An aspiring rental investor named Derick reached out to us for advice, as he starts down the road of buying income properties. His questions touched so many issues faced by new investors that we decided to answer him publicly, in the form of a blog post!

Derick also submitted two deals he was evaluating, and asked for our feedback about them. We kept it real with him, and walked through what looked good – and not so good – about his analysis.

The exact city in Florida where Derick is looking, and his last name, Derick asked us not to share.

If you’re new to rental investing, we’re pretty sure you’ll benefit from these questions and answers too!

 

Derick’s Scenario & Questions

Hi Brian,

I came across one of your articles on BiggerPockets and discovered your website. I am a new real estate investor currently in Chicago but looking at investing in some other locations. I’d love to connect and ask you a few questions about getting started!

My goal is to acquire 25 rental properties (single-family homes, duplexes, etc.) which will allow me to live off the cash flow. I would like to take on a more passive role once the property is acquired.  

I have an accounting background, so I plan to help run and understand the finances. I am partnering with my father who has an engineering background so he will be more involved in understanding the quality of the properties. We’re looking in central Florida as we identified the area as a good market based on a number of criteria.

Right now, I own my home without a mortgage. What is the best way to finance new properties? I know banks are more hesitant to approve investment loans, but can I just get a regular mortgage since I don’t currently have one? Can I just go to a regular mortgage broker, or do I need to go to someone who specializes in investment properties?

I’d consider taking a mortgage on my home to provide me more cash for investment purposes.

I plan on buying through an LLC. How does that affect getting a mortgage? Do you recommend having each property in a separate LLC? That seems a bit much.

Finally, I put together a budget on 2 properties I was looking at. Can I get your feedback? It doesn’t look very promising as the cash flow is low, low cap rate, etc. Am I totally off?

Thanks for your help!

Derick

 

Derick’s Prospective Deals

Property A Property B  Notes
Rental Income $1,600  $1,800
Property Value  $206,000  $259,000 Assumed purchase price with closing costs
Down Payment  $41,200  $51,800 20% down payment
Mortgage  $164,800  $207,200
Mortgage Payment  $758  $953 Assumes 3.75% interest rate
HOA  $233  $244
Taxes  $223  $281 At 1.3% of property value
Property Mgmt  $155  $174 8% plus 50% for new renter once every 30 months
Repairs/CapEx  $112  $126 At 7% of rent
Vacancy  $53  $60 1 month out of 30
Total Expense  $1,534  $1,837
Cash Flow  $66  $(37)
Annual CF  $789.04  (448)
Cash on Cash Return 1.92% -0.87%
Cap Rate 4.80% 4.24%

 

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Our Thoughts

Hi Derick,

Congratulations on taking your first steps toward passive income from real estate! Before you do anything else, we recommend taking our free mini-course on passive income from rentals.

Before getting into financing, it’s worth noting that investing out-of-state, especially as a first-time real estate investor, comes with challenges. In our passive income course, we recommend getting to know a neighborhood intimately before investing in it.

Because you live out of state, you’ll also probably need to hire a property manager. Just something to keep in mind.

 

Financing

The cheapest way to finance your initial property purchase(s) is by borrowing a mortgage against your primary residence. Be aware however that if you default, it’s your home that’s on the line, not the rental properties!

Alternatively, you could go the more traditional route of using investor purchase financing. For your first three or four properties, you can use conventional financing for investment properties, which typically requires 20-30% down. The interest rate will be higher than an owner-occupied homeowner mortgage, but lower than most alternative financing options.

If you buy properties that need repairs, you may need a hard money loan.

After your first four properties, conventional financing becomes more difficult. Fannie Mae does have a program for landlords with 5-10 properties, but it has strict guidelines. There’s a firm minimum credit score of 720, and down payments for single-family homes start at 25% (30% for 2-4 unit properties).

Crowdfunding and peer-to-peer loans are another option. They are more expensive than conventional mortgages, but don’t have the same limitations on the number of mortgages you can carry.

Lastly, portfolio loans from local community banks are often your best option, after your first few mortgages.

 

LLCs – Good Protection or Unnecessary Complication?

Owning properties under a legal entity will make financing that much more difficult. Still, many community banks are willing to lend to LLCs, for loans they intend to keep in their own portfolios. They’ll make you sign a personal guarantee, heads up.

I personally believe that the protections of LLC ownership are rather flimsy and overstated. And they come with downsides: besides the extra wrinkles they add to your financing, they come with annual fees, and of course they complicate your accounting and tax return.

With that said, the benefits are greater when you share LLC ownership with a partner.

If you want to ask questions directly to an attorney, without breaking the bank, here’s where you can do so:

Answers range from free to $80 I believe, with an average attorney answer costing around $40.

In addition to deciding whether you should use an LLC, you should also determine whether to use an Illinois or Florida LLC. With you living in Illinois, but the properties being in Florida, that’s an important question.

 

Property Analysis

I’ll be blunt: these are both bad deals.

But before we get into specific problems, you included all the major expense in your cash flow calculations, so great job there.

Starting with the simplest problem, neither of these has a very high cash-on-cash return. You’d be better off investing in a mutual fund. You’d potentially earn a higher return, and for far less work.

The properties’ cash flow is also far too low. Property B even has negative cash flow! Definitely not acceptable. As for Property A, the hassles and risks of owning a rental property are not worth a mere $66/month.

Worse yet, the calculations have some suspicious assumptions. Your interest rate assumption of 3.75% is very low, for starters. That’s the kind of interest rate that owner-occupied homebuyers with excellent credit would be lucky to nab. I would expect to pay between 5-7%, and those are still good interest rates for an investor loan.

The down payment of 20% is also a best-case scenario. You may well need to put down 25-30%, which bodes even worse for your cash-on-cash returns.

You were smart to include the vacancy-filling fee in your property management expenses. But unless you’ve already vetted and decided on a property manager who’s agreed to 8%, you should probably use higher numbers. That 8% fee is on the lower side for property management fees, as is 50% of the rent (it’s often a full month’s rent).

And then there’s the vacancy rate – a one-month vacancy every 30 months is a vacancy rate of only 3.33%, which is low. Granted, some markets are strong enough to support such a vacancy rate, but that’s an assumption worth researching further in your target neighborhood.

As a parting note, 7% of the rent is probably not enough to cover repairs, maintenance and CapEx.

 

Last Thoughts

Don’t get discouraged. You’re on the right track, and you’re identifying the right expenses when forecasting rental cash flow. Finding good deals isn’t easy, especially from afar.

You might consider looking closer to home, perhaps within an hour of where you live, for your first deals.

Talk to an attorney before committing to an asset protection strategy.

Maintain a high standard for cash flow and return on investment when evaluating potential rental properties, and if you stay disciplined, you’ll find that it’s difficult to lose money. If you get impatient and buy a property that is not a great deal, it’s difficult not to lose money.

Keep at it, and keep us posted on your progress!

What questions are you working through? Don’t hesitate to reach out and ask; maybe we’ll feature your questions next!

 

 

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