it was September.  I had owned the house since the end of January, very little had been done, and winter was coming.  In the meantime I had purchased and completed a cosmetic rehab on a four-plex and was even more exhausted.  I was overwhelmed with this house and didn’t know what to do.

Anyone who tells you that there are no emotions in business has never been in business. The emotions are always there, it is just what you do with them that matters.  Without them, we wouldn’t have gut instinct or intuition or creativity, which would make business very dull and less profitable.  When, however, you are exhausted and disheartened you should never listen to your emotions.  It is time to Go Back to the Numbers. Fortunately, that’s what I did and then I generated a short List of Options:  I could cut my losses and sell the house as a fixer, I could jump in and manage it myself, or I could try to find another contractor.

Emotionally, I just wanted to cut my losses and move on.  More than anything, I wanted to sweep this whole mess under the rug and pretend it never happened.  But when I looked at the numbers, I saw that it was really in my best interest to finish what I had started.  I was completely gun shy about general contractors, so I decided to jump in and take over the project myself.

More happened on that house in six weeks than in all of the previous six months.  I started using the Rule of Three in earnest.  When in doubt, call and meet with three contractors.  And when meeting them, trust your instincts.  If after talking with three contractors, no one stands out as the obvious choice, keep calling.  Do not settle for what is in front of you.

Because I was trying to accomplish so much in a short period of time, I ended up having a lot of people in the house which gave me a great deal of hands on experience with different contractors. I emerged from this mess with two of my favorite contractors–a handyman/carpenter and a plumber.  In both of them, I recognized exceptionally skilled people who took pride in their work, had good communication skills, and were extremely reliable.   Now that I have worked with them both for a number of years, the only reason I would use another contractor would be because of schedule conflicts.

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