Okay… So you wanna be the next real estate big shot and make millions with real estate? Well, you’ll have to start somewhere and understand the basics first if you want to become a real estate investor apprentice.
To be fully honest, I am not a real estate investor. Apart from my house, I do not own any other properties, I never have and I probably never will. But… I know a lot about real estate investing because I have held several positions in that field in my career, read a lot of books about it and even had university courses about it too, so I can teach you at least the basics behind making money the traditional way with rental apartments.
Let other people pay for your mortgage
What’s so interesting about investing in rental properties is that other people will make you rich. At least, that’s what’s supposed to happen.
They will pay for the mortgage, pay for the repairs, pay for the heating and you will make the money, a lot of money! Plus, you’ll get extra income for you to spend or reinvest at the end of each month.
Why? Because YOU took the financial risk of buying the property and you own it.
We call that strategy : using “financial leverage”. With a small investment (your down-payment), you can buy a huge rental apartment and start making money on day first. Other investors, who buy bundled mortgage loans as an investment, provide the funds for the mortgage for you to buy the property (you’ll get the mortgage through a bank).
So you basically are using mostly other’s people money to buy the property and other people (tenants) will theoretically pay for all the expenses (mortgage loan, management fees, taxes, insurance, heating, repairs and maintenance etc…) for you in the form of rent.
Your only job will be to manage the building : collect the rents, deal with the proverbial leaky toilet, pay the bills, find new tenants, handle the complaints etc… Or, if you wish, you could use the services of a specialized management company who will handle all of the problems for you (in exchange of approximately 5-6% of your cashflow, a big chunk of your profit)
That’s the theory behind real estate investing. But, what most people don’t know is that investing in real estate IS A JOB! It’s not passive income! Even though, it can be rewarding.
Four financial benefits of owning a rental apartment
A rental appartement must be bought as you would buy a small business. Prior to making a final offer, you have to study both the income and the expenses. You should make sure to validate the claimed income and expenses and cross reference them with real verification with tenants, utilities companies and verify the taxes and insurance on your side. We call this making your due diligence. Trust me, sellers and realtors always boost the income or potential income while they underestimate expenses to make you believe that the building is more profitable than it really is. Due diligence is very important.
You should also check the property condition, verify what kind of maintenance has been done and how, ask for the proofs, verify the soil contamination, estimate the future repairs or increase in expenses that you’ll have to face, check the potential to increase future income.
For example, would it be possible to rent parking spaces, increase the rents or add a service like a laundromat inside of the building? Or, on the opposite, would it also be possible to cut expenses?
Once you have made sure that you can make the numbers work in your favor and cover all the costs with an healthy margin of safety and positive monthly cash flow, then you are set to offer a price that will be fair.
You have to buy a rental apartment for its real intrinsic value, for the cash flow it will bring to you monthly and for the future cash flow it will bring to you for years and years.
I won’t get into too much more financial details here because it’s not the purpose of this post, but just keep in mind that investors must have or acquire at least a basic knowledge in finance and to learn a lot about appraising a property and evaluating a residential or commercial market. They need to know how to balance and income and expenses sheet and they also need to know the applicable laws in the region they want to invest in.
While it is not an obligation to have a degree in the field, it sure will help to avoid many costly pitfalls. Getting a job as a rental apartment mortgage underwriter would help you too.
Most investors eventually transfer their rentals into a corporation or a trust to protect their personal wealth. But financial institutions tend to cancel that advantage by requiring them to be guarantor on the loan.
You can make money by four different ways with a rental apartment :
1) Your mortgage amortization will slowly build equity into the property, but at first, in won’t build a lot since most of the rents will be used to pay for mortgage interests. But, you will eventually be able to either take out this equity by selling the building (and paying a capital gain tax) or like most investors do, by refinancing the property. This cash can then be used as you wish but most new investors use it to buy another building and increase their leverage!
2) The value will also appreciate over time. Usually, the real estate market goes up, slowly but surely. But, like the stock market, it can sometimes crash! And if you buy a rental apartment in a mono-industrial city then you face the risk that the industry eventually shuts down and you could lose your shirt… No work, no tenants… That’s why it is very important to know your market. Who are the tenants in that market. What do they seek for. Where do they work. Is the economy strong? Is the industry diversified in that market? How’s the neighbourhood? Is the building close to services? If not, can you offer parking because people will need cars…
3) You should always make sure to buy a building that will generate you a positive cash flow every month. A building giving you a negative cash flow is going to cost you every month. That’s not an investment, that’s an expense… Unless you have other projects with the land or the building. Some building can become so costly that some call them alligators. They literally eat you alive!
But, nowadays, many investors are willing to buy even with a negative cash flow because they want to convert those apartments into condominium units and sell them with a huge profit. Or, they just seek for capital gain and expect the land to increase in value. So buying a rental apartment the traditional way can be difficult in some regions… Times are changing!
4) Finally, you should be able to reduce your tax burden and declare some expenses.
That’s basically how you make money with a rental apartment. That’s not really complicated! Usually, you buy your first building with your own down payment and then, you wait until there will be enough equity to refinance and take the equity out to buy another building. Then you wait until you can refinance both buildings and buy another or two other buildings and so on… You never sell them because the goal is get enough positive monthly cash flow to eventually quit your day job and live off the rental income! Plus, you don’t want to pay a capital gain to the government! So, if you want money to spend, you could simply refinance and spend the money. The rents will cover the new mortgage and you might be eligible for a tax deduction on the interest part of the loan. It’s like double-dipping!
Within 10 to 20 years, it is very possible to become millionnaire using this technique. And, it is very tempting to grow your portfolio very fast, but it’s risky. It is very important to always keep liquid cash for vacancies and punctual problems and an healthy margin of safety in case of huge problems, high vacancy rate or high increase in interest rates. Since that technique uses a lot of leverage, a minor problem can have domino effect on the whole portfolio very fast.
The risks and flaws or real estate investing
I want to talk about that. Not to discourage you but you have to be aware of some risks and the reality of real estate investing. Many if not most investors won’t face that many problems but it can happen and ruin your investments and life…
There are so many gurus who try to make you believe that investing in real estate is easy, risk free and passive while it’s not true! There are huge risk and it’s far from passive. You have to know what to do. And, if it was that easy, everybody would do it.
I have a lot of friends who own rental apartments and have met with a lot of real estate investors over the course of my career. I heard a lot of stuff… maybe too much but I’m glad I did. Real estate investing is not for me even though I thought it would be back in the days.
One of my friends has a great portfolio of buildings with his father, uncles and brothers. Trust me, it’s a lot of work! He receives calls anytime during the day and night to handle “emergencies” and complaints and there are a lot. Tenants are customers and customers are king. You want to treat them well if you want them to treat your building well. You don’t want one to flee without paying you during the night with the sink’s faucet open… It happened to a friend of mine. The insurance covered most of the costs but it’s annoying.
My friend must spend most of his week-ends to fix apartments. He has to often go to court to get the judge to force people to pay him the rent or to order their eviction (it’s very hard to kick someone out here in Canada). He also receives calls from tenants almost everyday at any hours. He spends at least two nights a week running around his buildings for his rents… Most pay him on time but many don’t.
Last month he had to handle a bed fleas infestation, a water leakage and a fire to one of his buildings… The tenant of his neighbour smoked in the bed and the fire spread to his building. Dealing with insurance and contractors is painful and he spent tons of hours on that issue…
But, he loves it. For him, it’s part of the business. For me… well I wouldn’t like to deal with that at all!
He literally manages a full time business outside of his full time job. But, he will eventually be millionnaire.
Another of my friends recently had problems with two of his buildings. The first one had a sewer problem. The sewer system was too old and needed to be replaced. They had to dig in the street and that municipality doesn’t pay for such repairs. They do it and then they charge you. Such costs aren’t covered by insurance either. In the end, he had to pay… 150,000$ for a 4 apartments building… It’s just crazy! It will take years and years for the rents to cover that expense. Last year he had replaced all the windows and doors for 28,000$ and he knows that he will soon have to replace the roof… that will be another big expense. This building is an alligator and his dream of becoming millionnaire fast is gone.
His second problem is related to a building he sold years ago. He bought it at what he thought was a good price and flipped it not long after with a nice profit. But, the new owner has decided to dig in the yard to install a pool last summer and discovered an old buried oil tank… with a soil contamination… He got sued… The previous owner is dead and this oil tank probably was buried long before he bought the building himself. The poor guy wasn’t aware of it. But, unfortunately, and that’s something realtors don’t explain to you, you are responsible of all the hidden defects of the building you owned forever until you die… cool huh?! Soil decontamination is a bill you don’t want to handle. Depending on the contamination the price can become exponential.
I heard so many horror stories in my life about real estate nightmares that I got a little paranoid about it. 🙂
One of the uncles of my friends who own a huge portfolio rented to a tenant who did a marijuana grow op in his apartment. But not a traditional hydroponic one. That guy just brought in a couple of inches of black earth inside the apartment, layed it on the floor and planted his seeds in his new garden. For sure, he had to keep the soil wet for his plants to grow…
It made a lot of damage… trust me! And another of his tenants ripped off the kitchen cabinets doors to breed and keep live chicken inside his apartment. The kitchen cabinets were brand new!
There are weird people!
When picking tenants, you have to be careful but at the same time, if you refuse a tenant, you normally need a good reason and it should normally either be related to financial inability to pay the rent or poor/bad references. So refusing someone is not that easy and subject to official complaints.
With the new vogue of airbnb, many tenants now put their apartment for rent to tourists. Some have even started small underground businesses that way. It is not legal but they do it anyway. So they make money (more than you with little risk) by transforming your apartment buildings into hotels.
A rental apartment owner must be willing to deal with and face difficulties and problems. But with a little bit of luck, a lot of competence in performing proper due diligence, market analysis and tenant selection, investing in real estate can be rewarding and extremely profitable!
It’s just not for me… for now! But it might be for you!
If you want to know more, check Ken McElroy’s book. It’s a book I enjoyed reading back in the days.
Good luck with your investments and I hope you’ll soon become a real estate investor apprentice!
Want to know more about the subject?
Image courtesy of Stuart Miles / FreeDigitalPhotos.net