I get asked all the time by potential real estate investors how much they should invest in a rental. They do not want to be a line item on the “Why Real Estate Investors Fail” sheet. Some want to take a 401K loan out. Some want to bypass their 401K contributions to save money for real estate investment. For some reason, saving money seems to be difficult for many potential investors.
I say, do not do anything that may run you short of capital for your own life. Make sure your own life is secure, before you risk it all.
Here are some thoughts that I have written down.
Why Real Estate Investors Fail
It is not cheap to invest in real estate. In all of my rentals, it required a minimum of $100K just to ante up to the table. A 25%+ down payment was required for a non-owner occupied investment. After that, it required some fix up expenses. Painting, appliances, carpet, etc. were all more than I wanted to pay at the time.
If I did not have the capital to make the necessary improvements, I may have gone broke. If I could not recover from a bad tenant, I would be done. Never underestimate vacancy expenses either. If I could not pay the mortgage for months on end if needed I would be finished.
In one building, a 4-plex, I purchased, people told me that I could probably rent it out, as-is, for $800 a month. I explained to them that the people that would rent out this place for $800, I do not want. I wanted the people that will pay $1000 a month, for a fixed up place.
The Risk Premium Must Be High
Getting a lower return than the risk is a major fault of investors. If the stock market returns between 7% and 9%, and you can buy fairly safe dividend stock that return 3%-5%, why do some people buy real estate when the return is either less than 5%, or even negative? You can buy a REIT with a 5% return, and not have any work.
Stick to a minimum of 10% cash-on-cash return, or skip to the next investment. You may get lucky with appreciation, or depreciation, but you could have less risk in a MUCH safe investment. And it will be less work, and a lower initial investment.
Pay Yourself First
Never give up a 401K investment to invest in real estate. A tax deferred investment is worth a lot, especially if an employer matches some portion of it. If you have the ability to max out the 401K as I do, it does two things. First, your 401K account grows faster the more you put in it. That’s a no-brainer. Secondly, you learn to live on less. Passive income is what you are shooting for, why not start with a time tested idea, the stock market.
Then, max out your Health care Savings account, if you have one. Then max out your Roth or regular IRA.
And then, save for a real estate investment.
Understand Your Expenses (they will always be higher than you expect)
Far too many investors start to get nervous about cash flow and stop the improvements. Or they do not even realize they are that close to going broke. They are spending money hand over fist, and they take the first tenant that applies and the tenant was a scam artist or worse. Not much after that, they give up real estate. That is why you often hear of people who would not want to be a landlord “ever again”.
Mitigate Your Own Risk
Pay off your own mortgage. That gives you the freedom to explore riskier adventures. Get a HELOC on your own property to use as a temporary source of funds. That source of funds is not only cheap, it doesn’t cost anything if you do not use it. And if it’s large enough, you can make cash offers. Cash is still king in real estate investing.
Never chase an offer. Responding to a counter offer is OK, if the numbers still work. I passed on responding to a counter offer a $325K investment, only to see it sell just a few months later for $355K. The investor who bought it eventually might make money, but for now it is a lot tighter for him.
Learn some skills to preserve your capital once you own the property. Nothing eats up capital faster than paying some handyman $100 an hour to run a snake down a drain. Or paying to change out a light fixture or a simple light switch.
Vacancy and Maintenance
I do my own maintenance. Work always takes longer than you want to take, and fixes always cost more than you think. You start one fix, and it makes sense to fix the next thing while you are at it. You tear up the flooring, why not paint the ceiling and trim? You tear out the cabinets, it’s time to replace the counter-tops. Each month, the bank wants a mortgage payment, whether or not you have tenants.
I actually paid a painter quite a bit of money to paint an apartment, something I can do in less than 16 hours now. He took a week for each unit, I take two days, with lots of breaks. Looking back, this was money wasted.
Here are some painting tips I learned from a professional painter I worked with, and was a friend from a different life.
Paint out of a 5-gallon bucket with a painting screen. Pour in 2-3 gallons of paint in a clean bucket. You do not have to fill up the bucket near as often as a roller pan. That saves a LOT of time.
Use a 9” roller. No other roller fits in a 5-gallon pail. Sure, you can get a larger pail, but a heavier roller take more energy to use and tires you out faster.
Use a sheepskin roller cover, it holds more paint, and it has less dripping. It also cleans easier. Just drop the roller in a bucket of warm water, let it sit while you clean up the rest of the tools, and rise the roller cover out. Simple.
Tape only the horizontal lower edges of the painted areas, the rest you can cut in. You should be able to draw a clean enough line near the ceiling, and paint doesn’t drip uphill. On the bottom edges, such as baseboard molding use tape, you cannot control the gravity action of the paint near as well.
Use cheap quality 1.5” masking tape, not any ‘blue’ tape. You do not need the tape to be safe removal after a week, you are going to remove it about an hour after you paint. It will save a ton of money, and stick better.
Use a quality brush, like a Purdy to cut in the edges. I use a 3”, straight, swain brush. It is quite a bit thicker than a regular brush. It hold more paint, so less going back to the can to re-fill the brush. That saves time.
Use a paint roller extension handle. I use a 3’ handle. It allows me to roll a wall right close to the ceiling, and not have to extend my arms way up over my head. It also allows me to dip my roller in a bucket on the ground without bending over.
Use a long, but narrow, quality drop cloth – made from cloth. Slide it along as you paint the wall. Often, you will be spending as much time moving the painting cloth as you do painting. My cloth is 5’ x 15’. It takes about 5 minutes to cover the 15’ and it’s time to move the cloth again. Do not use a plastic cloth, they always get twisted and torn. And they catch on your feet when you walk on them.
Get rid of any fancy “cutter inners”. Use a brush. Spend the money on a quality brush and get rid of the gimmicks.
Do not use a fancy masking tape holder. Just pull the tape off the regular tape roll. The only exception is if you tape off a place with taping paper. I have a 3M masker that applies tape to a roll of brown paper that works great, especially if you are spraying paint.
Have you thought about investing in real estate? Do you think it’s easy to make money in it?
I have thought about investing in real-estate, not because the money is easy, but because the reward is potentially higher. As you say, if stocks can provide decent returns, it takes only a few clicks to start and maintain the investment. But with real-estate, there’s the search, acquisition and rental phases that need to succeed to make the investment work.
I want to start with my first RE deal next year, once I have confirmation that my job won’t transfer me to some random country.
In the meantime, I’m building a cash reserve and learning about the topic.
Great advice. I especially like where you said, “You may get lucky with appreciation.”
‘Lucky’ is the key word there.
Real estate agents and sellers love to entice novice landlords with the upside potential of a property, how much it can be worth in 2 or 5 years down the road. “Just think how much you’ll make,” is a common story. That’s all fine and dandy. But that mindset has never worked for me.
Just like you wrote, I want to know how much money I can make each month and how soon will it be in my pocket after I plunk down my hard-earned dollars.
George Lambert
Author, What You Must Know BEFORE Becoming a Greedy Landlord. How to build a portfolio of investment properties for an income that lasts a lifetime.
Thank you for reading George!
Those RE agents like to come up with all sorts of ways you can make money from this investment, after they get a commission, yet they very seldom have any real estate investments themselves…
These are great tips! So true that people always say “never again” after a bad experience.
I kind of disagree about the 401k part though – saving for a real estate investment is a version of paying yourself first. It is taxed advantaged, but in a slightly different way. Thanks to depreciation you likely won’t pay taxes on your yearly cash flow – the appreciation has plenty of options to not pay taxes on either. And there are no restrictions of accessing it before 65. I consider it part of the strategy, which one you fund first is up to each individual investor!
Thank you for reading Brian.
The problem of using your 401K funds is that you lose the ability to allocate funds in a more appropriate way. You are investing in a more risky asset, a 401K should be relatively ‘safe’. If you borrow the money, it must be paid back after you leave the job. You may lose any match if you do the real estate investment, rather than a 401K.
If you do it in a self-directed IRA, you have to farm out all the maintenance and management, according to the IRS.
I say fund both. I max out my 401K, max out my HSA, contribute to an IRA, and do real estate.
I agree. I guess I am approaching it from the perspective in their 20s or early 30s who doesn’t have a large 401k balance and is deciding how best to save. If they are interested in real estate, I wouldn’t say they have to max out a 401k before saving for a real estate investment. But you are right it depends on their risk factor.
Exactly. The 401K is forced savings, which is great discipline for some. Skipping a 401K contribution, I think too many people would save for a real Estate investment, and either not buy, or buy a property only returning 4%. So, they skip the 401K and spend it on ‘fun’, or earn less returns on a real estate investment.
Fantastic tips, thank you! I found the painting tips especially helpful as I’m considering repainting my home. On average, how much money are you saving painting your own apartment vs hiring a pro?
I probably save $500 or so. I know good painters, from a painting company, get $50 to $60 per hour. Handyman types are generally slower, and get $30+ per hour.
I figure if someone is going to get $40+ per hour, it may as well be me.
I’m always blown away by the 1% per month rent rule, I don’t know anyone in Canada who gets anywhere close to that. Typically landlords subsidise the tenants to a large degree.
I live in Germany and typical yeilds are in the 3-5% range but with some important differences. The bulk of the rental costs (i.e. Condo fees) are passed on to the tenants and more importantly tenants are generally expected to return the place freshly painted and spotless clean. We’re moving out and it’s going to cost me a 1000€ to get the place painted, even though it’s tax deductable it still sucks. Generally speaking German real estate is get rich very slowly. And lime everywhere It’s all about location location location.
Thank you for reading!
If you are subsidizing a tenant, it’s time to get into a different business. Odds are, real estate investors are making money, and the mom & pops are losing. It is about location, but also about buying distressed properties at the right price.
What a great post! I agree with you and have been using the same 10% minimum cash-on-cash return threshold. If it doesn’t at least hit this mark after taking into account vacancy, maintenance/repairs, property management, and the regular PITI, then I wouldn’t bother with taking on the riskier real estate investment.Also so true how much capital expenses are needed upfront when acquiring a property. These costs can be quite significant. I
I will say that regarding 401k loans, the rules vary widely and it really depends on the employer plan. At my company, I don’t have to pay my loan back in full if I were to leave my company. I can just keep making payments until it’s paid off or pay it off early as well with no penalty. It’s one of the cheapest loans I’ve come across where I pay 4% interest, but my fund will earn 3%, so the cost is really only about 1%. I can’t get this rate anywhere else. Forget private money or a hard money loan. Plus, at a time when stocks are at all time highs, I like to think that my borrowed money earning a steady 3% from myself is quite safe.
Thank you for reading!
You summarized it well. Buy right, use a cheap source of money, and you will be OK.
I would add, never listen to a realtor. I remember when I first started investing, and the realtors who would give me pro-formas that are clearly from a different planet. Somehow they never had any maintenance expense, even painting, or vacancy, or ever a scammer tenant.
Then after ignoring all the costs, these properties would either break even or “cash flow $100 a month”. So glad I had read more online and had a better idea of costs.
I see listed on the MLS every day, buildings for sale where the rents won’t cover property taxes, maintenance, insurance, mortgage interest. Anyone who buys these buildings will only make money if they get lucky and the value rises.
Bad tenants are not bad luck, they will happen. You can screen, and be diligent, but just need the numbers to work. Equally leaking plumbing, new roof, air conditioning going out on hottest weekend of year, etc. None are bad luck, just a cost of doing business. Good landlords know this, and make the numbers work at purchase.
Thank you for reading!
They are in the sales game. I have seen a small apartment use a number like $600 a year maintenance. Most skip vacancy rates. Most assume management is free.
Hey NNL,
Very solid advice and points, has been a learning curve for us, but fortunately civil construction experience (from work) and finance experience (also from work) has helped a lot. Still make a couple of mistakes, but small ones fortunately.
But due to the completely different market conditions and tax regulations, not all your points apply to our situation. Still, great read, thanks!
Cheers.
Used your painting advice to clean up our workflow. Me and the wife painted a 1200sq 2bd 2bth in 2 days. This included spraying the ceiling, in other words we painted everything. Also replaced all the plugs and wall switches. They needed to be done since we just purchased the property didn’t think we could do it! Loved the article!!
Got a question. Just took over ownership of a duplex. Our general rule of thumb is to vacate a just purchased property and do all necessary repairs and upgrades to get the type of tenants we want to attract. The rental market is hot so here is what we did. We had to honor the leases that where in place after taking ownership. Upped the rent from 1000$ To $1200 as it was way under market and the tenants gave notice. Didn’t really advertise the unit was available at 1200$ but came across what we hope will be a good tenant. I feel I could have gotten even more for rent if we where to hold the unit off market a month why I do neccasary upgrades like granite, new baths ect.. All these upgrades would be less than 5k all done by myself. Is spending 5k to get an extra 200$ Per month holding unit off market for a month? Don’t think we would be attracting better tenants just puts us in a higher end rental market.
Thank you for reading! I am glad I can help out.
Spending $5K to get another $200 takes ~5 years to recoup the extra expense, less labor. If you can get a no-headaches tenant, you may find the payoff well within the first year. With a duplex, why not keep the best tenant, and remodel the other side while you still collect some rent. Once one unit is complete, then move on to replace the second tenant.
Make sure you have a desired tenant quality in mind, as indicated by income, credit score, criminal history and rental history.
Why is it ~5 years.. seems ~2 years to recoup? We have 2 rental properties and looking for 1 or 2 more before year end. The two are 10% LTV and 50% LTV. We are going to do a cash out refi on #1 and it will then be ~60% LTV. We will use that money to buy two additional properties. We both work and yearly income of $200k on corp jobs only. The issue I have is that rental prices in Dallas don’t seem to be catching up to the dramatically increasing home costs. Each home produces ~$500 net cash flow after all expenses/budgets (after the cash out refi). These new homes might only produce $200 net cash flow (homes around $200k and rents around $1700). No state income tax in TX but higher property taxes. Property tax is about $4200 on these. We have a normal goal of retirement age. We are 39 and 47 with goals to retire in 15 years max. Do you feel like a retirement planner yet? I guess the question is: is $200/mo cash flow ok and do you see rents usually pick up relatively soon after increases in home prices. We do have an agent to provide comps. Any concern with the cash out plan?
Thank you for reading!
My rents were basically flat for over 10+ years. From 2000 to about 2013 or so. $200 maybe OK, $2400 per year, if that is over 10% of the amount you have invested. I am guessing that you have a lot more than $24,000 of cash money invested. You can stretch it a bit by adding the principle part of the mortgage payment, but that is pretty light.
Thx for the reply!
You touched on something that most novice real estate investors fail to do, and in my opionion another reason why they fail. I think it’s one of the MOST important things you must do before you even began to start looking for a property. You mentioned “desired tenant quality”. Man was this a hard lesson learned! Cost me100k. 😉 Most starting out fail to define their desired market. First and foremost landlording is a business! You MUST define your market as in what type of tenant you want. The more specific the better. You must know where this type of tenant lives, works, plays, goes to church, eats and sleeps, ect. If I was starting out fresh I would join a Landlord association and befriend someone with a portfolio I’d admired. Ask him if he would take you on a tour of his portfolio and ask him to describe his ideal tenant. You would be surprised, landlords like to share knowledge. This is a quick way to find out how much of an ameatur you really are and will learn far more in 2 hours with him than reading anything in a book. After you buy your first place and have rented it out several times you will have even more of a clearer picture of your “type” and how to attract them.
I love the painting tips. LOL 🙂 I’ve been painting the decks. I did notice with the pan, I have to pour out more often so I opted to have it in the bucket. LOL 🙂
Some of the landlording issues are subsiding, I’m still finishing up some painting, but I won’t pick more projects until next year or so. Thanks for the tips!
Cheers!