The Power of Real Estate Investing
Welcome to this post, “The Power of Real Estate Investing”!
I recently joined a group of teens who are interested in early financial independence called SheeksFreaks. These teens are very passionate about personal finance, investing, entrepreneurship, but most of all, real estate.
I have to admit, out of all of those topics I just mentioned, I probably know the least amount about real estate. I’ve always known that I’ll get into real estate investing someday, but I never really had an interest to start learning about it until I joined SheeksFreaks.
For the last few weeks, it feels like I’ve done nothing but think about real estate. I’ve been reading articles, watching videos, and listening to podcasts while writing down my biggest takeaways.
There’s an Teen Financial Freedom podcast episode coming out in the next few weeks about real estate, so stay tuned!
Today, I want to share some of those takeaways with you guys. By no means am I a real estate expert yet, but I think I know more now than the average teen so I figured it was time to write my first post on the subject. Without further ado, let’s get into it!
The 4 Main Wealth Building Tools In Real Estate
Cash Flow – The first wealth building tool is the one we are most familiar with. Cash flow is simply the difference between the income and expenses. It is the amount of money you get to keep at the end of each month.
Equity – I like to think of equity as the amount of ownership you have in the property. If you buy a house, you technically own it. However, the bank gave you a loan to buy the house and ultimately gets control over the house if you fail to pay them back. Each time you pay them back, you’re adding to ownership you have in the property. The amount of ownership you have in the property is referred to as equity.
Appreciation – Like most assets people invest in, the value of real estate usually goes up over time. Someone may buy a house for $200,000, but 10 years later that house is worth $300,000. That $100,000 of appreciation is actually added to your equity which means that if you sold that house, you would profit that $100,000.
Tax Benefits – Finally, there’s some major tax benefits to owning real estate. Not only can you offset the income that you generate from real estate, but you can also offset some of your ordinary income. This means by owning real estate you might pay less in taxes.
How To Get Started In Real Estate Investing
By now you probably are thinking, “Okay that sounds great, but how exactly do I get started?”.
To start using the powerful benefits of real estate investing, you have to acquire your first property. This is a lot easier said then done. Not only is there so much to learn before you can do this, but it will require thousands of dollars to make a down payment.
Most people stop right here because they don’t think they can afford a 20% down payment on a property, and rightfully so. A lot of people don’t have tens of thousands of dollars sitting around to make a down payment.
But what if I told you that you could get started with no money down? That’s right, some people pay next to nothing to acquire their first property.
Types of Financing
When it comes to financing a real estate investment, you generally have 3 options.
The first is the conventional loan that most of us are familiar with. This is where you put 20% down, and use a loan from the bank to cover the other 80%. However, we already said that most people don’t have enough cash to put 20% down. Therefore these types of loans are more for the wealthier, older, or more experienced investors.
Owner Occupied Loan
Then we get to owner occupied loans. These loans are generally for first time home buyers, although you can get them multiple times. They offer lower down payment requirements in exchange for the buyer agreeing to live in the property. Therefore traditional investors who just want to acquire the property and rent it out to other people can’t use these loans.
The first type of owner occupied loan is a VA (Veterans Affairs) loan. These loans offer Veterans the option to do a 0% down payment. However, they still have to cover closing costs, which can be several thousand dollars. While these loans are great for providing for veterans, not everyone is a veteran.
Then there’s FHA (Federal Housing Administration) loans. Finally one that almost everyone is eligible for! FHA loans allow you to put down as little as 3.5% in addition to closing costs. While they are designed for first time home buyers, you can actually get FHA loans multiple times as long as you meet the other eligibility requirements. However, you have to live in the property you are purchasing for at least a year in order to qualify.
While these loans may save you thousands of dollars on a down payment, they do come with a cost. Your mortgage payment will be much higher with you having a higher principal amount to pay and your interest rate may be higher as well. Whenever you put less than 20% down on a property, you also have to pay mortgage insurance which is usually 1% of the property value annually.
Down Payment Assistance
Now 3.5% down is certainly a lot less than 20% down. But for some people, that still isn’t enough. Luckily, there is a solution for you. Down payment assistance (DPA) programs give you money in terms of a grant or loan to help cover the down payment and the closing costs. Think of it like a second mortgage on your house. The first mortgage covered 96.5% of the cost which is the FHA loan. The second mortgage covers 3.5% of the cost and the closing costs which is the DPA loan..
Now unfortunately in most situations you have to pay this money back. However, sometimes these DPA loans have no interest, no minimum payments, and can even be forgiven! It will just vary from program to program so I would recommend searching “DPA programs (Your State)” to find out more.
The last financing option is seller financing. Instead of having the bank issue you a mortgage, you can have the seller act as the bank. This can be a great option for someone who can’t get approved for a loan through the bank. You also can make the mortgage much more customized to your individual needs. These notes are often much shorter (5-10 years) which will make your monthly payment much higher. However, it will be very hard to find sellers who are willing to do this.
One powerful way to get into real estate investing is through house hacking. Housing is American’s largest expense category at roughly 30% of a household’s income. What if I told you there was a way to live in your own home for free? Or better yet, what if you could get paid to live in your own home?
This is where the power of house hacking comes in. House hacking is when you own a multi-family property (duplex, triplex, or fourplex usually) and rent out all but one unit. You live in one unit and the other units generate enough income to cover the mortgage and expenses. On certain deals, you can even cash flow several hundred dollars a month which is when you are getting paid to live in your home.
For the best results, you should live in the smallest unit and allow the bigger, more profitable, units to be rented out. You should also try to manage the property by yourself to save a few hundred bucks a month.
House hacking can be an incredible wealth building strategy. For starters, consider that you can save 30% of your income by not having to pay for housing. If you do it right, you can even profit a few hundred dollars a month. But that’s not all, your tenants’ rent is going toward your mortgage which pays down your principal and builds equity. Hopefully your property will also gain value over time through appreciation. To top it off, there’s some awesome tax benefits as well.
Sounds pretty awesome, right? Well the real magic comes after you move out. You see, an FHA loan only requires that you live in the property for one year. So after that one year is up, you could move out and allow someone else to move into your unit. Since your property was already cash flowing when you lived there, the additional income is pure profit! This means you could net an extra couple hundred or thousand bucks a month.
Then you could get another multi-family property with an FHA loan and repeat the process. Each year you’re adding thousands of dollars of income to your real estate portfolio. After a few years, you could have several properties worth hundreds of thousands of dollars and an annual cash flow of tens of thousands of dollars. This isn’t even considering your other jobs, businesses, or investments! Talk about financial independence!
Before you get too excited about all this money you can make, do know there are some expenses that come along with real estate investing that can make things complicated. Unpredicted expenses can turn great deals into terrible ones so make sure you account for the expenses on the front end. Here’s a few to keep in mind:
- Down Payment (Anywhere from 0-20% of the property value depending on your loan)
- Closing Costs (Around 4% of property value on average)
- Mortgage (At first around 30% of your mortgage will be principal that you keep in the form of equity and the rest is interest)
- Property Taxes (Depends on where you live)
- Home Insurance (Depends on where you live)
- Mortgage Insurance (Around 1% of the property value if you put down less than 20%)
- Utilities (Few hundred bucks a month)
- Repairs (Save money every month for the smaller repairs)
- Vacancy (Save money on the basis that your property will be vacant about 5% of the time)
- Property Management (10% of monthly rent)
- HOA Fees (Depends on where you live)
- Legal Fees (Depends)
- Capital Expenditures (Save money every month for the bigger repairs)
- Other (Even after factoring in all of this, there will be other expenses that you don’t think about, so leave some room for error!)
By now you are probably realizing that real estate investing is a lot more complicated than most people think. However, the best thing to do is just start running some numbers. The more you practice analyzing properties, the better you will get at understanding all of this.
How To Analyze A Rental Property
- In the beginning find a real estate deal analyzer spreadsheet or calculator to help you. I like Lili Thompson’s spreadsheet.
- Use Zillow to find properties for sale. Filter by the price you are looking for, multi-family homes, and by the number of bedrooms and bathrooms. Zillow will tell you some of the costs that you can plug into the calculator.
- To find the estimated rent, I like to look up X beds for rent in City, State. I find comparable properties and try to average their prices to make an estimate for the property I’m looking at.
Things To Look For In A Property
- First and foremost, you want to try to maximize the number of bedrooms and bathrooms per dollar. Triplexes are usually better deals than duplexes, and fourplexes are better deals than triplexes.
- Location is key. You want to try to find cheaper properties that are in the middle of an expensive area. This will keep your costs low and your rent high.
Rules for Quick Analyzing
- 50% Rule: Roughly 50% of the monthly rent will go towards expenses (everything besides the mortgage). Therefore you want your mortgage to be less than half of the monthly rent.
- 1% Rule: You want to try to find properties that rent for roughly 1% of the property value (ex. $300k property should rent for $3k/mo). If you can find deals like this, they most likely cash flow.
Measuring How Good A Deal Is
Once you run the numbers, you may have a hard time figuring out what a good deal is. I would use the following formulas:
- Calculate your cash on cash ROI by dividing your annual cash flow (annual income – annual expenses) / your initial investment (down payment and closing costs). The stock market generates an average rate of 7% (0.07) so you know it’s a good deal if your property does better than that.
- Calculate your cap rate by dividing your annual net operating income (income – expenses not including mortgage) by the current value of the property. Cap rates depend on what area you are in, but anything from 6-15% is usually considered good.
Notice how we only factor cash flow into these equations. We don’t really factor equity, appreciation, or tax benefits into how profitable a deal is. The reasoning behind this is that those factors change too frequently. Home values and taxes fluctuate quite often (just look at 2008 recession or Biden’s new tax plan). Therefore, we would rather base deals on cash flow which is pretty guaranteed. Think of the other wealth building tools as an added bonus. If you happen to gain $10,000 in appreciation while you live in this home for a year, great. But, don’t count on that when you run the numbers to see if a deal is profitable.
I’d like to wrap this post up by going over an example with you guys so you can see the power of real estate investing.
I’m going to use this triplex I found for sale in Tuscon, AZ. This multi-family is selling for $257,500. Each unit is a 2 bedroom and 1 bathroom.
Down Payment: $9,012 (3.5%)
Closing Costs: $10,300 (4%)
Total Initial Investment: $19,312 (Down payment + closing costs)
Monthly Rent: $2,600 (I found that 2 bedrooms in the area were going for an average of $1,300/mo. Since we have two units to rent, we can estimate $2,600/mo in rent)
Mortgage: $1,186 (I used a mortgage calculator with a 4% interest loan to calculate this)
Other Expenses: $1,300 (I used the 50% rule here to estimate that 50% of the $2,600 rent will go towards expenses)
Monthly Cash Flow: $114 (Income of $2,600 – Mortgage and Expenses of $2486)
Annual Cash Flow: $1,364
Cash on Cash ROI: 7% (Annual cash flow of $1,364 / Initial investment of $19,312)
Cap Rate: 6% (Net operating income of $15,600 / Property Value of $257,500)
Now let’s suppose that after one year we move out and have an additional unit to rent for $1,300. All the sudden our monthly cash flow jumps to $750/mo, our annual cash flow goes to $9,164, our cash on cash ROI is 47%, and our cap rate is 9%.
So as you can see, this is an alright deal. It cash flows which is great, but it’s not anything crazy. It’s at the low end of deals I would take at a 7% ROI and a 6% cap rate. However, this is just a random one I found for the sake of this post. I’ve seen much better deals out there even in this super hot market.
Hopefully by now I have convinced you of how powerful real estate investing is. This is usually where people get skeptical and think there has to be a downside. There is a downside, it’s called education. Very few people actually put in enough work to learn how to do this. If you want to succeed, you need to educate yourself like no other. There’s a lot to learn, comprehend, and understand. Thankfully, you started the process today! Take one small step tomorrow to learn even more and you’ll be there in no time! Best of luck on your real estate investing journey!
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