Starting out in real estate investing

Real Estate investing can be daunting when starting out. The natural tendency is to look online for information. Some sources, such as Bigger Pockets, are credible. But it’s important to not drown yourself out in information. I will touch upon some important basics.

The first thing is due diligence. This is what makes or breaks the deal you are conducting your due diligence on. For larger properties that involve institutional investors, we look at Annual Cash Flows- Property Level, Institutional Cash Flows Base, Investor Cash Flow Refinance, Year 1-5 Pro Forma, Closing Cost Analysis, Monthly/Yearly Cash Flows, Unlevered Returns, Lever Returns Property Level, Returns Net To Investors, etc. It gets complicated. We use our own proprietary underwriting model which has more than 30 sheets in excel with hundreds of formulas. It’s something we discuss in great detail in our strategy session. For ex. if the rehab involves 300 units, you need to know how the returns will be affected as those units are rented out post rehab. It gets messy. But for smaller properties this level of analysis is rarely necessary.

Another critical factor that will determine returns is property management. Most investors of dream of being absentee owners, but the reality is that you will have to be more involved than you think. Many owners choose to manage their own properties, which is fine. But it’s all about your goals and the income you seek. However if your goal is to eventually form a real estate syndicate, you will have to work with property management firms. My partners however own the property management side as well. The benefit of that is they control quality of the operations rather than depend on a 3rd party firm. Property management is generally not a very lucrative business.

For rehab projects you need to be aware of how to work with a general contractor. Often times they will under budget and underestimate the time needed to complete a job. This is bad because it hurts your bottom line. If the property is not habitable, that means you spend more time without collecting rent. My partners who control almost 1,400 units also control the construction side. The benefit of that is we again get to control the quality and also make money on the construction side.

Lastly, as a landlord, you need to know how to find good tenants. These is a screening process that we use when offering our properties to tenants. One of the basic principles is rent to tenants who have something to lose. For ex. any tenant who has a good job, decent or better credit, etc. will not leave your property in a bad condition, abandon it or avoid paying rent. If you rent to deadbeats, you can expect a lot of problems. Quite frankly it’s surprising to hear stories of landlords suffering. Sure, once in a while a bad tenant will slip through the cracks. But often times it’s a pleasant experience. We rarely have had to evict a tenant. But again, it also depends on the type of property you own. If you own a Class D apartment building, you are generally catering to the more blue collar tenant and as a result you can face slightly more problems than renting out to a young professional at Bank of America.

Value of a Mentor

Let me be upfront and say it out loud: It’s scary to start alone because these properties are often times a couple of hundred thousand dollars or more. Most times are people are not able to muster the financial commitment needed. But what really creates fear? If you know exactly what you are doing, would you still have the same amount of fear as a novice? No. You would push ahead. You need to understand every little aspect of real estate investing to avoid the deadly pitfalls. Lack of knowledge makes you think, “what if it doesn’t work? I’m screwed!”. And it’s true, you could ruin yourself.

But how do you learn about real estate investing? By reading books and blogs? Sure, you can get a baseline level from these sources. But just like anything in life, you will learn best by doing with others who have done it before. I started with partners who provided capital. My current partners run real estate syndicates who manage several thousand units and have half a dozen analysts working for them. Would it be easy to learn the industry by working with me and my partners. Sure. I’ve even taken on mentees, but the problem is they expect us to do all the work. Everyone says they are highly motivated. But the moment the going get’s a little bit tough, they bail or expect us to do all the work. We get it, the idea of having cash flow from rental properties is very appealing. But it’s not easy. It’s a competitive business.

First, let’s understand the mentor-mentee relationship. Should a mentor just give and mentee receive? Is it a one sided relationship? It’s not. Often times, we think that a mentor will provide capital, knowledge, guidance, advise and everything else that comes along and all we have to do is absorb. That’s far from it. Mentors are often busy. I run my multi-million property business and I’m looking to grow it. I hardly have time to bring someone on board who will not add any value to my venture. My partners are even busier. Why should we take on anyone who says they are highly motivated? A mentee needs to add tremendous value to bring the relationship close to equilibrium.

What should you look for in a mentor? In short, someone who has done it and is living the life you want to live. Now specifically talking about real estate, they need to have experience building a portfolio, they need to have capital, knowledge and experience. It takes years to develop skills. I’ve spent more than a decade to get to where I’m at. In the real estate industry, there are many “services” offering training for thousands and thousands of dollars, some charging $20k+ just to teach you things you can learn over time with a mentor. Don’t fall for that. You want to work with a group of people who are as motivated as you are. If your goal is to build a portfolio of assets, you need to work with people who have the exact same goal.

You have to keep in mind, mentors are busy. They are viewed as mentors by you precisely because they are successful and running their own businesses. I have been fortunate to put a group together where we continually build portfolios all around the country. I’ll talk more about this at a later time. But hopefully at this point you should realize that you don’t need to spend $20k dollars to learn or attend annoying “free seminars” where at the end the vultures try to sell you. Find a group that has a similar goal as yours and if luck has it, a mentor will be involved.

Adding Value Through Rehab

It’s important to know which rehab work will add value to your building. If you look at my properties, I’ve spent a lot of time and money making them look amazing. Why? Because that gives me a competitive edge over others in the neighborhood and it allows me to charge more in rent. By doing this, I also attract better quality tenants who will leave the place in almost a perfect condition as they found it. That’s important because I spend less money to bring it back to rentable condition. And when I do eventually plan to dispose off my property, I will get good value for it. Sure there will be minor repairs and work that will be needed, that’s natural. I will share these strategies with you another time. The purpose of this chapter is to talk about the overall work we need to execute upon to add value.

One of the things I like to add value with is by creating more livable area. This is especially useful in regions where multiple tenants tend to share a unit. This is why I like to buy buildings that need a lot of interior work because I get to redesign the interior and add more livable area. This means I get to collect more rent. Sure, it makes the rooms a little smaller, but in densely populated regions, this won’t be held against you.

I always start with kitchen and bathroom. Now you don’t need to go overboard in creating kitchens and bathrooms that look like model homes on HGTV. But good enough. What’s good enough? Slightly better than the ones in your neighborhood is a good place to start. It’s important to plan these things out before letting your contractor begin. You need to be well educated on how the various moving parts work: cost of labor, cost of material, time, etc.

It’s important to make sure your rental property conforms somewhat to the neighborhood you are in. If you do something over the top, such as painting each room with a different color or adding funny tiles to the kitchen or bathroom, you can even take away from the value. I mentioned earlier about adding livable area, it’s important to keep it in line with the property and that it fits. If you simply add a unit for the sake of it and it doesn’t mesh with the overall property, you will be taking away from the property, not adding value. Additionally, when you sell the property you will not be able to count the additional room as a bedroom, unless it meshes. So it depends case by case.

Rehabs are often intimidating to new landlords. If you are completely new to the rental property business, start with properties that need a little work. Fix them up. Don’t go overboard. My partners and I are experienced with very large apartment buildings (1,000+ unit buildings) and even we don’t go overboard. A 1,000 unit uninhabitable building would be overwhelming even for us. Mass rehab projects are usually ideal for smaller rental properties. If you are in the market for a 150+ unit building, don’t go for a building that’s uninhabitable. The units should be rentable, but still needs work that can be done concurrently. This means you will have rental income coming in and you can reinvest that income into work by working on a block of units at a time. This is what my partners do on their large apartment complex projects.

Leveraging Debt in Real Estate Investing

There is a different between bad debt and good debt. Bad debt includes things like credit card debt, student loans or any other type of consumer loan. Even your car note should be paid off as soon as possible. Good debt is real estate debt. That’s where you leverage a dollar 4-5 times to control more real estate. The more real estate you control the more rental income you generate.

Currently I have mortgages one all my properties. But I don’t mind it at all because they are cash flowing beautifully. Had I paid cash for my properties, I wouldn’t be able to own as much real estate as I do, which would mean less rental income.

Now the question is should you take an ARM (adjustable rate mortgage) or a fixed rate loan. I prefer ARM because over the course of the whole term it turns out to be a cheaper option. A lot also depends on the economic condition. During the housing bubble a lot of people abused the system to buy houses they couldn’t afford. They took adjustable rate mortgages to buy the most house for their dollar. These notes often had teaser rates with appealing payments for the first 6 months to 1 year. However, things turned sour as those introductory rates expired and people were no longer able to afford the payments. It’s for this reason that ARM gets a bad name. Again, if you are knowledgeable about what you are doing, you can avoid the common pitfalls that ignorant people would make. Don’t be that person!

Another important issue to discuss is making the lowest possible monthly debt service payments. Why do we invest in real estate? For the most part, the monthly cash flow. Therefore, your goal should be to reduce the expenses and debt service as much as you can. So when you apply for a loan, you need to go over the amortization schedule to see what the monthly payments will be. You should shop around for the best terms (interest rate, amortization, closing costs and term). All of these will ultimately impact your returns.

Should you apply for a commercial loan or a residential loan? It depends on the type of property you are purchasing. If it’s less than 5 units and owner occupied, you will get a residential loan. If it’s 5 units or more, it’s a commercial real estate loan. Commercial real estate loans are very different from residential loans. There are a lot of details one needs to consider which will be discussed another time. For this, you need to understand real estate finance. It’s not as simple as saying “here’s my down payment and this is my mortgage”. There are a lot of terms and conditions one has to deal with. My partners own two buildings each with 1,094 units and 288 units. They have commercial loans on the those properties. It’s a different mechanism to finance a commercial building than a small multifamily building. But even in that case, the goal is to reduce the monthly payments because we are in this business for the cash flow.

In conclusion, there are lot of things that go into financing a property. It’s crucial to get properly educated to avoid making mistakes that may bankrupt you or provide low quality returns that discourage you from further real estate deals.

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Risks of Investing in Real Estate

One of the best ways to reduce risk is to always try to buy below market value. You want to be able to build in equity immediately. This is why you buy properties that need work and look ugly. I typically like to build 20-25% instant equity. But these deals are hard.

When you acquire your new building, you need to factor in rehab costs, closing costs and have a buffer of about 10% (depending on the type of deal) for what may go wrong (time and cost wise). You need to remember that you may not be able to rent the house out immediately. These are all things you need to be aware of before you jump in. You need to be aware of market rents and the costs you will face in running the property. At the end of it, if it’s cash flowing positively, it’s a win-win. I will cover cash flow another time.

Another thing to keep in mind is the age of the property. The older the property, the more the risk it has and it will naturally require more capital for repairs. Now age depends on what part of the country you look at. For example, if you want to invest in the Northeast, buildings will generally be 75-100 years old or more. But if you invest in Texas, as my partners do, you don’t want to go older than 50 years or so.

Some of the other more common risks with rental properties are having bad tenants who damage and vacate your property in the middle of the night. But this type of risk can easily be mitigated by investing in generally decent areas and screening for tenants. Don’t let your friends or family who have never invested scare you by saying that bad tenants are a reason to never invest and are not worth the headache. Those are pains any landlord can face. It’s all about knowing your options and dealing with those problems. Just know what you are getting yourself into, be knowledgeable and have a plan.